Americans residing in Canada may not realize the extent to which the U.S. government's tax-filing rules for non-resident citizens hit home.
There's been a lot of attention in recent years on how U.S. citizens in Canada are being targeted by the Internal Revenue Service. Lost in all the commotion is a little known, long-standing rule concerning houses: If Americans living in Canada sell a house for a gain of more than $250,000 (U.S.) per taxpayer, they must pay capital gains tax on it.
The single greatest tax advantage we have in Canada is arguably that we can sell a house tax-free as long as it's a principal residence. Americans get a tax deduction for the home mortgage interest they pay, but they may also face a capital gains tax when selling a house at a profit. This applies in both the United States, and Canada.
"I call it a hidden tax – nobody knows about it," said Larry Jacobson, a Vancouver-based registered financial planner (RFP) with Macdonald Shymko & Co. who recently advised a client, a U.S. citizen, on the sale of a home owned by him and his wife. "He fell off his chair," Mr. Jacobson said in describing the client's reaction to a six-figure tax bill owed to the IRS (in U.S. dollars). "He said it puts a real damper on his retirement plan."
An estimated one million U.S. citizens live in Canada. Those affected by taxes on the sale of a home would be the long-timers who over the years have seen house price gains measured in the hundreds of thousands of dollars. Residents of the prime neighbourhoods in Vancouver and Toronto might see that kind of price appreciation in a fairly short period of time.
Wayne Bewick, a Canadian- and U.S.-accredited accountant with Trowbridge Professional Corp., said the first $250,000 gain on the sale of a house is exempt from taxes for a U.S. citizen, or $500,000 for spouses who are both U.S. citizens or where there is a Canadian spouse if the couple has elected to file joint returns in the United States. Gains above those thresholds are taxed at rates of 15 to 20 per cent, he said. A 3.8-per-cent Medicare surtax applies for higher-income people.
In Canada, we pay tax on 50 per cent of our capital gains (again, houses are an exception). Americans living in Canada would pay U.S. capital gains taxes on the entire amount of their house gain above the exemption amount.
If you're steamed about these taxes, just wait. Mr. Bewick said there's an additional and even more onerous tax rule applying to American homeowners in Canada. It concerns mortgages and the Canada-U.S. exchange rate at the time someone takes out the loan and pays it off or remortgages it. Listen up if you bought a house back when the Canadian dollar was worth more than $1 (U.S.).
In fall 2007, a $350,000 mortgage in Canadian dollars would have been valued at roughly $367,000 in U.S. dollars. Let's say you pay this mortgage off at some future date when the Canada-U.S. exchange rate is the same as was at the start of the year. That would cut the initial cost of that $350,000 mortgage in U.S. dollars down to about $298,000. As Mr. Bewick describes it, the IRS would view you as having made a gain on your mortgage of $69,000 – it only took $298,000 to pay off a debt of $367,000.
This gain would be taxed as ordinary income and would apply even if you have a loss on the sale of the home. Also, you can't offset a capital loss on the sale of a home against the mortgage gain.
The obvious question in considering the potential taxes for American homeowners in Canada is how the IRS can enforce the rules. Canada shares information with U.S. tax authorities, but virtually no one in Canada reports the sale of a principal residence on their tax returns.
Mr. Bewick said the IRS might be able to find out about the sale of a home through the Foreign Bank Account Reports that U.S. expatriates are supposed to file annually if they have more than $10,000 in financial accounts outside the United States. Reporting an unusually large bank balance one year would raise the possibility you deposited the proceeds of a home sale.
Mr. Bewick's advice to American homeowners in Canada is to discuss taxes with an accountant before they sell because there are measures that can be taken to at ease the damage somewhat. Many U.S. citizens in Canada don't even realize that their Canadian principal residence could be subject to tax by the IRS, he added. "It's kind of a time bomb there for people."