Esmeralda Buys US Property

Esmeralda has come to a landmark decision – on top of her gambling, she chose to invest in real estate to diversify her portfolio. She was also getting sick of staying in hotels. In order to avoid hotels – she went out and bought a house where she has decided to stay when she gambles or when it gets too cold for her up in Canada.

She wanted to discuss tax implications of owning a rental property since she already got a shock with her winnings. I told her that she would have to pay the US tax of 30% on her Gross Rental Income (you do NOT get to deduct expenses) – she would not have to file a 1040NR for the rental alone. However, since she is a compulsive gambler and will want the taxes on her winnings anyways, she may as well file the 1040NR.

If you have never gambled in the United States or filed a tax return in the US, you actually need an ITIN ( Individual Taxpayer Identification Number) to file the 1040NR. For information on the application process please refer to my post “Esmeralda Wants Her Money Back”.

Most people do not like paying 30% to the United States on their rental income. Esmeralda doesn’t like that idea either. In order to avoid paying 30% it is sometimes beneficial to elect to have the rental income treated as “effectively connected” to the United States. The election allows for 2 main things – First, you are taxed at the marginal tax rates instead of the 30% and Secondly, you are taxed on your Net Rental Income (the big difference being, you get to deduct your expenses).

In order to make the election, you need to write a letter and attach it to the tax return. In practice most people just file the 1040NR their first year with the rental schedule attached. The IRS has now added a new Box M on Page 5 of the 1040NR (Schedule OI – Other Information). The first year that the 1040NR is filed you need to check off box 1 if you want to make the election. In future years, make sure to check off box 2. If the IRS wants a letter highlighting the fact that you are making an election – there are some specifics that need to go into it.

The letter / statement must possess all of the following information:

1. That you, the tax payer want to make the election;
2. A complete list of all of the real property (you cannot decide to elect some and not others), or any interest in real property, located in the United States (including location). Give the legal identification of U.S. timber, coal, or iron ore in which the taxpayer has an interest;
3. The extent that you own the property (if there are any partners);
4. A description of any substantial improvements to the property (used to calculate the starting basis of the property);
5. Income from the property (if partners, including spouse – your portion);
6. The date(s) property is owned;
7. Whether the election is under section 871(d) or a tax treaty;
8. Details of any previous elections and revocations of the real property election.

Once you make this election, it is not revoked in future years unless you decide to revoke it. If you acquire new property, you will have to up date the list (you should have one in your records in case the IRS wants to see it). There is a deadline for making the election,the 1040NR is normally due by the June 15th of the year following the calendar year the property was acquired. However, the ability to elect to treat the rental income as effectively connected with a U.S. trade or business will be lost after 16 months from the original due date of the return. If the election is not made in a timely manner, you may get stuck paying the 30% instead.

There are a few things that must be mentioned here – even if your partner is your spouse – both of you will have to file a 1040NR, separately. When claiming your expenses – you MUST claim depreciation (this is a big difference when compared to Canada). Many of the expenses claimed in Canada on a rental property can also be claimed in the US – the main difference is the previous point. I think the IRS’s reasoning for this is they want to potentially recoup some of their money once the property is sold. You may also have to file a State tax return, depending on which state you are in.

Esmeralda must also claim this income in Canada on her Canadian return. I do not know how many times that I have heard – “My rental is in the States so I don’t have to declare it”. It actually does have to be claimed on your Canadian tax return, including when you actually sell the thing. When claiming in Canada, you do not have to claim depreciation on the Canadian side. If a profit is made on the rental income – you may be able to claim a foreign tax credit so you are not taxed on both sides of the border. As well, if the property is over $100 000.00 and you are using it as a rental, you must report the property to Canada on T1135 (Foreign Income Verification Statement). I will explain to Esmeralda about the T1135 and why it is so important in my next post.