If absence makes the heart grow fonder, then being shacked up with your spouse during the COVID pandemic can be the straw to break the camel’s back. And for many couples it is. With rates of separation and divorce climbing, getting things aligned in terms of your tax situation is important. This is especially true if the couple owns real property south of the border.
I see many clients who don’t realize how different the tax systems are in Canada and the United States, and complications often arise. While we have foreign tax credits and the Canada-U.S. Income Tax Treaty, not being clear of how these systems work can mean double taxation.
Consider Canadians who own real property in the United States and are separating or divorcing. Some people think if one spouse retains the property, both parties can avoid paying taxes on capital gains but this is not the case. According to U.S. tax rules, if one party transfers the property to the other it is disposed of at fair market value. By the same token, the party who acquires the property also acquires it at fair market value.
Thus, even though no money is exchanged, the one parting with the property must pay a U.S. 15 per cent withholding tax, as per the Foreign Investment in Real Property Tax Act. That person must provide the funds to the other spouse who then remits the withholding tax to the Internal Revenue Service (IRS), along with all the required paperwork, and there isn’t much time to do it. The penalty for not meeting this obligation is US$10,000.
But it’s still not over. When tax season rolls around the next spring, the spouse who is transferring the property files in the United States a non-resident income tax return to report disposition of the property. The natural expectation is that this person will get a refund — the difference between the withholding tax and the actual tax — provided they have a U.S. tax ID (i.e., social security or Individual Taxpayer Identification number).
What about Canadians who own real property in the United States? This is where potential tax exposures come into play. In Canada, the value of the property at the time of the separation or divorce is the original cost of the property, unless one party elects to transfer the property at current market value. So, Canadians who own U.S. real property and are separating or divorcing will transfer the property (from one spouse to the other) with no other considerations and no tax to pay in Canada — at the time.
But the Canada Revenue Agency (CRA) will impose tax when the property is eventually sold by the spouse who is parting with it, and any gains made are computed according to how much the property has appreciated since the time it was initially acquired within the marital union. This is where it’s best for both spouses to be on the same page — even during a nasty separation or divorce.
The spouse transferring the property who thinks the Canadian default option is better may be creating a scenario of double taxation because they pay tax in the U.S. now and cannot recover it later through a credit in Canada. Bear in mind that both parties being in alignment on the tax situation can serve as a negotiation tool in the separation or divorce process for Canadians who own real property in the U.S.
The key is to match the timing of the transfer on both sides of the border. Why? The spouse doing the transfer would be responsible for U.S. and Canadian tax — for the appreciation of the property from the date of purchase to the date of transfer — while the other spouse would be responsible for U.S. and Canadian tax from the date of transfer to the day of the actual sale.
If the timing isn’t aligned, the spouse who is transferring will be responsible for U.S. tax for the same period and will not be responsible for any Canadian taxes. But the other spouse must pay U.S. tax on the gain from the date of acquisition to the actual sale plus Canadian tax on the gain from the original purchase date to the sale date. As Canadian taxes tend to be higher, this may cause more financial grief to the spouse receiving the property.
The best advice for Canadians who own U.S. real property and are going through this is to seek the expertise of one who knows the tax systems in both countries. With proper alignment of the tax treatment and application of foreign tax credits, the two spouses can come out of the marriage with minimal financial damage.
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This article was originally published by The Lawyer’s Daily (www.thelawyersdaily.ca), part of LexisNexis Canada Inc.
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