US Federal Income Tax – Gains on Sale of your Home Part 1

Generally, Canadians living in Canada are not subject to tax on gains from the sale of their principal residence. However, for a Canadian resident who is also a U.S. citizen or resident (including permanent resident or “green-card” holder and those meeting the “substantial presence” test), the same capital gain may be taxable on his or her US income tax return. Under US Federal tax law, an individual may exclude from income up to US$250,000 of gain from the disposition of his primary residence. For a married couple filing a joint US income tax return, the maximum exclusion is US$500,000. Any capital gain exceeding the excluded amount is taxed in the U.S. in the year realized.

Under US tax law, the $250,000 exclusion ($500,000 if married filing joint) cannot be used more frequently than once every two years. To be eligible, an individual must own and use the property as their primary residence for periods totaling two years or more in the last five years ending on the date of the sale. Unlike Canadian tax law, a vacation home could not qualify as a principal residence unless it was the home predominantly used as such. The individual is not required to use the property continuously for two years during the five year period or use the property as his primary residence at the time of purchase or sale. Temporary absences such as vacations from the property are counted as periods of use even if the property is rented during the period of absence. Different rules may apply if the property was used as both one’s primary residence and as a rental property.

For a married couple filing a joint US income tax return, the above ownership and use test is met if either spouse meets the test and neither spouse is ineligible for the exclusion within the prior two years. If only one spouse is subject to US income tax, only his or her portion of the capital gain from the sale of their jointly owned principal residence is taxable on US return.

If the property is not used as a primary residence for at least two of five years, a partial or reduced exclusion may be available if the property is sold due to change of employment, health reasons or unforeseen circumstances.

Other related considerations include:

• When the capital gain is taxed in the U.S. but not in Canada an individual’s combined tax liability likely is higher as there is no Canadian tax on the gain available in the form of foreign tax credit to reduce U.S. tax liability;
• Cost and proceeds from the purchase and sale of a principal residence in Canada is translated to US Dollars using prevailing foreign exchange rates on the date of each transaction. As a result, the appreciation of the Canadian Dollar against the US Dollar in recent years tends to reduce the property’s cost basis in US Dollars which increases the capital gain in US Dollars and increases US income tax liability;
• Capital gains are taxed at 100% in the U.S. while it is generally taxed at 50% in Canada;
• The US Federal income tax rate for long term capital gains (property held longer than one year) is scheduled to increase after 2012 from a maximum rate of 15% to rates in the range of 20% to 24%;
• U.S. citizens moving from Canada to the US who have not yet sold their Canadian principal residence may still exempt the gain on sale from Canadian income tax where they sell the property by the end of the calendar year after the year of move. However, U.S. citizens would still be subject to U.S. tax on the gain that exceeds the primary residence exemption of US$250,000 (US$500,000 for married filing joint).

In a future blog entry, we will discuss this subject further and address the principal residence exemption rules where a non-U.S. citizen moves from Canada to the U.S. and does not yet sell their Canadian home. We will also address the Canadian and US tax rules for individuals no longer living in Canada that sell their former Canadian principal residence.