Moving from the U.S. to Canada? Learn 10 important tax factors to consider.
John and Jane had been dreaming of a life in Canada for years. They loved the idea of living in Canada – with its laid-back lifestyle, beautiful scenery, and ample opportunities for business. So, when they got the chance to move to Toronto, there was no hesitation.
But what John and Jane didn’t anticipate was all the tax implications that came with moving across borders. When it comes to cross-border taxes, there are some important things everyone should consider before they make their decision.
The first thing on their list was determining whether or not any large investments would be subject to capital gains taxes – something that could have an enormous impact on their finances if left unchecked. Then they had to think about how investing in U.S.-based assets while living in Canada might affect them; this included foreign asset disclosure requirements between both nations.
All in all though by taking their time and doing proper due diligence prior to relocating northward, John & Jane managed not only to keep themselves out of hot water with their taxes legally but also saved lots of money come Tax Day…something we’d all like a little bit more of, wouldn’t we?
Here are some insights into what John and Jane considered with their cross-border tax advisor.
Tax Implications of Holding a Principal Residence After Moving from the U.S. to Canada
John and Jane were advised that if they were considering moving to Canada while still owning a principal residence in the U.S., it was crucial for them to understand the potential tax drawbacks that may arise from this situation.
Under U.S. tax rules, homeowners may be eligible to exclude a certain amount of gain from the sale of their principal residence. Single taxpayers can exclude up to $250,000, while married taxpayers can exclude up to $500,000. However, to qualify for this exclusion, certain criteria must be met.
Firstly, the property must have been owned and occupied as the taxpayer’s principal residence for at least two out of the last five years prior to the sale. Additionally, the exclusion only applies to one sale or exchange every two years. Any gain linked to periods of nonqualified use of the property is not eligible for exclusion.
So, what does this mean for John and Jane moving to Canada while retaining their U.S. property? While they may fulfill the ownership test by keeping legal title, the occupancy/use test could be compromised. As a result, the longer they own the U.S. property without occupying it, the more their eligible exclusion from capital gains may be reduced. This can potentially lead to a significant tax bill for married couples living in Canada, which can be avoided through proper planning.
In Canada, the rules regarding principal residences also come into play. If a property is deemed a ‘principal residence’, any capital gain from its sale is exempt from taxes under the ‘Principal Residence Exemption‘ regulation. To qualify as a principal residence in Canada, the taxpayer must reside in the property during the year and designate it as their principal residence. It’s worth noting that the property doesn’t have to be the taxpayer’s main home; as long as they or their family ordinarily occupy it during the tax year, it may still qualify. However, justifying a principal residence exemption for a U.S. property that is not ordinarily occupied can be challenging under Canadian rules.
Fortunately, if subject to taxes on any gains on the property, it may be possible to claim foreign tax credits on a Canadian return to offset balances owed to the CRA.
With these tax implications in mind, it is crucial to make informed decisions when it comes to holding a principal residence in the U.S. after moving to Canada. Professional guidance and strategic planning can help minimize tax burdens and ensure compliance with both U.S. and Canadian tax regulations.
Investing in the U.S. after Moving to Canada
Discovering that Canadian residents are subject to taxes on their worldwide income was an eye-opening realization for John and Jane. It became evident that the location of their investments and the currency they held were inconsequential. The only thing that matters is their residency in Canada, as the Canada Revenue Agency (CRA) is entitled to their fair share of income tax on any earnings, no matter where they originate.
To ensure compliance with this requirement, there is a specific form known as Form T1135 – Foreign Income Verification Statement. This form serves the purpose of reporting foreign assets and income to the CRA. It must be completed if the cost of certain foreign assets exceeds $100,000 Canadian (based on the exchange rates at the time of purchase) at any point during the year. Most investment assets, such as U.S. stocks, fall under the category of specified foreign property.
The IRS, the U.S. taxation authority, also mandates tax withholding on certain types of income based on the country of residence of a foreign individual. To regulate this, Canada and the U.S. established a tax treaty named the Convention Between Canada and the United States of America back in 1980. This treaty has undergone various amendments since its inception and establishes treaty withholding rates depending on the income type and the taxpayer’s residence.
