Blog – U.S. and Canadian Capital Gains
Capital gains are distinguished from other types of income for both Canadian and U.S. tax purposes. Often, capital gains are taxed at a lower effective rate than ordinary income, and in some cases they are exempt from tax altogether. Taxpayers should consider how these preferential rules could apply to their situation. Capital transactions can be planned in advance to achieve the optimal tax result. In a cross-border context, taxpayers should consider both Canadian and U.S. consequences of the transaction to ensure optimal cross-border tax results.
This blog will provide general rules regarding the taxation of capital gains, highlight the differences between Canada and U.S., and discuss opportunities and challenges for taxpayers in a cross-border setting.
IDENTIFYING CAPITAL GAINS
Capital gains are not precisely defined in the Canadian Income Tax Act or the U.S. Internal Revenue Code. When a property is disposed, the profits need to be characterized as ordinary income or capital gain.
Generally, capital gains may arise from the disposition of a taxpayer’s capital property, which could include real estate, securities, and business assets.
Property held for resale is considered to be inventory and not capital property. Profits from the sale of inventory are always taxed as business income, and are ineligible for preferential tax treatment available to capital gains. Some taxpayers deal in property with such frequency and expertise that the property is treated as business inventory.
The sale of property held for investment will generally result in a capital gain or loss. Also, taxpayers who sell depreciable or amortizable business assets may often enjoy the benefits of capital characteristics on gains and ordinary characteristics on losses.
TAXATION OF CAPITAL GAINS AND LOSSES, GENERALLY
Capital gains are characterized as short-term or long-term, based on the holding period of the property. Capital assets held for one year or less before disposition, will result in short-term capital gain or loss upon disposition, while those held for more than one year will result in long-term capital gain or loss.
Individuals, estates and trusts who realize net long-term capital gains (and qualified dividend income) may be eligible for preferential tax rates. The individual tax rate on long-term capital gains varies depending on the type of asset disposed and the taxpayer’s other sources of income. Non-corporate taxpayers are required to net the gains and losses within each tax rate group.
Capital losses may be deducted in the U.S. to offset capital gains. In addition, individuals can offset up to $3,000 USD of ordinary income per year using capital losses ($1,500 USD for married individuals filing separate returns). Unused losses are carried forward by non-corporate taxpayers indefinitely, retaining their short-term or long-term nature.
Corporate taxpayers currently pay a 21% federal tax rate on all types of income, and must include both net short-term and long-term capital gains in their gross income to extent they exceed capital losses for the tax year. Corporations can generally apply capital losses to offset only capital gains, and not ordinary income. Corporations can carry back net capital losses to the preceding three tax years, and can carry forward net capital losses for the following five tax years.
In Canada, capital gains and capital losses are netted to determine “net capital gains”. 50% of net capital gains is taxed at ordinary income rates, regardless of the holding period. The other 50% is exempt from tax. Net capital losses are carried back for three years and carried forward indefinitely to offset net capital gains of other taxable years.
SOURCING AND FOREIGN TAX CREDIT
Where income is taxable in both Canada and the U.S., sourcing determines which country has the first right to collect tax. The other country is obligated to grant a foreign tax credit to eliminate or reduce double taxation on the item of income.
Capital gains and losses are generally sourced using the following principles:
- Real property is sourced to the country in which the property is situated
- Business assets are sourced to the country in which the assets generated business income
- Other property is sourced to the country where the taxpayer resides
Real property can include ownership interests in corporations, partnerships, and trusts, if their value is principally attributed to real property.
While foreign tax credits are helpful to reduce double taxation, they do not eliminate double taxation in all scenarios. Taxpayers should plan ahead to align the timing of gain recognition in Canada and the U.S. in a manner that optimizes the use of foreign tax credits.
The amount of taxable gain or loss can be affected by the foreign exchange rates in effect when the property is purchased, improved, and sold. Amounts paid and received in a foreign currency must be translated to the reporting currency of the applicable tax return. Therefore taxpayers can consider the impact of exchange rates when they make decisions to purchase, improve, or sell property.
REAL ESTATE TRANSACTIONS
Canada and U.S. each provide a tax exemption for capital gains on certain sales of a principal residence.
