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American citizens living in Canada for more than five years face an imposed exit tax on unrealized gains.
One of the most common questions we receive from Americans moving to Canada is how to navigate around the Canada Revenue Agency’s five-year deemed disposition rule. Canada assesses an exit tax on any unrealized capital gains inside taxable accounts in cases where the U.S. citizen moves back to the United States after having been a Canadian tax resident for longer than 60 months.
It is important to note that this rule does not apply to any tax-deferred investment accounts or plans.
Some visa holders arrange their date of return to the United States to be 60 months less a day in order to avoid qualifying for this event. But in many cases, this is inconvenient for the corporations that employ them. And it can create personal family hardship, should it occur, for example, in the middle of a school year.
The Canada-U.S. tax treaty requires that non-tax-deferred securities accounts be taxed in the country of the beneficial owner’s residency. Accounts that are transferred to Canada from the United States “in kind” retain their original cost basis (usually the purchase price) for U.S. tax purposes. But a second cost basis—equal to the accounts’ market value on the day the beneficial owner became a Canadian resident for tax purposes—is automatically generated. This can cause confusion, and in many cases erroneous tax reporting, in both Canada and the United States.
Does leaving your accounts in the U.S. help?
In the past, some U.S. citizens would simply leave their U.S. taxable and trust accounts in the United States in an attempt to get around the Canadian five-year tax rule. Prior to 2013, this sometimes worked. The CRA required, but did not rigorously enforce, reporting of unrealized capital gains of all taxable accounts, including those remaining in the U.S.
In 2013, however, the CRA introduced a revamped, more robust version of a form called the T1135 Foreign Income Verification Statement, which is somewhat similar to the IRS’ foreign reporting requirements in the United States through IRS Form 8938 and the FinCEN 114. The CRA T1135 form requires a detailed annual accounting of all foreign accounts (including those in the United States) held by a Canadian tax resident. Failing to file this form leads to penalties. And given the increased information sharing initiatives now in place between the CRA and IRS, taxpayers must be compliant. If an American moves back to the United States after five years, the CRA will have a complete record of all of their taxable investment accounts in both countries. When completing the Canadian exit tax returns, you will be assessed on any unrealized capital gains from the date of when you entered Canada to the date of departure. This is reported on your Canadian exit return through Forms T1161 and T1243.
How do the tax rules work?
Let’s use a hypothetical example to illustrate how the rules work. For simplicity’s sake, we will ignore currency exchange. Bear in mind that in real life, currency exchange must be accounted for to determine the proper Canadian basis and ultimate proceed numbers for Canadian and U.S. purposes.
- You purchase a number of investment securities (stocks, bonds ETFs etc.) in a taxable account that has a U.S. cost basis of $50,000. When you later move to Canada, the account is worth $100,000 ($50,000 of which is unrealized gains). Regardless of where the account is domiciled (Canada or the United States), you now have two adjusted cost bases for tax purposes. The U.S. basis is $50,000. The Canadian basis is $100,000.
- Five years later, you move back to the United States; the account has now grown to a value of $150,000 ($100,000 capital gains for U.S. tax purposes and $50,000 for Canadian tax purposes). For Canadian tax purposes, you will have an imposed departure gain of $50,000. In Canada, 50% of the gain is taxable at your respective marginal rate. Assuming that you are in the highest marginal rate in Ontario upon exit, your net tax would be 24.76%.
For U.S. tax purposes, you would have to pick up capital gains of $100,000. The current U.S. long-term capital gains rate of 15% would be applied. However, depending on your filing status and U.S. Adjusted Gross Income amounts, you could be subject to an additional 5% capital gains tax and a 3.8% levy on all net investment income for the tax year. Therefore, it is extremely important to proactively gain a sense of what exposure might exist in Canada and the United States prior to departure or the end of the tax year in order to avoid any unnecessary surprises.
- On any Canadian tax paid, you would receive a passive foreign tax credit. The credit may be used for U.S. tax reporting purposes under the Canada-U.S. tax treaty—provided that it is properly filed by your accountant. It should be noted that this is a “deemed” sale, and not an actual sale of the securities in the account. For U.S. tax purposes, your original adjusted cost basis is still $50,000.