A potential complication that can arise is that most U.S. brokers are not authorized to serve individuals residing in Canada. As a result, these brokers often inform individuals that their funds will be liquidated within a short timeframe, thereby creating an unforeseen and significant tax impact. However, this issue can be mitigated through careful tax planning and by consulting with a cross-border tax advisor who can provide valuable guidance.
In addition, when an individual establishes Canadian residence, Canadian tax rules consider them to have sold and repurchased each property they own at its fair market value at the time of arrival. This means that any gains or losses accrued before becoming a resident are not relevant for Canadian tax purposes when the property is sold later on. John and Jane knew they would calculate their capital gain or loss based on the fair market value at the date of immigration. These rules ensure that the taxpayer is not taxed in the future on gains that were accrued while not a resident in Canada, with some exceptions.
Foreign Asset Disclosure Requirements in Canada and the U.S.
John and Jane took the time to understand the foreign asset reporting rules in Canada and the U.S. They learned that Canadian residents, including corporations, must report any specified foreign properties that cost over $100,000 Canadian at any point during the tax year. This can be done through the T1135 – Foreign Income Verification Statement form, with the exception of immigrants who are exempt in their first year of residence.
They also discovered that reporting foreign bank accounts in the U.S. can be complex. It involves understanding the requirements of both the Financial Account Tax Compliance Act (FATCA) and the Financial Crimes Enforcement Network (FinCEN).
US individuals must also consider the FinCEN requirements and file a FinCEN Form 114, Report of Foreign Bank and Financial Accounts (FBAR), to report foreign financial accounts.
It’s essential to note that filing Form 8938 does not exempt a U.S. filer from the FBAR reporting requirements.
Armed with this knowledge, John and Jane took steps to streamline their foreign asset reporting process and consolidate their assets.
Pension Considerations for Moving to Canada From the U.S.
Concerns about the tax impact of their U.S. pensions have arisen for John and Jane, who have worked for many years and have accumulated significant funds. However, there are options to address these concerns.
For Traditional IRAs, it’s a relief to know that they can maintain their tax-deferred status in Canada under the Canadian Income Tax Act and the Canada-US tax treaty. They may even consider transferring funds to Canada for the sake of consolidating their assets and simplifying their estate plan.
On the other hand, Roth IRAs are similar to Canadian Tax-Free Savings Accounts, but they don’t enjoy the same tax deferral benefits in Canada. Income earned in a Roth IRA is generally taxable in the year it’s earned. However, John and Jane discovered that it’s possible to file an election for tax deferral with the CRA for a U.S. Roth IRA, but they need to be cautious about making Canadian contributions.
When it comes to 401(k) plans, they are similar to Canadian defined contribution plans. Canadian residents can still benefit from tax deferrals on earnings in a 401(k) under the Canada-U.S. Income Tax Treaty.
If John and Jane decide to withdraw funds from their U.S. retirement plan, they need to be aware that the amount withdrawn is taxable in Canada. However, under certain conditions, it may be possible to transfer the funds to a Canadian RRSP. However careful planning and assessment of tax considerations are necessary to ensure long-term benefits. Factors to consider include U.S. tax implications and the ability to claim foreign tax credits in Canada for taxes paid in the U.S.
Avoid PFICs when Investing Abroad
John and Jane has never heard of a PFIC. It stands for Passive Foreign Investment Company. This investment vehicle, which includes various funds and trusts, is registered outside of the U.S. But here’s the catch: PFICs are subject to a complex and strict tax system, far more complicated than U.S. mutual funds or exchange traded funds.
So, how are PFICs taxed? Let’s break it down.
Excess distribution, Mark-to-Market (MTM), and Qualified Electing Fund (QEF) are the three methods of PFIC taxation.
The default option is excess distribution as a §1291 Fund. Under this method, you will be taxed on excess distributions and any gain when you sell or dispose of your stockholdings.
Alternatively, you can choose the Mark-to-Market (MTM) election. This means that yearly increases in your PFIC’s value will be taxed as ordinary gains. At the end of the year, your marketable stock will be treated as if you sold and repurchased it at its fair market value on the last business day. Remember, for this election, you need to make the choice in the first year, or your PFIC will default to being taxed under excess distribution.
