When a surviving spouse decides to sell their home after the death of their partner, whether for downsizing or moving to a retirement home, understanding the cross-border tax implications is crucial for a US citizen living in Canada. Proper planning can help optimize tax outcomes.
Canadian Tax Implications
In Canada, the sale of a principal residence is non-taxable, regardless of the holding period or the amount of gains provided it is not a flipped property. Properties sold on or after January 1st, 2023 are subject to the flipped property rules put in place to ensure taxpayers cannot treat profits from a flipped property as a principal residence exemption.
US Tax Implications
However, a US citizen residing in Canada must still meet US tax filing obligations and declare worldwide income to the IRS. The Section 121 home sale exclusion in the US can help reduce gains, but it’s far less generous than Canada’s principal residence exemption.
To qualify for the Section 121 exclusion:
- The property must be owned and used as the primary residence for at least 24 months within the last 60 months.
- The 24 months do not need to be consecutive.
- For married couples, only one spouse needs to meet the ownership test, but both must meet the use test.
- The exclusion cannot be claimed if it was used for another property sale within the previous two years.
Exclusion Limits
- Married couples can exclude up to U$500,000 from the gain.
- Single filers or married couples filing separately can exclude up to U$250,000.
Example Scenario -Sale of a Canadian Principal Residence by a U.S. Citizen Widow
For a US citizen couple living in Canada, the surviving spouse will see an increase in the cost basis for the property for U.S. tax purposes, affecting the U.S. taxable gain. Understanding these tax implications in advance can significantly impact financial planning for a surviving spouse considering selling their home. Let’s explore an example to illustrate this:
Home Ownership
Home owned jointly and purchased in 2005
For this illustration, exclude currency fluctuations and all figures are in USD.
Scenario:
The surviving spouse sells the home three years after the passing of the deceased spouse for $1,100,000. Assume the client’s US capital gain tax rate is 20% and the Net Investment Income Tax (NIIT) of 3.80% is applicable.
Facts:
Original purchase price: $350,000
Fair market value at the death of the spouse: $1,000,000
New cost basis for the surviving spouse: ($1,000,000/2) + ($350,000/2) = $675,000
Capital Gain on Sale of the Home for the Surviving Spouse: $1,100,000 – $675,000 = $425,000
Tax Implications:
Canadian tax on sale of home: $0
US tax on sale of the home: ($425,000 – $250,000) * 23.80% = $41,650
In this example, the surviving spouse faces a US tax liability of $101,150 due to the sale of the home. The $500,000 exclusion cannot be applied in this situation.
Mortgage Forgiveness Debt Relief Act of 2007:
However, under the Mortgage Forgiveness Debt Relief Act of 2007, the exclusion amount can increase from $250,000 to $500,000 if all the following conditions are met:
1. The home is sold within two years of the spouse’s death.
2. The surviving spouse hasn’t remarried at the time of the sale.
3. Neither spouse took the exclusion on another home sold less than two years before the date of the current home sale.
4. Both the surviving spouse and the former spouse meet the two-year ownership and residence requirements.
Optimal Outcome: If the surviving spouse had sold the house within two years following the spouse’s death, the $500,000 exclusion would apply, resulting in no gains levied on the sale of the home. With proper advice, the client could save $41,650 in tax by adjusting the date of the sale.
A Note on the NIIT
There are new developments regarding the NIIT and its cross-border application. A recent court ruling determined that foreign tax credits can be utilized against the NIIT, in a case involving a U.S. citizen couple residing in France. However, it’s important to note that the IRS is currently appealing this decision, leaving the final outcome uncertain.
Prepare in Advance
At i2 Wealth Cross Border Planning we work closely with U.S. citizens living in Canada to help them understand the tax and financial implications related to their oftentimes complex situation. Our advice can help clients make the most of their financial assets and help them obtain the clarity they need in the future. Schedule a consultation with us today to get started!