It goes without saying; the past five months have been challenging.
In fact, for some couples, the extra quality time together in quarantine proved to be the proverbial straw. And while it may have been difficult to get aligned in the marriage, it’s very important to get aligned in the divorce, particularly for Canadians who own U.S. real property.
With all the cultural and economic similarities between the U.S. and Canada, it’s often shocking to discover how the two countries’ tax systems are so different and how that creates complications for taxpayers on both sides of the border. Of course, there are foreign tax credits and the Canada-U.S. Income Tax Treaty, but without the right understanding of how these systems work together, one may find themselves in a double taxation trap.
For example, when Canadians who own U.S. real property are separating or divorcing, there is often a misconception that if one spouse retains the property, they can both avoid the rigmarole of paying taxes on capital gains. Unfortunately, this is not the case. When it comes to the division of U.S. real property resulting from the marital breakdown of a Canadian couple, U.S. tax rules dictate that the property is disposed of at fair market value by a transferor spouse and acquired at market value by a recipient or transferee spouse.
Although no money is exchanged, the spouse who relinquishes the right to the property must come up with enough cash to pay a U.S. 15% withholding tax, known as Foreign Investment in Real Property Tax Act (FIRPTA) tax. The transferor spouse must provide the funds to the transferee spouse, who will remit the withholding tax to the IRS, along with certain paperwork, within a narrow timeframe. For the transferee spouse, the penalty for failing to meet this obligation is $10,000 USD.
When tax season rolls around the following spring, the transferor spouse files a U.S. non-resident income tax return to report the disposition of the U.S. real property. The expectation is that the transferor spouse will receive a refund of the difference between the withholding tax and the actual tax. The transferor spouse is required to have a U.S. tax ID (i.e. a social security or Individual Taxpayer Identification number).
Now, for Canadians who own U.S. real property, here’s where the potential tax exposures enter into the picture.
In Canada, the value of the property at the time of the division is the original cost of the property, unless an election is made to transfer the property at market value. So, by default, Canadians who own U.S. real property and are separating or divorcing will transfer the property from one spouse to another with no other considerations and no tax to pay in Canada – at the time. Instead, the CRA imposes tax when the property is eventually sold by the transferee spouse, and the gain is computed on the appreciation of the property from the time it was acquired within the marital union.
This is where good alignment between the divorcing couple is critical. Here’s why. If the transferor spouse feels the Canadian default option is better, they may be creating a double taxation situation for themselves and the transferee spouse by paying tax in the U.S. now and not being able to recover it through a credit in Canada later.
In this regard, alignment on tax treatment can serve as a negotiation tool in the separation or divorce process for Canadians who own U.S. real property. By matching the timing of the transfer on both sides of the border, the transferor is responsible for U.S. and Canadian tax for the appreciation of the property from the date of purchase to the date of transfer, and the transferee spouse is responsible for U.S. and Canadian tax from the date of transfer to the actual sale.
If the timing is not aligned, the transferor will be responsible for U.S. tax for the same period and will not be responsible for any Canadian taxes, while the transferee spouse will be responsible for paying U.S. tax on the gain from the date of acquisition to the actual sale and Canadian tax on the gain from the original purchase date to the sale date. As Canadian taxes tend to be higher, this late discovery may cause even more financial damage to the transferee spouse.
It’s important to ensure that Canadians who own U.S. real property, and are going through a divorce, enlist the guidance and expertise of someone who knows both tax systems. With proper alignment of the tax treatment and application of foreign tax credits, both spouses can come out of the marriage…well…a little less scathed.