With Canada and the U.S. sharing the world’s largest land border, it’s no surprise that many Canadians are interested in buying real estate down south. Whether it be a cabin to visit during the summer, a home to escape to during the brutal winter months, or purely an investment property, there are plenty of reasons and opportunities to invest in the U.S.
Such investment carries its own tax burdens that many casual investors may not be aware of, including some severe default tax withholding on rental income as well as sale proceeds. Below, we'll discuss issues including withholding tax and the Foreign Investment in Real Property Tax Act (“FIRPTA”). I'll note up front, however, that these rules are applicable for U.S. nonresidents/non-citizens only. If you're a U.S. citizen living in Canada, these rules may not apply.
Withholding Tax on Rental Income
For those planning on renting out U.S. real estate, there can be some nasty tax obligations. By default, a tax equal to 30% of the gross rental income applies and must be remitted to the IRS by the tenant or management company. That means that by default, the IRS gets to skim 30% off the top of your rents without any regard to your expenses of operating the rental property, including expenses such as depreciation. As you can imagine, this can be painful. Fortunately, there is a way around this.
First of all, a special election, called an 871(d) election, can be made to treat your rental income like regular business income. Why would you want to do this? The main benefit is that instead of getting taxed on the gross rents of your property, you instead get taxed on the net income of the property. Further, marginal rates kick in instead of the flat 30%, and these marginal rates are very often lower. This is almost certainly a win. The election is made when a tax return is filed.
This is all well and good come tax filing time, but what about the months leading up? Are you obligated to simply withhold the 30% and wait months to request it back from the IRS? Fortunately, there’s a way to avoid the withholding as well. By providing a completed Form W-8ECI to whoever sends you the rental income (e.g., the property management company, the rental platform such as Airbnb or VRBO, or even the tenant directly), you can relieve them of their obligation to withhold that 30%. That means more money in your hands in the meantime.
I’ll make one quick note on the above, however. Just because the tenant isn’t required to withhold if you give them a Form W-8ECI, that doesn’t mean you shouldn’t pay taxes. You might still need to make some estimated tax payment installments throughout the year to avoid IRS penalties and interest. Overall though, it’ll almost certainly be much less.
FIRPTA – Selling the Real Estate
When it comes time to sell the real estate, another withholding regime kicks in, regardless of whether you rented out the property or not. The Foreign Investment in Real Property Tax Act (“FIRPTA”) mandates that the buyer of the real estate withhold and remit 15% of the gross sale price to the IRS in most circumstances.
What does this mean? Let’s say you buy a property for $750k USD back in 2021 and you use it personally for a couple of years. In 2023, you decide you no longer want the property, and put it up for sale. It sells for $800k USD. Instead of sending you the full $800k, the buyer only sends you $680k. The other $120k (15% of $800k) went to the IRS. That’s a hefty chunk of change, especially considering the actual gain on the property was only $50k, let alone the actual tax on that gain.
There are a few ways to handle this:
1. Wait until next year and file a tax return – This is the path of least resistance, but it also may mean waiting months or even years to get your money back (you may think I'm exaggerating, but the IRS has been notoriously delayed as of late, especially when claiming refunds on excess FIRPTA withholding). It means filing a tax return and reporting the amount of actual gain as well as the amount of tax withheld at the time of sale. The difference between the tax withheld and the actual tax liability is refunded (or paid, if not enough was withheld).
2. Apply for a withholding certificate – This option is more involved, but it may mean you can get your money back much sooner. The mechanics vary depending on the timing of this application, such as if it’s done before or after the closing of the sale, but the gist of this option is to try and get your money back sooner. If you sold the property for a lot of money but are expecting a relatively small gain, this may be worthwhile.
One other thing of note is that some states have regimes similar to FIRPTA, but the availability of something like a withholding certificate may vary.
If you need help dealing with the U.S. tax side of investing in U.S. real estate, we'd be happy to help.
Please note that this post is informational only, and should not be relied upon as official tax advice.