Blog post

Introduction

Moving to Canada from the U.S. not only requires proper immigration strategies but also proper planning for both your specific tax and investment situation. Tax rules between Canada and the U.S. can be quite different and the additional complexities introduced by the Canada-U.S. tax treaty can overwhelm most new American entrants to Canada. In this article we will be outlining some cross-border tax and investment mistakes you’ll want to certainly avoid.

Did You Know? As a U.S. Citizen, you are required to file U.S. tax returns regardless of whether or not you actually live in the U.S.

1. Make Sure to File the Right Tax Returns

After the first year of entry to Canada both the Canadian and U.S. tax returns will be reported on a full-year basis and further State tax returns will not be required unless the taxpayer receives taxable income from specific states.

Did You Know? Managing money for a U.S.-based resident & managing money for a Canadian and U.S. resident are two very different jobs that require significantly different skill sets.

2. Don’t Forget About Financial Asset Disclosures

Although understanding which tax returns need to be filed upon entry to Canada is extremely important, understanding foreign financial reporting requirements between Canada and the U.S. is equally important. Under both Canadian and U.S. tax law governments often require that taxpayers not only disclose their worldwide income but also disclose interests in foreign financial accounts and related income on these assets. Not only can these disclosures be difficult to complete, the penalties associated with late filing these forms are significant.

Canada requires that you disclose foreign (non-Canadian investment and bank accounts) assets if the total cost of these assets is over $100,000 CAD. This reporting is done on form T1135 and the penalty for late filing this form is $25 a day up to a maximum of $2,500 plus interest.

The U.S. Treasury department requires that U.S. persons that have an aggregate highest balance total of foreign assets accounts (non-U.S. based investment and bank accounts) greater than $10,000 USD must disclose these assets on FinCEN 114, also known as FBAR filings (foreign bank account reporting). Similar to the T1135 filings above, a late FBAR filing carries a penalty, albeit it much higher than the T1135 penalties. The penalty for failure to disclose an account on an FBAR is up to $10,000 per violation and could be as high as 50 per cent of the undisclosed account if the late disclosure was considered willful.

The T1135 and FBAR requirements above are some of the most important foreign financial disclosures, however other foreign disclosures may be required depending on your situation. For example, on the Canadian side, T1142 (foreign trust filings) and T1134 (foreign corporation filings) could be required, and form 8938 (foreign account disclosures) and form 8833 (treaty-based disclosures) may also be required for U.S. purposes. Make sure to discuss any possible foreign disclosures with your cross-border tax advisor to ensure all relevant forms, disclosures and elections are properly filed.

It goes without saying that a proper review of your financial assets is a must to ensure none of the Canadian or U.S. foreign disclosures are missed for any particular year.

Note: The penalty for failure to disclose an account on an FBAR is up to $10,000 per violation and could be as high as 50 per cent of the undisclosed balance.

3. Don’t Stick With Your U.S. Investment Advisor

Of course, it’s always nice to stay with a professional advisor that you’ve worked with for years. However, most U.S. investment advisors do not have the knowledge or the ability to help manage investments for Canadian residents. Once you move to Canada your investment advisor will likely not be able to help manage your money without violating securities regulations.

Managing money for a U.S.-based resident and managing money for a Canadian and U.S. tax resident are two very different jobs that require significantly different skill sets. When Americans move to Canada, they are now required to contend with two different tax systems that have different rules for how investments should be planned and managed. For example, some investment strategies employed by U.S. advisors simply don’t work and could be quite punitive for Americans living in Canada given how Canadian tax rules treat these strategies. Some examples include:

• Tax-free muni-bond interest will be taxable in Canada
• Investments held in revocable trusts often don’t work well for Canadian
• Dividends from U.S. companies are much less tax efficient than those from Canadian companies
• Understanding Roth IRA conversions for Canadian purposes (more on this below)
• Planning for spending in Canadian dollars from U.S. investment accounts

Using a Canadian investment advisor that has licenses on both the Canadian and U.S. side of the border will allow you to be confident that investments are properly planned from both a Canadian and U.S. perspective.

4. Paying Tax on Investments You Owned Before You Move to Canada

Without proper tax and investment planning advice Americans moving to Canada may end up paying a lot more tax than required. Generally speaking, under Canadian tax law new tax residents will only be taxed on income earned after they enter Canada and on gains accumulated after their date of entry. For example, if you move to Canada with XYZ stock that you purchased five years ago for $100 and is now worth $200 and you sell it immediately after your entry to Canada you should not be taxable on any of the gain for Canadian purposes. You will have a $100 gain for U.S. purposes, however the Canadian government should only be able to tax you on increases in investments after you actually enter Canada.

