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This article provides a summary of important points concerning the taxation of Canadian real estate for non-residents of Canada.
The Canadian real estate market has attracted a lot of attention from foreign buyers. The Toronto and Vancouver residential property markets have had extraordinary price increases (for example, a 30% increase in Toronto in one year). This has caused governments at all levels (federal, provincial, and municipal) to focus on the area. Government attention has produced the following results:
- An additional 15% land transfer tax for foreign buyers for properties in a defined area of Southern Ontario (in and surrounding Toronto) and British Columbia (Vancouver area)
- Increased enforcement of income tax compliance
- Changes in legislation to close a number of loopholes
The opportunity to profit from Canadian real estate is enticing for three main reasons:
- Availability of low interest rate financing in Canadian currency
- The low value of the Canadian dollar (at $.76 to the U.S. dollar) allowing for possible foreign exchange gains
- Steady price increases in Toronto and Vancouver compared to bargain prices elsewhere (such as in Calgary, Edmonton, and Montreal)
As a result, there continues to be a steady flow of investment funds into Canada, chasing real estate bargains.
Taxation on Purchase
For a foreign buyer, a purchase of residential real estate in Southern Ontario and in the Vancouver area will now attract an additional 15% land transfer tax. In Ontario, this is on top of a 2.5% land transfer tax on value exceeding $2,000,000 (lower rates apply on the value below this). In addition, the City of Toronto levies a municipal land transfer tax at the same rate. This means that a non-resident buying a home in Toronto, for example, will now pay up to 20% land transfer tax, while a Canadian resident will pay 5%.
The additional 15% tax does not apply to Canadian citizens, even if they are non-residents of Canada.
There are certain exceptions for non-resident persons who become permanent residents of Canada. Because of this, persons who are planning to immigrate to Canada may wish to carefully consider the timing of the move and co-ordinate this with the timing of the purchase of a residence.
The additional 15% land transfer tax does not apply to non-residential property.
Taxation on Sale
On a sale of Canadian real estate, the first question to arise is whether any resulting gain is a capital gain or business income. A residential property which is purchased for personal use, or for rental and held for long-term investment, will be capital property. On a sale, any gain will be a capital gain. However, a property which is purchased on speculation (an adventure in the nature of trade) will result in the gain on sale being treated as business income.
The important distinction is that business income is fully taxable, whereas only 50% of a capital gain is included in income.
The Canada Revenue Agency (C.R.A.) is now aggressively following up on sales of real estate – especially residential real estate – examining the circumstances concerning the purchase and the sale, and the occurrence of other similar transactions (a pattern of buying and selling). In some cases, C.R.A. will challenge the capital gains treatment on sale. The “default” position is that the gain is business income and not a capital gain.
In order to support a gain being a capital gain, the seller may need to demonstrate that the property was purchased for personal use or long-term investment, with no intention to sell the property in the short term. There is a great deal of uncertainty and subjectivity concerning this area, and advice should be obtained at the time of purchase as to the likely treatment on an eventual sale.
The most important point is to demonstrate an investment intention at the time of purchase. This can be hard to show objectively so intention is often deduced from other factors such as the following:
- Frequency of transactions
- The length of time the property is owned
- The use to which the property was put
- Whether rental income was derived (showing production of income was a main purpose)
- The factors that led to the sale
For a Canadian-resident individual, the gain on sale of a principal residence is tax free. Non-residents have tried to use the same exemption through the use of Canadian-resident trusts and other means. These planning possibilities have now been closed by new legislation.
Graduated tax rates apply for individuals and vary based on the income level. The lowest tax rate for a non-resident is approximately 22%, while the highest rate – reached at taxable income over $200,000 (roughly) – will be about 49%. The effective tax rate on a capital gain is half of these rates.
Ownership of Canadian real estate by foreign persons through a foreign corporation can result in a significant tax advantage because such a corporation will pay a 25% corporate tax rate. Thus, on a capital gain, the effective tax rate will be 12.5%.
If the real estate is not capital property, the gain will be fully taxable. If a foreign corporation is used, then branch tax at 35% (or the lesser treaty rate if applicable) will also be charged. Treaty shopping limitations need to be considered in determining the rate of branch profits tax.
The other possible structures are use of a Canadian corporation or a trust.
There is no tax advantage to using a Canadian corporation versus a foreign corporation and there may be a disadvantage (the rate of dividend withholding tax may be higher than that of the branch profits tax). However, a Canadian corporation may be able to obtain Canadian financing more easily that a foreign corporation.
