For most individuals, their principal residence is their single most important asset. In Canada, when an individual sells their principal residence the gain on the sale is exempt from capital gains tax in most instances. A taxpayer must designate the property as their principal residence when they file their Canadian personal income tax return. This is one of the biggest gifts to individuals in the Income Tax Act.
Canadian residents who are also U.S. persons will also be subject to the U.S. rules surrounding the sale of a principal residence. These rules are quite different and for many taxpayers, given the increase in value of Canadian real estate, may give rise to an unpleasant surprise. For U.S. purposes, only the first $250,000 USD of gain on the sale of a principal residence is exempt from capital gains tax. For a married couple this exemption is $500,000 USD, but only if both taxpayers are U.S. persons. Amounts above the exemption will be subject to capital gains tax.
To calculate the gain for U.S. purposes, the proceeds from the sale are translated into U.S. dollars using the spot rate on the date of sale and the cost base is translated into U.S. dollars using the spot rate on the date of purchase. Using this method, any increase or decrease in the value of the U.S. dollar versus the Canadian dollar is also included with the sale.
In addition to the capital gains tax, U.S. persons who hold a Canadian mortgage on their principal residence may also be subject to tax when that mortgage is discharged. This tax comes into play when the value of the Canadian dollar has decreased against the U.S. dollar since the mortgage was obtained. This tax is best explained with an example:
Let’s take the example of Sam, who is a U.S. citizen resident in Canada. Sam purchased his principal residence in Canada and obtained a mortgage of $100,000 CAD when the Canadian dollar and U.S. dollar were at par (1 CAD = 1 USD). Therefore his mortgage was worth $100,000 CAD and $100,000 USD. He subsequently sold the property. At the time of disposition (and assuming he did not pay off any of the mortgage principal) the value of the Canadian dollar had decreased to 75 cents U.S. (1 CAD = .75 USD). At the time of discharge, his $100,000 CAD mortgage is now worth $75,000 USD. Because it takes fewer U.S. dollars to pay back his original obligation, the U.S. views this $25,000 foreign exchange difference as a taxable gain to Sam for U.S. income tax purposes.
This, of course, is a simplified example to illustrate the concept of a Foreign Mortgage Gain. The example does not take into account the principal on the mortgage that has been repaid by Sam, which is considered in an actual Foreign Mortgage Gain calculation.
The Foreign Mortgage Gain on a principal residence is considered foreign-source ordinary income and can be offset with foreign tax credits. The gain is allocated to the general foreign income basket, so if a taxpayer has sufficient accumulated excess foreign tax credits in this basket to offset the Foreign Mortgage Gain then no tax may be payable. A Foreign Mortgage Loss on a principal residence is considered a personal loss and is disallowed.
While technically a Foreign Mortgage Gain or Loss should be calculated on each mortgage payment made, the Internal Revenue Code states that a personal foreign exchange gain of $200 or less does not have to be reported. Therefore, in practice the Foreign Mortgage Gain calculations are not typically performed.
With the substantial rise in real estate values in most Canadian cities, we have seen many U.S. persons pay U.S. tax on the sale of their principal residence when they had assumed the sale would be tax-free. It’s important that U.S. persons become familiar with these rules and plan for any potential U.S. tax on the sale of their home.
Cadesky U.S. Tax is a full service advisory and compliance firm. We monitor U.S. tax news that may be of interest to our readers and share our thoughts in U.S. Tax Tips. If you require our assistance please do not hesitate to reach out to us.
