Are You in For a Treat? U.S. Citizens with Canadian Mortgage May Be Up For a Treat by the Internal Revenue Service (IRS)!

Author(s): Alex­ey Man­a­suev The fol­low­ing arti­cle co-authored by Alex­ey Man­a­suev and Roy A Berg of Moodys LLP, Cal­gary, first appeared in Cana­di­an Tax High­lights, Vol­ume 25, Num­ber 8. Date: August 2017

While many Cana­di­ans are tak­ing the advan­tage of a hot hous­ing mar­ket in Toron­to and sell­ing their prin­ci­pal res­i­dences real­iz­ing sig­nif­i­cant gains tax-free, U.S. cit­i­zens who live in Cana­da and want to take a sim­i­lar advan­tage may be up for a nasty tax sur­prise by the IRS¹. What’s worse, they may be sub­ject to addi­tion­al tax even if they sus­tained a loss on the sale of their prin­ci­pal res­i­dence. The US func­tion­al cur­ren­cy rules have a broad­er reach and are a trap for the unwary that may be eas­i­ly missed by tax­pay­ers and their advi­sors. U.S. cit­i­zens liv­ing in Cana­da are sub­ject to U.S. tax despite their Cana­di­an res­i­den­cy. This dif­fers from the Cana­di­an tax regime that uses a res­i­den­cy-based tax­a­tion. The cross-bor­der tax com­plex­i­ty for U.S. per­sons resid­ing out­side the Unit­ed States is sub­stan­tial and they fre­quent­ly need help of a qual­i­fied U.S. tax advi­sor. One should not eas­i­ly assume that they would get the same tax treat­ment under U.S. tax rules as they would in Cana­da. Cana­di­an res­i­dents have long enjoyed the favor­able tax treat­ment of sell­ing their prin­ci­pal res­i­dence. Gen­er­al­ly, any gain real­ized on a sale of a prin­ci­pal res­i­dence by Cana­di­an res­i­dent indi­vid­u­als is exempt from tax under the prin­ci­pal res­i­dence exemp­tion². Although the Unit­ed States also pro­vides its res­i­dents (which includes U.S. cit­i­zens, no mat­ter where they live) with a prin­ci­pal res­i­dence exclu­sion, the amount of such exclu­sion is lim­it­ed to US $250,000 in cap­i­tal gains on a dis­po­si­tion of a qual­i­fy­ing res­i­dence³. Any gain in excess of that amount may be taxed up to 23.8 per­cent (that includes a long-term cap­i­tal gains tax rate and Net Invest­ment Income Tax (NIIT) com­bined⁴). As it turns out, pay­ing tax on the sale of Cana­di­an home by U.S. cit­i­zens liv­ing in Cana­da is not good enough for the IRS. U.S. cit­i­zens sell­ing their homes in Cana­da may have to pay even more tax to Uncle Sam. Specif­i­cal­ly, if they pur­chased their house in Cana­di­an dol­lars (you would think, dah – how else would they have pur­chased it in Cana­da??) and used a mort­gage to finance the pur­chase, they are like­ly look­ing at pay­ing addi­tion­al tax due to the for­eign exchange gain under applic­a­ble U.S. tax law. So, why and how does this work? The rea­son for addi­tion­al tax cost is due to the U.S. tax law, accord­ing to which U.S. cit­i­zens are gen­er­al­ly required to use the US dol­lar as their “func­tion­al cur­ren­cy.”⁵ That means that any deter­mi­na­tion of US person’s US tax lia­bil­i­ty must be made in US dol­lars (oth­er cur­ren­cy is con­sid­ered a “non­func­tion­al cur­ren­cy” in this respect). Fur­ther, the deter­mi­na­tion of for­eign cur­ren­cy gain/loss must be made on a trans­ac­tion by trans­ac­tion basis. As a result, (i) when a U.S. cit­i­zen bor­rows funds denom­i­nat­ed in for­eign cur­ren­cy (oth­er than US dol­lar) to pur­chase a res­i­dence, and (ii) where the for­eign cur­ren­cy depre­ci­ates in val­ue against the US dol­lar from the date the debt (such as a mort­gage) was incurred until the date the debt was sat­is­fied (this would include refi­nanc­ing)⁶, the U.S. cit­i­zen would be taxed on a for­eign exchange gain real­ized on the lat­ter trans­ac­tion. Under such cir­cum­stances, an indi­vid­ual would have repaid the mort­gage using less US dol­lars for US fed­er­al income tax pur­pos­es. It’s best to illus­trate the result­ing adverse U.S. tax con­se­quences by review­ing the fol­low­ing sce­nario. Sup­pose that a U.S. cit­i­zen liv­ing in Cana­da pur­chased a house on Decem­ber 31, 2012 (when the Cana­di­an and US Dol­lars were prac­ti­cal­ly at par). The house pur­chase price was C $1,000,000 and the mort­gage was C $800,000. Let’s assume that the said U.S. cit­i­zen sold his house on Decem­ber 31, 2016 for C $1,300,000 (at that time, 1 Cana­di­an dol­lar equaled rough­ly $0.75 US dol­lars). Under Cana­di­an tax law, the U.S. cit­i­zen real­ized C $300,000 cap­i­tal gain on the sale of the house. How­ev­er, no tax would be due in Cana­da on that real­ized gain due to the prin­ci­pal res­i­dence exemp­tion dis­cussed above. But the U.S. tax result is strik­ing­ly dif­fer­ent. Under the facts in this case, the U.S. cit­i­zen would real­ize a cap­i­tal loss of US $25,000 [(C $1,300,000 x 0.75) – (C $1,000,000 x 1)] on the dis­po­si­tion of his Cana­di­an prin­ci­pal res­i­dence (the US $25,000 loss occurs because of the deval­u­a­tion of the Cana­di­an dol­lar against the U.S. dol­lar since the date of the orig­i­nal pur­chase). More impor­tant­ly, because the func­tion­al cur­ren­cy of the U.S. cit­i­zen is US dol­lar, for U.S. fed­er­al income tax pur­pos­es, the gain/loss on the sale of the house is required to be cal­cu­lat­ed in US dol­lars by using the for­eign cur­ren­cy exchange on the trans­ac­tion dates (here, the pur­chase and sale of the house).  Accord­ing­ly, the U.S. cit­i­zen would have addi­tion­al tax on US $200,000 cur­ren­cy exchange gain [C $800,000 x 1) – (C $800,000 x 0.75)] on the extin­guish­ment of the debt.⁸  (For prac­ti­cal pur­pos­es, the Unit­ed States views this trans­ac­tion as if the indi­vid­ual received an US $800,000 mort­gage but repaid that same mort­gage debt with only US $600,000 because of the fluc­tu­a­tion in cur­ren­cy, hence the cur­ren­cy gain). The sad news is that the loss can­not be rec­og­nized and ever used to off­set the cap­i­tal gain.⁹ The U.S. func­tion­al cur­ren­cy rule has broad­er impli­ca­tions for U.S. cit­i­zens and res­i­dents liv­ing in Cana­da or out­side the Unit­ed States. Any time when a tax­pay­er pur­chas­es for­eign cur­ren­cy, she/he should think of it as a prop­er­ty. As such, like oth­er invest­ments, a sale of the for­eign cur­ren­cy would be treat­ed as a real­iza­tion event for U.S. fed­er­al income tax pur­pos­es that may result in a gain or loss recog­ni­tion, depend­ing on the tax basis and the fair mar­ket val­ue of the prop­er­ty at the time of the sale. Fail­ure to report the for­eign cur­ren­cy gain may result in sub­stan­tial penal­ties for under­re­port­ing of income. Note that there is a de min­imis rule that exempts from tax a dis­po­si­tion of non­func­tion­al cur­ren­cy as long as the gain real­ized on the dis­po­si­tion is lim­it­ed to US $200 or less. Cana­di­an res­i­dents are required to use Cana­di­an dol­lar (nation­al cur­ren­cy) for dai­ly trans­ac­tions in Cana­da. As such, U.S. cit­i­zens liv­ing in Cana­da rarely have a choice, but to use “non­func­tion­al cur­ren­cy” for U.S. fed­er­al income tax pur­pos­es in their dai­ly lives. This would be true in most coun­tries, includ­ing the Unit­ed States (you can only trans­act in US dol­lars there). Cur­rent­ly, there is no relief under the func­tion­al cur­ren­cy rules for U.S. cit­i­zens and res­i­dents liv­ing out­side the Unit­ed States (the lim­it­ed excep­tion for a qual­i­fied busi­ness unit (“QBU”) is very restric­tive and does not apply to per­son­al trans­ac­tions). Until such relief is pro­vid­ed, U.S. cit­i­zens and res­i­dents liv­ing in Cana­da and oth­er coun­tries should care­ful­ly plan their trans­ac­tions and seek advice from qual­i­fied tax pro­fes­sion­als to ensure U.S. tax com­pli­ance and ade­quate penal­ty pro­tec­tion.