Generally speaking, there are no advantages to using a trust over a corporation. If a trust is to be used as part of the structure, it should be in the ownership of the corporate entity.
Clearance Certificate Procedure
Where a non-resident sells Canadian real estate, the purchaser is required to withhold 25% of the gross purchase price and remit this to C.R.A. as a withholding tax. If the property is (i) land inventory, (ii) real estate which is not capital property, or (iii) the building component that is used in a rental activity, the withholding tax rate is 50% of gross proceeds.
The vendor is required to obtain a clearance certificate from C.R.A. which serves two purposes: a notification to C.R.A. of the sale and a request for a reduction in the amount of the withholding tax. C.R.A. will give permission to reduce the withholding tax to 25% of the gain rather than 25% of the gross proceeds. (This presumes that the gain is a capital gain and not business income – or else the rate of withholding will be 50% of the gain.)
The clearance certificate process requires the filing of a form with C.R.A. together with a considerable amount of back-up information. At least 30 days, and preferably 60 days, should be allowed for completion of this process prior to closing of the date of the sale.
A Canadian tax return must be filed to report the sale. The withholding tax will be claimed there as a tax payment. Any excess will be refunded.
Rental
If the property is rented out, then the rental income will be subject to Canadian tax. This is often overlooked by non-residents, especially if the property produces rental losses.
There are two choices as to how the rental income can be treated. The default is that the tenant should remit to C.R.A. 25% withholding tax on the gross rental income. No reduction or offset is allowed for expenses. The alternative is to make an election to report the net rental income on an income tax return filed in Canada, in which case expenses may be deducted.
Many non-residents only become aware of the requirement to pay tax on rental income when the property is going to be sold and they apply for the clearance certificate.
The election to report the net rental income at regular Canadian income tax rates is usually beneficial compared to paying 25% withholding on the gross rental income. This is particularly the case if a foreign corporation holds the real estate, since its corporate tax rate will only be 25% in any event.
The election to pay tax on the net rental income must be made within two years of the end of the taxation year (six months if an application has been made to reduce the 25% withholding tax from gross rental income to the estimated net rental income and to file on the net rental income basis).
There is no provision to late-file the election. However, C.R.A. will allow a one-time late filing of elections going back to inception by administrative policy if it is done voluntarily by the taxpayer coming forward.
This will require filing of a tax return: a T-1 for a non-resident individual, a T-2 for a foreign corporation, or a T-3 for a foreign trust. The tax return is due six months after year end (calendar year for an individual or a trust).
Financing
Interest expense incurred on debt used to purchase a Canadian residential property will not be deductible if the property is held for personal use. However, interest will be deductible from the net rental income if the property is rented. One complication, however, is that a net rental loss cannot be used – except against other Canadian net rental income – and cannot be carried forward or back.
If the interest expense is paid to a related non-resident, it may be subject to non-resident withholding tax.
Interest expense may also be subject to capitalization limitations (the limit is generally 1.5:1 debt to equity).
H.S.T. (Harmonized Sales Tax)
The purchase of used residential property is exempt of H.S.T. (a V.A.T.-type sales tax at 5% federally and a provincial component of, typically, 8%). Other real estate, however, is also subject to H.S.T. A person paying H.S.T. may claim it back if the person carries on a business activity other than an exempt activity. Real estate rental and/or development will not be an exempt activity except for rental of residential real estate.
A person is required to register for H.S.T. to obtain a refund of H.S.T. or if taxable receipts exceed $30,000.00 in a 12-month period.
In a commercial real estate rental, the tenant will add H.S.T. to the rental. The landlord will collect the H.S.T. and remit to C.R.A. after claiming H.S.T. paid. Remittance may be required annually, quarterly, or monthly based on the amount.
Conclusions
As can be seen from the discussion above, the issues involved in owning Canadian residential property are complex. There are both tax planning considerations and tax compliance issues (various tax filings which need to be done). There are three main taxes to consider: land transfer tax, income tax, and H.S.T. Each comes with tax filing requirements.
C.R.A. is now aggressively enforcing the rules and following up on delinquent filers. They are examining land title registries and tracing title changes to tax returns. Because of the political attention which this area has now attracted, further and even more aggressive action can be anticipated from C.R.A. going forward.
Any non-resident of Canada who has ownership of Canadian real estate, or who is considering the purchase of Canadian real estate, should obtain professional advice.