"Living with Uncle Sam"

 Samantha Prasad LL.B.

Tax pitfalls may cast a dark cloud over your sunny southern lifestyle

South-bound snowbirds seeking relief from Canada's seemingly endless winter may find themselves encountering some frigid tax rules en route to sunnier climates. Although you may consider yourself a resident of Canada, and you've duly filed your Canadian tax return as you do every year, you should be aware that if you spend a substantial portion of the year in another country, you may be found to be resident in that country for tax purposes. This can, in turn, lead you to more tax headaches than you imagined. For example, if you are found to be resident in the U.S. for tax purposes, you will be taxed in the U.S. on your worldwide income in much the same manner as a U.S. citizen. That means you will be required to file a U.S. tax return and pay U.S. tax on your income from all sources.

 Residency Rules

Specifically, you will be resident in the U.S. if you meet either the lawful permanent resident (or green card) test, or the "substantial presence" test. Under the first test, if you have a green card, you will be treated as a U.S. resident, regardless of whether you are physically present in the U.S. The second test, however, requires a little more analysis.

Under the "substantial presence" test, you will be considered a U.S. resident if you spend a substantial portion of the year in the U.S., calculated as follows:

• you have been in the U.S. for more than 30 days in the current year; and
• if the total number of days you spent in the U.S. during the current year, plus 1/3 of the days you spent in the U.S. in the last year, plus 1/6 of the days you spent in the U.S. in the year before last equals or exceeds 183 days.

You can, therefore, spend up to 120 days each year in the U.S. without crossing this threshold test. In calculating the number of days, you should be aware that a partial day in the U.S. counts as a full day, although you can exclude days that you were in transit in the U.S. (for less than 24 hours) on your way to another foreign country. As well, you may be able to exclude days spent as a teacher, trainee, student, or professional athlete competing in certain charitable sporting events in the U.S.

If you meet the above "substantial presence" test, you will be subject to U.S. tax and filing requirements. This will be so, even though you may also be a Canadian resident and pay Canadian taxes. If you are considered a U.S. resident you can try to extricate yourself from the U.S. by either claiming the "closer connection exception" allowed under the Internal Revenue Code or claiming a treaty exemption.

To claim the "closer connection exception", you have to establish that you have closer connections to Canada, such as:

• maintaining a permanent home in Canada (no need to own; you only need continuous access), as well as personal belongings
• having family in Canada
• being employed in Canada, or carrying on business in Canada
• banking, and holding investments, in Canada
• voting in Canada
• participating in social or religious organizations in Canada

You cannot, however, claim this exception if you spend more than 183 days in the U.S. in the current year or you have applied for a green card. If you can't claim the closer connection exception, there are "tie-breaker" rules under the Canada-U.S. Tax Treaty. For example, if you have a home available to you only in Canada, you can claim residence here. However, the likelihood is that you may own property in the U.S. (or will be tempted to purchase what with the depressed Florida real estate market) so you most likely don't get off that easily. Accordingly, you would then look to see where your centre of economic interest lies, and claim residence in that jurisdiction.

Note: You will be subject to certain filing requirements in the U.S. in order to claim any of the above exemptions. Care should be made to ensure you have filed the appropriate forms and that they have been filed by the deadlines.

 Rental income

If you own a winter home in the US, chances are that you may be renting it out during the summertime to help offset costs (especially if the home is sitting empty for that part of the year). However, if you do so, you should be aware that in the U.S., withholding tax of 30% normally applies to the gross rent paid to you. This withholding tax is not reduced by the Canada-U.S. Tax Treaty (unlike withholding taxes on interest and dividends).

You can avoid this withholding tax by voluntarily filing a U.S. tax return and electing to pay the tax on the net rental income. It may be advisable to take advantage of the net rental income election if you incur expenses in respect of your U.S. rental property, such as mortgage interest, maintenance, insurance, property taxes etc., by deducting such expenses (yes, you can deduct mortgage interest payments in the U.S.).

This election can apply for future years and applies to all of your rental real estate in the U.S. On your U.S. return (1040NR) you would show the income and expenses, as well as the amount of tax withheld. This may also allow you to receive a refund for any taxes withheld (to the extent the withholding amount exceeds the tax payable).