¹  The issues dis­cussed in this arti­cle are equal­ly rel­e­vant to U.S. cit­i­zens resid­ing in oth­er coun­tries out­side the Unit­ed States. ²  See Sec­tion 40(2)(b) of the Income Tax Act. Note that cer­tain require­ments must be met to qual­i­fy for the prin­ci­pal res­i­dence exemp­tion. ³  IRC Sec­tion 121(a). Note that cer­tain require­ments must be met to qual­i­fy for the prin­ci­pal res­i­dence exemp­tion. ⁴  IRC Sec­tion 1411(a)(1) impos­es the 3.8% (NIIT) tax when cer­tain thresh­olds are met. NIIT is not cred­itable in Cana­da. ⁵  See IRC Sec­tion 985(b)(1)(A). Cer­tain excep­tions exist, but are irrel­e­vant for pur­pos­es of the dis­cus­sion in this note. ⁶  The debt is con­sid­ered sat­is­fied in case of refi­nanc­ing or dis­po­si­tion of the prop­er­ty. In addi­tion, each prin­ci­pal and inter­est pay­ment would attract the same issue. ⁷  See IRC Sec­tions 1011 and 1012. ⁸  Under these facts, the U.S. tax may be as high as US $47,600. ⁹  Off­set­ting real­ized cap­i­tal loss on the sale of the house against cap­i­tal gain real­ized on the repay­ment of the mort­gage is not allowed because the bor­row­ing and repay­ment of the mort­gage loan is a sep­a­rate trans­ac­tion from the pur­chase and sale of the per­son­al res­i­dence. How­ev­er, the loss is a per­son­al loss. See IRC Sec­tion 165© (the loss deduc­tion is lim­it­ed to loss­es incurred in a trade or busi­ness, loss­es incurred in trans­ac­tions entered into for prof­it, and casu­al­ty loss­es). See also Qui­jano v. Unit­ed States 93 F.3d 26 (1st Cir. 1996) (a U.S. cit­i­zen liv­ing in the Unit­ed King­dom was denied relief under sim­i­lar to the sce­nario used in this note for illus­tra­tion pur­pos­es); Rev. Rul. 90–79, 1990–2 CB 187.