- Interestingly, when moving back to the United States, the IRS does not allow for a stepped-up basis to be used for securities bought while living in Canada. Unlike in Canada, where the basis for Canadian tax purposes is calculated based on the market value on the day that the beneficial owner became a Canadian resident for tax purposes, the U.S. will only recognize the original basis. This means that if a security was bought in Canada for $50,000 and it was valued at $100,000 at the time you move back to the U.S., the IRS would consider $50,000 to be the cost basis—it will not allow it to be stepped up to $100,000.
How to minimize the Canadian exit tax
A qualified Canada-U.S. cross-border financial advisor will keep track of both your Canadian and U.S. cost bases, and tax-manage your portfolio accordingly. Actively and prudently employing tax-loss harvesting to offset gains can reduce the amount of exit tax owed. Contact Cardinal Point to learn more about our tax-managed portfolio strategies for Americans living in Canada, and how we personalize our investment process to fit your needs.
About the Author: Terry Ritchie is the Director of Cross-Border Wealth Services at the Cardinal Point, a cross-border wealth management organization with offices in the United States and Canada. Terry has been providing Canada-U.S. cross-border financial, investment, tax, transition, and estate planning services to affluent families for over 25 years. He is active as an author, speaker and educator on international tax and financial planning matters. www.cardinalpointwealth.com
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When a U.S. citizen or U.S. resident alien is married to a Canadian spouse who is not a U.S. citizen, then property transfers between the spouses could be taxable in the United States or subject to U.S. gift-tax rules.
Most Canadians are not familiar with a gift tax or an estate tax because Canada doesn’t have such taxes. In the United States, however, gift and estate taxes exist alongside regular income tax, and can run as high as 40% of the value of a U.S. taxpayer’s wealth over a certain amount.
Inter-spousal transfers can take place via a gift, a sale or incident to a divorce. For U.S. tax purposes, a gift is treated as a transfer of property without receiving full consideration in return. For married couples where both spouses are U.S. citizens, transfers are not subject to regular income tax or gift tax. But problems arise when one or both spouses are not U.S. citizens.
Sale of property to a spouse
If both spouses are either U.S. citizens or U.S. tax residents, then an inter-spousal transfer by sale or divorce is tax-free. If, however, one spouse is a non-resident alien for tax purposes, then the transferring spouse will recognize a gain or loss for U.S. tax purposes.
Gift of property to a spouse
When one spouse is not a U.S. citizen, then U.S. gift-tax rules could apply. Unlike the unlimited marital gift tax deduction applicable to U.S. citizen spouses, a gift to a non-citizen spouse is only exempt from gift tax up to $147,000 (for 2015). This rule applies regardless of whether the receiving spouse is a green-card holder or otherwise a U.S. tax resident. As a result, care must be taken to analyze transactions between spouses to determine whether a gift tax return needs to be filed to pay any gift tax.
Let’s look at an example of when this situation would apply. Neil Youngman is an American citizen living in Malibu, Calif., and his wife, Cinnamon, is a Canadian citizen living in Toronto. Neil is a musical legend. Because Neil has a Heart of Gold, he decides to give his Canadian wife a gift of $500,000 to buy a home Down By The River in Muskoka. Unfortunately for Neil, only $147,000 of the gift is tax-free. The remaining $353,000 will need to be reported on a gift tax return, and is subject to gift tax.
As you can see, failing to plan ahead for spousal transfers could leave you afoul of complex tax rules—and subject you to unexpected tax surprises.
Marc Gedeon is a CPA (U.S), CPA (Canada) and Tax Attorney at Cardinal Point, a cross-border wealth management organization with offices in the United States and Canada. Marc specializes in providing Canada-U.S. cross-border financial, tax, transition, and estate planning services. www.cardinalpointwealth.com This piece is for informational purposes only and should not be considered legal or tax advice. Online readers should not act upon this information without seeking professional counsel.
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