To make the net income election you must file a 1040NR, including a statement declaring that you are making the election. The election should include the address of the property and your percentage ownership. The 1040NR is due by June 15th of the year following the calendar year in question (subject to any extensions). Once the election is made, you should provide Form 4224 to your tenant and the 30% withholding will not be required.

 Sale proceeds

If you decide that in the bottoming out US market that you want to sell your "home away from home" while you can, withholding tax of 10% of the gross sale price is normally payable under the Foreign Investment in Real Property Tax Act ("FIRPTA") at the time of sale. In addition, you will still be required to file a US tax return for the year of sale as the US has the right to tax nonresidents on the sale of real property in the US. The tax withheld under FIRPTA may be offset against the U.S. income tax payable on any gain realized on the sale (or refunded if it exceeds the income tax liability) that you will have to report in your US tax return. Note, however, that the tax under FIRPTA may be reduced or eliminated in certain circumstances:

1. There is no withholding requirement where

a. the purchase price for the property is under $300,000(USD), and

b. the property is acquired by the purchaser as a home, with actual plans to reside in it for at least 50% of the time that the house is occupied in the first two 12 month periods after purchase.

2. The withholding tax can be reduced if you obtain a withholding certificate from the IRS on the basis that the expected U.S. tax liability on the gain will be less than 10% of the sale price. The certificate will indicate the reduced amount of tax that should be withheld.

On a sale of your real estate, you will need to provide an Individual Taxpayer Identity Number ("ITIN") to the transfer agent. This is so, even if there is no withholding tax due. The sale cannot close without both the vendor and purchaser providing an ITIN.

As mentioned above, if you sell your real estate, you will have to file a US tax return to report the gain (with a credit that may be claimed for tax withheld under FIRPTA). In the U.S., the capital gain by an individual is currently 15%. If you have owned the property since before September 27, 1980, you can take advantage of the Canada-U.S. Tax Treaty to reduce the gain. In this case, you will only have to pay tax on the gain that accrued since January 1, 1985 (this does not apply to business properties that are part of a permanent establishment in the U.S.).

To claim this treaty benefit, you have to make the claim on your U.S. tax return and include specific information about the sale. Any U.S. tax paid on the sale of the property will generate a foreign tax credit which you can use to reduce your Canadian tax on the sale (courtesy of the Treaty). Note: This tax credit may be limited if you use your principal residence exemption to reduce your Canadian gain.

U.S. Estate Tax

If you continue to own the U.S. property until you pass away, U.S. estate tax will apply that can range from 18 per cent to as high as 45 per cent. However, under the Treaty, there is currently a USD $3.5 million exemption available to Canadians in 2009 based on world-wide assets, although this exemption is prorated based on the ratio of the value of U.S. situs assets compared with the value of the estate as a whole.

 Happily, you can take advantage of a unified credit that is available. This credit, currently, is equal to the greater of USD $13,000 and $1,455,800 x (the value of your U.S. assets / the value of your world wide assets). So, if your U.S. assets represent 20 per cent of your worldwide assets, you will be entitled to a credit equal to $291,160 ($1,455,800 x 20 per cent).

Interestingly enough, under the current U.S. legislation, U.S. estate tax is to be repealed for 2010, but then re-introduced in 2011 at 2001 historic rates, such that the unified credit will be reduced to $345,800. Note: The Treaty also provides for a marital credit where property is left to a surviving spouse.

One may also want to consider a non-recourse loan on the U.S. property which could reduce the value of the property for U.S. estate tax purposes.

Samantha Prasad, LL.B., is a tax partner with the Toronto-based law firm Minden Gross LLP, a member of Meritas Law Firms Worldwide, and a Contributing Editor of The TaxLetter, published by MPL Communications. Samantha can be reached at sprasad@mindengross.com or at 416-369-4155.

 (c) Copyright 2009 MPL Communications Inc. Reproduced by permission of The TaxLetter 133 Richmond St. W., Toronto, Ontario M5H 3M8

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