The way this is accomplished via Canadian tax rules is by adjusting your Canadian cost basis in your investment to fair market value at the time of entry to the country. This increase in market value (or “bump”) resets your costs basis to fair market value upon entry and thereby will only result in a gain on increases above this new cost basis. This increase or decrease in cost basis (or “bump”) resets your costs basis to fair market value upon entry and thereby will result in a gain or loss on the increases/decreases above this new cost basis.

Of course this is a fairly simple explanation as the actual calculations and tracking of investment for entry purposes can be significant and will fluctuate based on the exchange rate between Canada and the U.S. changes after your entry to Canada. The takeaway here is simple, make sure to review your investment and retirement portfolios with a competent cross-border wealth manager before you make the move to Canada. If not, you may end up paying much more tax than you should.

5. Don’t Forget to Sell Your U.S. Principal Residence

In many cases, when Americans move to Canada they either rent out their U.S. principal residence or keep it as a vacation property. In some cases this can work, however if you’ve owned the property for some time it’s likely that the value of the property has increased significantly in value. Under U.S. tax law American couples are able to shelter up to $500,000 ($250,000 married filing separately or single) of capital gains on principal residences. However, to take advantage of the exemption the taxpayer needs to meet specific criteria: At the time of sale, the taxpayer would have had to live in the property for at least two years out of the last five years. The two years, however, do not have to be consecutive.

Americans moving to Canada could run into a situation where they have a large, accrued gain on their U.S. principal residence and then move to Canada. For example, let’s say a couple moves to Canada in 2022 and they still own a U.S. principal residence with a $400,000 accrued capital gain. In a future year they sell the principal residence, however if they haven’t lived in the property two out of the last five years, they will not be eligible for the U.S. principal residence exemption and will end up paying tax on the full gain. Assuming a 15 per cent rate of tax (could be higher for high income earners) on the $500,000 possible exemption amount that is an extra $75,000 of tax incurred unnecessarily. Definitely an amount of tax anyone would love to avoid if possible.

Without proper tax and investment planning advice, Americans moving to Canada may end up paying a lot more tax than required.

6. Failure to Wind Up Certain Trusts

The use of trusts are much more prevalent in the U.S. compared to Canada. One of the reasons for this is that certain U.S. trusts such as revocable trusts are relatively easy to set up and are disregarded for tax purposes. This simply means that the income of the trust is treated as earned by the beneficiary and no additional trust tax forms are required, unlike Canadian trusts that require separate tax return filings.

U.S. revocable trusts are often used to shelter assets from U.S. estate tax and for other estate planning strategies. They can work well for U.S. purposes, however once you move to Canada the trusts will likely be considered Canadian resident trusts and additional time consuming and costly Canadian trust reporting forms will be required. Before moving to Canada make sure to have your cross-border advisors review any trust holdings to potentially proactively wind-up trusts that may not serve any future benefit once you become a Canadian resident.

7. Don’t Forget to Review Your IRAs and 401(k) Accounts

Your U.S. registered accounts like 401(k)s, traditional IRA and Roth IRAs require some planning attention before you move to Canada. Although these accounts are tax deferred under the Canada-U.S. income tax treaty some strategies do exist to attempt to reduce future taxes on these accounts.

First, for very similar reasons as mentioned above these accounts should be managed by a cross-border investment advisor in Canada. This will allow you to better manage future required minimum distributions and strategies around foreign currency fluctuations. It’s often advantageous to consolidate IRAs and 401(k)s into one custodial account for simplicity and ease of management.

Roth IRA accounts on the other hand require much more focused attention to ensure you can take advantage of future tax deferral and potentially significant tax savings. In cases where your income before you move to Canada will be relatively modest there is an opportunity to convert some of your traditional IRA to a Roth IRA before the move. For example, you might convert a portion of your traditional IRA to a Roth IRA and pay 15 per cent {used for illustration purposes} tax on the conversion. If your tax rate when you move to Canada is more than 15 per cent {which is often the case after entering Canada given our higher tax rates} you’ll save the difference in tax upon distribution of the Roth IRA. If properly converted to a Roth IRA, the full amount of the account will not only generate tax-free investment income, qualified future distributions will be considered tax free for both Canadian and U.S. tax purposes.

For this strategy to work properly however, you’ll need to ensure you file appropriate Roth IRA treaty elections with Canada in the year of entry.

Conclusion

Although the list of planning items above is not exhaustive, you can see from the complexity of the tax system between both Canada and the U.S. that proper planning for your investments and your tax situation is imperative. Developing a competent group of cross-border tax and investment professionals to help you navigate both the tax and investment strategies above will not only assist in simplifying your move but will also help you save taxes in the years to come.

If you would like to discuss your tax or investment situation please reach out to Phil Hogan at phil@beaconhillwm.ca.

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Email: phil@beaconhillwm.ca
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Information in this article is from sources believed to be reliable; however, we cannot represent that it is accurate or complete. It is provided as a general source of information and should not be considered personal tax or investment advice or solicitation to buy or sell securities.