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How I talked myself out of buying a vacation home (tax & other implications of owning US real estate)

Who can resist these views?
View from a sidewalk in Phoenix

I have never been keen on the idea of owning a cottage.  Don’t get me wrong – I love cottage country, but only when it’s someone else’s cottage.  I have no desire to fight traffic every weekend in the summer only to spend my time away painting the fence, mowing the lawn, etc.  Of course, I might feel differently if I lived in the middle of the city (which I don’t).

The other thing about owning a cottage that has never appealed to me is being “locked in” to going to the same place every year for vacation.  Our family really enjoys exploring new areas and doing different things.  Going to the same place each time would get boring very quickly for us.

All that being said, I was tempted to buy a vacation home in Arizona this month.  We’re down to the last few days of our visit, and I think I’m going to cry when we leave.  This place is gorgeous.  The mountains provide an incredible view even from the middle of Phoenix.  There are many things to do from museums to culture to fabulous hiking all within a 15 minute drive of where we’re staying.  Best of all, it’s warm and it has not rained a single time in the 4 weeks we’ve been here.  I suppose that’s to be expected being in the middle of the desert and all, but where I live, everyday sunshine is such a foreign concept – especially in the winter.

Being completely enamored with the area is what made me Google houses for sale.   The rumours about cheap housing proved true.  Many 2-3 bedroom homes are less than $100,000.  That’s just unheard of in many Canadian cities.  We met a family from Calgary on one of our hikes who bought a vacation home at the base of North Mountain last year.  The prices were just too good to pass up, they said.  They are looking forward to wintering here when they retire.

Hmmm…. Would it be a good idea for us to invest in real estate while the market is still in a bit of a slump?  (Although it seems to have recovered somewhat since the crash a few years ago).  I had to pause here and remind myself that of all the tax returns I have reviewed in my lifetime (quite a significant number), I have never seen anyone make a significant amount of money on renting a vacation home  If they broke even, they were doing well.  But perhaps that was because most of these people were using the home themselves for 3-4 months every year instead of renting it out all the time?  Or perhaps their mortgage interest was higher than ours would be if we bought?  After all, $100k is not that much for a real estate investment.

So, I decided to evaluate the prospect for myself and share my thoughts with you.

Estate tax implications

Being an accountant, I started my analysis with the tax implications.  Normally, I tell people not to do that.  Start with basic numbers first and then look at taxes.  However, the United States estate tax has been the deal breaker for many of my clients in the past, so I decided to start there.  If it was a deal-breaker for my husband & me, then no further number crunching would be needed.

US Estate Tax kicks in once the total estate (including life insurance proceeds and other assets worldwide) reaches a minimum level.  This minimum level has changed many times in recent history.  It’s one of those areas that could have many foreigners on the hook for a significant amount of money if the exemption is reduced again.   I used an online calculator and ran some numbers for our proposed purchase.  It would take a very odd set of circumstances to generate estate tax, so I decided this wasn’t a deal-breaker for me.    If you’re considering purchasing US property, you need to consult a professional who is knowledgeable in this area. 

It’s also worth noting that each US state has its own rules for calculating estate tax.  Even if you’re exempt from Federal estate tax, you may still owe state taxes.

On-going tax implications

Residency and the substantial presence test

If we purchased a vacation property, it would still be our intention to remain residents of Canada for tax purposes.  Canada is where our income comes from, where our home is, our health care coverage, etc.  No problem on the Canadian side, but it’s vital to avoid difficulties on the US side.

If we were ever to meet the substantial presence test for United States tax purposes, the US could consider us resident there for tax purposes as well, which would mean paying tax to both countries if the appropriate paperwork is not submitted.  This is where the Canada-US Tax Treaty comes in to give us a closer connection to Canada instead of the US.  As long as we file the forms we need to by the due date, we shouldn’t have any on-going US tax difficulties.

If there is any possibility that you could meet the US substantial presence test, consult a professional before you travel.  It may impact how many days you decide to say, and you need to submit the appropriate forms (including form 8840) to claim a closer connection to another country by the due date. 

Income tax returns relating to the property

If property is for personal use only, then there won’t be any income tax liability until the property is sold.  It’s important to keep records of purchase price and all improvements made to the property for capital gains purposes (see when the property is sold – below).

If there is rental income on the property, the tenants are supposed to withhold 30% of the gross rent paid and remit it to the IRS.  If this process is completed correctly, then you may be able to avoid having to file a US return.  However, chances are that the taxes will be significantly lower if you file a 1040 NR and complete the rental schedule.  This will allow you to deduct your rental expenses and pay tax on the net rental income, rather than the gross.

If you are going to receive rental income from a US property, talk to an advisor before the first payment comes.  File the proper forms to avoid having 30% withheld off the top.

When the property is sold

Article VI of the Canada-US tax treaty grants the United States the first right to tax capital gains on real estate situated in the US.  US tax returns in the year of sale will be required.  The US return would be completed first.  The sale would also be reported on the Canadian tax return for the year, with a tax credit for the tax paid in the US.

Treaties are reciprocal.  If a US taxpayer sold property located in Canada, Canada would have the first right to tax the gain.  The US would also tax the gain, with a credit for tax paid in Canada.

Still considering it?

The mountain of paperwork associated with owning and renting a US property was not enough to scare me off.  If we had to pay someone to complete all this, chances are it would wipe out our profit.  However, I would do it myself so the cost would be my time.

Running the numbers from an investment perspective

I made up a quick spreadsheet of what I expected the costs of owning a property to be.  You can download that here:  (Condo calcs) and enter your own numbers.  Please note that these numbers are just my rough estimates.  Don’t use them as a basis for your decision if you’re making one – find the numbers for the area you’re looking at and put them in.  Also add anything I may have forgotten.

Based on my calculations, a vacation home would only generate positive cash flow under a very optimistic scenario.  The odds of everything working out completely well are slim to none – and this is before looking at the cost of furnishings, repairs, and incidentals.

Running the numbers from a personal perspective

If we were planning to use the property for several months every year, it may make more sense to add up the costs of owning the property and compare them to the cost of renting a property for that length of time each year.  On the same spreadsheet I mentioned above, I added up all the costs that we’d have if we never rented the property at all and stayed for 2 months.  That number worked out to $6,000-$10,000 per year.  The cost of renting a place comparable to what we would buy is around $4,000 per month on a short term basis.  So, if we were to stay for 2 months per year for sure, it may make sense to own under that scenario because it saves us $8,000 of rent.  However, we’re not able to commit to 2 months per year at this stage.  Even one month every year would be pushing the envelope.  Given those circumstances, it doesn’t make sense to buy.  Sigh.  I really wish the numbers had worked out differently!

Another area?

The bee hasn’t totally left my bonnet yet.  Florida might be a possibility.  We can get there without having to take an airplane, which makes the possibility of using the place ourselves that much more attainable.  No flight expenses or car rentals – just gasoline and a whole lot of motion sickness from the drive (lucky me).

Every year, countless families that we know make the trek to Orlando at some point or another, so generating rental income to offset some of our costs would probably be easier.  Florida also has the advantage of year-round rental appeal whereas nobody in their right mind would voluntarily visit Phoenix in July.

Housing prices in Orlando seem to be generally higher than those in Phoenix, which would mean a higher cost of capital… looks like I need to do some more analysis.  However, I’ll save that for when I’m back at home stuck inside during the latest snowstorm.  Right now, I’m headed back outside to enjoy the sunshine!

February 23, 2014

1 responses on "How I talked myself out of buying a vacation home (tax & other implications of owning US real estate)"

  1. Thank goodness I’ve read this before I buy a vacation home.
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