Dreaming about purchasing a holiday home or seasonal retreat in the United States? And thinking about offsetting the costs by renting out the property to others? You could be getting more than you bargained for.

While a growing number of Canadians are purchasing vacation property south of the border, surprisingly few seem to realize that U.S. income taxes could also apply to the ownership of the property.

Whether you already own U.S. vacation property or are contemplating such an investment, the income tax implications in both Canada and in the United States are important factors in your overall costs. (We assume the vacation property owner is a Canadian and neither an American citizen nor a U.S. resident subject to U.S. income taxation.)

30% Flat Tax

If, as a Canadian owner, you rent out your U.S. vacation home, the rental income you receive is subject to a flat 30% tax in the U.S. before any deductions for expenses incurred in earning this income. As the tenant must withhold and remit this tax to the IRS, the Canadian landlord does not have to file a U.S. personal income tax return for that year, provided the taxes are remitted.

Rental Expenses

In addition to the large cut the 30% tax makes on your rental income, you also have expenses such as mortgage interest, taxes, repairs and maintenance, and utilities to consider before you see any cost recovery. To benefit from the deductions for your rental property expenses, you must elect to be taxed within the U.S. on a net basis. But before making this election, you should be aware that you must rent the property for a minimum length of time before any deductions against rental income will be allowed. If your property is rented for fewer than 15 days per year, the deductions will not be allowed. Even if you meet the 15-day requirement, there are other rules that further limit the amount of expenses considered deductible.

Another important consideration is that once you have made this election, you will be required to file a U.S. return annually. This election remains in force for subsequent years and can only be revoked with the consent of the IRS. When you file, your rental income will be subject to the graduated tax rates applicable to a U.S. resident on the taxable income realized from a rental activity.

CCRA's Share

Back home, you must also report this U.S. rental income on your Canadian personal income tax return. You may allocate property expenses in relation to your personal and income-generating use. The U.S. taxes may provide some relief as a foreign tax credit against the Canadian income taxes payable on your net rental income.

For both the U.S. and Canada, you should maintain records of your personal and rental use of the property and related expenses.

Exchange

The cost of a U.S. vacation property may seem like a real bargain but don't forget to convert those U.S. dollars to Canadian dollars - - it could mean an additional 45 to 50%. Fluctuations in the exchange rate during the period of ownership can, in some circumstances, result in a loss on a sale in U.S. dollars but a gain in Canadian dollars, or vice versa.

On top of that, your mortgage payments will be in U.S. dollars. Even if your mortgage rate is low, your payback is at the mercy of fluctuations in the exchange rate.

Mortgage

The property will have to be mortgaged by a U.S. financial institution. Since the banking system is not as centralized as Canada's, you may be dealing with a smaller financial institution than what you're used to back home. As well, the lender may require that the rental property be inspected periodically to ensure the value of the property. If the rental property is not maintained, the financial institution could reduce or remove financing.

Extended Stays

If you plan to stay at your vacation property in the U.S. for long periods of time, you should also seek tax advice from Logan Katz LLP about the "substantial presence" rules. Under U.S. tax laws, you could be considered a U.S. resident for tax purposes.

Estate Taxes

If you die while owning U.S. real property, your estate could also be subject to U.S. estate taxes. Depending on the value of the U.S. property, this could be a substantial liability for your estate.

Avoid Surprises

Increased co-operation and database sharing between IRS and CCRA could unearth unanticipated tax liabilities for Canadian residents who own U.S. vacation property. If you have held property within the U.S. for a number of years, it may be time to meet with Logan Katz LLP to refresh your understanding of your tax responsibilities and potential liabilities. If you are thinking about buying a vacation spot in the south, talk to us before you make an offer to purchase to ensure you are fully informed of the potential impact on your personal taxes.

The above provides general information only. It should not be regarded or relied upon as accounting or taxation advice or opinions. Logan Katz LLP Chartered Accountants would be pleased to provide more information or specific advice on matters of interest to you.

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