US Taxpayers and the Principal-Residence Exemption

In most cases, the principal-residence exemption (PRE) will completely eliminate the capital gain for Canadian tax purposes arising on the disposition of a taxpayer’s home in Canada. However, US taxpayers (US citizens, green-card holders, and US residents) are taxable on their world income, and the analogous provision to the PRE under the Internal Revenue Code is more restrictive. Therefore, a US taxpayer may incur a US tax liability on the sale of a Canadian home that cannot be fully offset on the US return with a foreign tax credit (FTC).

Consider a single US taxpayer residing in Canada who incurs a capital gain of $750,000 (all figures in this article are in US dollars) on the sale of her principal residence. There is no Canadian tax liability on the sale, but for US tax purposes there is a $250,000 limit on the amount of the capital gain that can qualify for exclusion (IRC section 121). The US tax liability is approximately $119,000 ($750,000 − $250,000 exclusion × 23.8%, the top US personal income tax rate on long-term capital gains). The liability will be less for married taxpayers who file a joint US income tax return; the exclusion is $500,000 in that case.

The issue is whether this liability can be offset by the FTC on the US return. The sale of the principal residence attracts no Canadian tax, so no FTC can arise from that income. Excess FTC might arise from the taxpayer’s other income, since the Canadian tax on that other income is probably higher than the similar US tax. However, gains on homes can be large relative to other income in the year, and thus the US tax on that gain may not be fully sheltered by a US FTC.

A second problem is that the gain on the Canadian home may not qualify for any US exclusion at all. In the five years leading up to the disposition, the taxpayer must have both owned and resided in the home for at least 24 months (not necessarily the same months) (IRC section 121). A taxpayer who has owned the home for less than two years fails the ownership test, and a taxpayer whose child was the occupant (rather than the taxpayer) fails the use test. The PRE is available in both of these situations.

The capital gains on the Canadian home for US purposes can be reduced by increases in the basis in the property—for example, the cost of a fence, a new roof, new siding, built-in appliances, and flooring and carpeting (see “Selling Your Home,” IRS Publication 523). Therefore, US taxpayers should keep all receipts for improvements and for certain repairs in order to reduce the future capital gain on disposition.

Further planning to mitigate US tax exposure may be available for spouses if one spouse is a US taxpayer and the other spouse is taxable only in Canada. In that case, a couple can consider an ownership structure in which the Canadian taxpayer holds title to the property. This is a practical solution when a property is first acquired; however, it may not be practical if the property is already jointly owned. A gift of the US taxpayer’s share in the property to the Canadian taxpayer is problematic because US gift tax may apply.

Bradley Jesson
Mowbrey Gil LLP, Edmonton
[email protected]

Canadian Tax Focus
Volume 5, Number 3, August 2015
©2015, Canadian Tax Foundation