Canadians Paying Tax on U.S. Real Estate Investments
NOVEMBER 10, 2017
In spite of the less then favorable foreign currency exchange rate between Canada and the U.S., many Canadians continue to profit on investments in rental real estate in the U.S. Many Canadians however, are still unsure as to how they are supposed to properly report this rental income for U.S. tax purposes. Generally, a Canadian can meet their income tax obligations related to U.S. rental property to the IRS in one of two ways:
Form 1042 – Annual Withholding Tax Return for U.S. Source Income of Foreign Persons / Form 1042-S – Foreign Person’s U.S. Source Income Subject to Withholding
The first option is for the Canadian real estate investor to pay the IRS a flat 30% tax on gross rents collected during the year. Under this option the withholding agent (usually the tenant or property manager) withholds 30% of gross rents before paying the remaining amount to the Canadian real estate investor. The withholding agent would then File Forms 1042/1042-S to declare the annual withholding and remit that amount to the IRS. Ultimately, however, the responsibility for filing form 1042 lies with the investor.
It is important to note that under this option the U.S. tax liability is not reduced by the cost of any rental expenses, but rather is based on gross rent. This option can be preferable to some taxpayers however, who pay sufficient tax in Canada to make use of the higher foreign tax credit and wish to avoid to the cost of preparing a U.S. tax return (see below).
Form 1040NR - U.S. Non-resident Alien Income Tax Return
Under this option the Canadian real estate investor can provide the withholding agent with a completed form W-8ECI Certificate of Foreign Person’s Claim that Income is Effectively Connected with the Conduct of a Trade or Business in the United States electing to treat the rental income as effectively connected with a US trade or business and thus exempt from withholding. By doing this, the withholding agent is released from their obligation to withhold the 30% tax on gross rents (above). However, the Canadian real estate investor must then file a Form 1040NR tax return and pay tax at the applicable US marginal rate on net rental income.
This is generally the preferred method of satisfying the US tax obligation given the ability to claim rental expenses to offset gross income generally significantly reduces the US tax liability. Additionally, the Canadian investor does not have to worry about withholding tax on gross rent throughout the year.
If you are a Canadian resident investing in real estate in the U.S. who has questions about complying with U.S. federal and state tax obligations please feel free to contact our U.S. Tax group for a consultation.