The Canadian principal residence exemption can apply to a house, apartment, cottage, mobile home, trailer, or houseboat. The exempted residence can include up to 0.5 hectares of land (approximately 1.2 acres). To qualify for the exemption, the property must be solely or jointly owned by the taxpayer, and ordinarily inhabited by the taxpayer, their (former) spouse or children, or in some circumstances, an elderly relative. In the year of disposition, the taxpayer must file a form to designate the property as his or her principal residence for all or some of the years that the property was owned. The gain on sale of the principal residence can be fully or partially exempt from tax depending on the number of designated years.
With a view to increase the availability of housing, Canada introduced new anti-flipping rules for residential property dispositions that occur after 2022. Gains from property flipping will be classified as ordinary income and will not qualify for the principal residence exemption. Losses from property flipping are not deductible. Flipped property includes any property located in Canada that was owned by the taxpayer for less than 365 consecutive days prior to disposition. Some exceptions are available for unforeseen events, including disability, death or insolvency of the taxpayer, domestic abuse, and marriage breakdowns.
Capital gains can also result from a deemed disposition of real estate upon the change of use of a property, such as a change from rental use to personal use.
U.S. taxpayers can exclude up to $250,000 USD (for single individuals and married individuals filing separate returns) or up to $500,000 USD (for married individuals filing jointly) of capital gain from the sale or exchange of a principal residence. To qualify for the exclusion, the taxpayer must own and live in the property for two out of the five years immediately preceding the sale, and must not have used this exclusion during the two years preceding the sale. Some exceptions to this requirement are available, including for disability, death, and relocation for health or work reasons.
Gains on the sale of real property other than a principal residence or flipped property will generally be a capital gain. Gains are reduced by any costs incurred to acquire, improve, or sell the property. Taxpayers should maintain documentation of these costs. U.S. individuals that incur losses on the sale or exchange of their principal residence may not deduct the realized loss.
Taxpayers that exchange U.S. real property of the same nature, can structure the transaction as a like-kind exchange, wherein the recognition of the gain or loss can be fully or partially deferred.
Sales of real property by non-residents are subject to tax withholding requirements in the U.S. and Canada. The purchaser of real property from a non-resident is generally required to withhold a percentage of the gross sales price and remit it to the relevant tax authority. The amount withheld by default is generally excessive and can create cash flow concerns for the seller. Therefore it is often worthwhile to apply for a clearance certificate from the relevant tax authority, which can reduce the amount of tax required to be withheld. Taxpayers should file the application in advance of closing the transaction to allow time for the tax authority to process the application. Non-resident sellers of real property are also required to file a non-resident income tax return to report the disposition.
MOVING ACROSS THE BORDER
Canada deems taxpayers to dispose of most types of property for fair market value when they cease Canadian residency. Therefore, any accrued gain or loss on the property is deemed to be realized and subject to Canadian tax at the time of emigration. Fortunately, the Canada-US tax treaty allows taxpayers to elect to increase the basis of such property for U.S. purposes. The election can help taxpayers avoid double taxation of the gain when the asset is eventually sold.
Similarly, upon immigration to Canada, the cost basis of property is deemed to be its fair market value on the date of immigration. Immigrants should maintain documentation, such as a recent property tax assessment, to support the valuation of assets on this date. The increase in basis can help taxpayers to reduce their overall tax liability. If the taxpayer is not a U.S. citizen, the gain that accrues before immigration may avoid taxation in both Canada and the U.S.
ASSETS USED IN A BUSINESS
When business assets are sold at a gain, the depreciation and amortization deducted in prior years will generally be recaptured as ordinary income. The capital gain is also reduced by the amount of recaptured income. The U.S. offers individuals a preferential unrecaptured tax rate for gains, attributable to the cost basis that was depreciated on real property.
USE OF PARTNERSHIPS AND TRUSTS
In lieu of a sale, taxpayers can consider contributing appreciated assets to a partnership or trust generally on a tax-deferred basis. In the case of a partnership, the taxpayer can receive an ownership interest as consideration for the contributed property. The taxpayer will generally not recognize capital gain until they dispose of the partnership interest or the partnership disposes of the contributed property. These tax planning strategies can be complex and should be considered with the assistance of a tax advisor.
SALE OF PRIVATELY HELD CORPORATIONS AND PARTNERSHIP INTERESTS
U.S and Canada offer tax code provisions that can help taxpayers defer the recognition of capital gain on the transfer of corporate and partnership ownership interests. These tax planning strategies can be complex and should be considered with the assistance of a tax advisor.