Lastly, there is the Qualified Electing Fund (QEF) election. With this option, your PFIC will be taxed on its pro-rata share of undistributed earnings for both ordinary income and long-term capital gain. However, the associated documentation requirements make this method challenging to implement.
Here’s the bottom line: investing in foreign mutual funds may not always be worth the cost. The complex tax reporting requirements and higher tax rates associated with PFICs can erode your investment returns over time.
Furthermore, reporting PFICs on IRS Form 8621 is both time-consuming and costly. Each PFIC investment requires a separate form, with an estimated average of 22 hours to properly fill out. For American expat investors, building a portfolio of non-U.S. mutual funds could be a major hassle to avoid.
Stock Compensation Benefits from an Employer in the U.S.
John and Jane’s tax advisor informed them that Canada taxes the benefit gained from stock option exercise as employment income, either at the time of exercise or when the shares are sold. This means that for non-residents who exercise foreign stock options in Canada, there has been a historical risk of Canadian taxation and uncertainty around treaty application. To minimize tax liabilities, it may be advisable for individuals to exercise the options before becoming a resident or to hold onto them throughout their temporary stay in Canada. The decision to exercise the stock options will be influenced by the individual’s marginal tax rate in their home country.
Working Remotely in Canada for U.S. Company
As a resident of Canada or someone deemed to be a resident of Canada, it is important to be aware that you must report all of your income from worldwide sources for Canadian income tax purposes.
If you are a Canadian resident, you are subject to taxation on your income from employment, business, property ownership, as well as certain other forms of income.
This means that if you work for a U.S. employer while residing in Canada, the income you earn will be taxable by Canada. Whether the income is considered Canadian or U.S. sourced will depend on where the work is performed. Sourcing rules determine which country is entitled to the income and which country can claim a foreign tax credit. Working for a U.S. employer while living in Canada can potentially create complications regarding payroll and taxes in general.
No Option for Joint Tax Filing in Canada
Many newcomers to Canada are surprised to learn that joint tax filing is not an option for Canadian taxpayers. Unlike the United States, where married couples can file jointly and benefit from potential tax advantages, each taxpayer in Canada must file separate tax returns. This means that any advantage that joint filings may have is eliminated.
The U.S. – Canada Tax Treaty
Under the U.S.–Canada Tax Treaty, Americans living in Canada can file their U.S. taxes and avoid double taxation through tax credits. It is recommended to file Canadian taxes first and then claim U.S. tax credits using Form 1116 alongside Form 1040.
Alternatively, you can utilize the Foreign Earned Income Exclusion by completing Form 2555. Furthermore, students and trainees can prevent double taxation by using Form 8833 if applicable. If you have U.S. Roth IRAs, you can take advantage of a tax treaty provision to ensure your withdrawals remain tax-free in Canada.
Important Dates for Filing Taxes in the U.S. and Canada
The deadline for filing Canadian taxes is April 30, or June 15 for self-employed individuals. There are no extensions allowed. However, American citizens living in Canada have an automatic extension until June 15 to file their U.S. taxes. If needed, they can request a further extension until October 15.
Additionally, some Americans in Canada may still be required to file U.S. State taxes if they have ties to the state where they last lived, such as financial accounts, property, or dependents. The rules for each state may vary.
The blog post provides a comprehensive guide to managing financial responsibilities for Canadians who have moved or are considering moving from the U.S., focusing on crucial aspects such as principal residence, investments, foreign asset disclosure, and pension considerations. It emphasizes the importance of understanding the tax laws of both countries and making informed decisions to avoid unexpected tax liabilities. The use of professional guidance is highlighted, especially in navigating complex issues such as reporting foreign assets, managing investments, and planning for pension funds. Whether it’s maintaining a tax-deferred status for traditional IRAs or assessing tax implications for withdrawing funds from U.S. retirement plans, the post underscores the necessity of strategic planning and compliance with tax regulations for financial stability.
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Karlene J. Mulraine, EA, CPA, CA, CPA (NH) is the President of Cross-Border Financial Professional Corporation. Follow us on Linkedin and Twitter, or hang out on Facebook.
The views expressed in this article are those of the author and should not be relied on to make decisions. Consider discussing your specific circumstances with an appropriate specialist.
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