A solid financial plan can be destroyed when clients get divorced. This is particularly true when the divorce involves a couple with Canada-U.S. financial, tax and estate-planning considerations.
We’ve seen more planning inquiries by people who’ve met their spouses via online dating sites. In many cases, one person will be moving from Canada to the United States or vice versa. If those clients get divorced, there are many tax complications.
It’s critical to identify the type of assets for distribution (traditional investments, retirement plans, real property, business interests, etc.), their locations (Canada, U.S., elsewhere) and the cost basis of non-retirement plan assets.
Property transfer due to divorce
When spouses transfer property to each other, there could be differing Canadian and U.S. income tax results. Further, given U.S. transfer rules, unintended gift taxes could be imposed based on the tax residency and citizenship of the spouses.
If both spouses are U.S. citizens, Section 1041(a) of the Internal Revenue Code (IRC) provides for the transfers of assets free of U.S. income and gift taxes — irrespective of gain or loss. Such a transfer is considered a gift between spouses.
But if one of the spouses is not a U.S. citizen or would be considered a nonresident alien (NRA), IRC Section 1041(d) overrides the non-recognition provisions and an income or gift tax result could occur.
Is a spouse a non-resident alien?
To find out what will happen if your clients transfer property to each other, first determine whether one spouse is an NRA.
U.S. citizens are considered residents of the U.S. for income, gift and estate tax purposes, irrespective of where they generate or receive investment income, hold or transfer assets, or die. This is also the case for green card holders or people who meet the U.S. substantial presence test.
An NRA is generally subject to tax on U.S. source income, such as net income from a rental or gains from selling U.S. real property. Certain types of U.S. investment or pension income could also be subject to U.S. tax. However, under the Canada-U.S. Tax Treaty, this obligation might be dealt with through withholding taxes at source.
So long as the underlying passive investments that generate this income are not through a U.S. trade or business but rather through direct investments, there would be no tax on U.S. source interest and only 15% withholding on U.S. source dividends and pension distributions.
Read: Snowbirding in the U.S.
Under U.S. tax rules, an income or transfer tax could apply if property is transferred within a year of the divorce. U.S. transfer tax rates start at 18%, with the maximum rate being 40%. If the U.S. citizen spouse had highly appreciated stock to transfer to the NRA, then the U.S. citizen would have to pay income tax on the gain as if she’d sold it.
Further, a U.S. gift tax could apply, even if the transferor spouse was considered a U.S. resident for income tax purposes. U.S. gift tax would result if a transfer to a non-citizen spouse exceeds US$143,000. This number is indexed annually for inflation.
If there’s no income or transfer/gift tax imposed on the property settlement, the recipient spouse would take over the transferor’s original cost base in the property (referred to as a carry-over basis).
If the recipient were an NRA, the carry-over basis rule would not apply and the recipient spouse’s tax basis would be equal to its fair market value.
Transferring real estate
Canadian income tax doesn’t apply upon the sale of real estate as part of a divorce settlement. However, if one or both spouses are U.S. citizens, U.S. income tax could apply upon the sale or transfer.
Upon divorce, a U.S. tax resident can exclude up to US$250,000 of his share of the gain from U.S. income tax. In order to qualify, the spouse must have owned his share for at least two years of a five-year period ending on the date of sale AND have used the home as a principal residence for at least two years during that period.
We have seen situations where U.S.-citizen clients have had to pay U.S. income tax on gains exceeding US$250,000 on Canadian principal residences.
If an NRA spouse is transferring U.S. real estate, the Foreign Interest in Real Property Tax Act (FIRPTA) could apply. The U.S. may withhold 10% of the transferred value. The recipient spouse would have full and personal liability of the withholding tax if not completed.
A withholding tax obligation might not apply if the transferee used the property as her residence AND the amount realized by the transferor is less than US$300,000.
Spousal and child support
It may be difficult to collect spousal and child support between both countries. Using Maintenance Enforcement can help, but it doesn’t always work. Also, if one spouse is paying alimony to a previous spouse who now lives in Canada, the U.S. citizen payor can deduct this amount under U.S. tax rules, but additional documentation will be required.
With offices in Canada and the United States, Terry F. Ritchie is the director of Cross-Border Wealth Services for Cardinal Point Wealth Management and Jeff Sheldon is the principal and co-founder of Cardinal Point Wealth Management.