Following is information provided by Richard Frunzi for informational purposes for Canadians Acquiring or Selling Real Property in Hawaii. We will be adding a tab to our website with additional information on this topic as well as Foreign Investors Acquiring or Selling Real Property in Hawaii shortly. Please look for it soon.
© 2010 Richard L. Frunzi
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Business and Tax Consulting
Issues in Dealing with Canadian Citizens
Who Acquire or Sell Real Property in Hawaii
As with many tax concerns affecting real estate, its acquisition, its ownership and its
disposition, the issues are magnified when dealing with citizens of foreign countries. The issues
relating to how we should handle purchases, management or sales of Hawaii real estate when
dealing with our neighbors directly north of us in Canada are unique and often not fully understood
by the Hawaii professionals with whom they may be dealing. How a Canadian owning real property
in Hawaii will be taxed for U.S. income tax purposes depends in great part on the status of such
individual as such is determined by the IRS. Remember, as a general rule, the United States
Treasury Department cares little about how the Canadian Revenue Agency classifies a Canadian
citizen for either residency or immigration purposes.
1. What/Who is a Canadian (or Better Stated, Who is a United States Resident)?
a. Rule For Immigration Versus Tax Purposes. The test of whether an individual is
considered a resident of the United States differs depending upon whether the discussion is about
income taxation, estate taxation or immigration. While it may be very difficult for a citizen of
Canada to be treated as a resident for U.S. immigration purposes, and fairly difficult for such person
to be considered a resident for U.S. federal estate tax purposes, it is relatively easy (and in many
cases, even inadvertent) as to how a Canadian citizen can become treated as a resident of the United
States for federal income tax purposes.
b. True Canadian Citizenship Versus Dual Citizenship. Not all Canadian citizens
are, however, created equal. While most citizens of Canada will hold citizenship only in Canada (or
in Canada and some third country other than the United States, there is a growing group of
individuals that hold citizenship in both the United States and Canada. These dual citizens are
automatically considered U.S. taxpayers for United States’ federal income tax purposes.
2. How Does a Canadian Inadvertently Become a U.S. Taxpayer? Increasingly, we see
Canadian citizens inadvertently becoming U.S. taxpayers without intending to make such an
adjustment in their status for U.S. tax purposes. If a Canadian citizen fails either of the two tests
that are currently in use under United States tax law to determine his or her status for the income
tax purposes, then they will be considered for income tax purposes to be a United States resident.
The two tests are the “Green Card” test and the “Substantial Presence” test (sometimes
referred to as simply the “presence” test). These two tests are what the United States taxing
authority, called the Internal Revenue Service (or IRS for short) use to determine if an individual is a
U.S. taxpayer for United States income tax purposes. There is currently a treaty between the United
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States and Canada that provides some guidance on this issue, but in essence, if a Canadian citizen
either obtain a green card or fail the presence test, he or she would be considered to be a United
States taxpayer for income tax purposes.1 Becoming a U.S. taxpayer for income tax purposes would
mean that such individual would essentially be taxable for U.S. income tax purposes on his or
her worldwide income, regardless of in what country such income is earned or paid.
a. Green Card Test. The Green Card Test is fairly easy to identify and understand – if
a Canadian citizen has a United States green card for permanent resident status (the original color of
the card granted by the U.S. government to individuals who became permanent residents of the
United States) – then he or she is considered to be a resident of the U.S. for income tax purposes.
b. Substantial Presence or Presence Test. Unfortunately, the Substantial Presence
Test is more complicated. Under the Substantial Presence Test, a foreign national will be deemed a
resident for tax purposes if he or she has been in the United States for 31 days during the present
year and at least 183 days during the present year and the preceding two years, with each day in the
present year counting as a full day, each day in the immediate prior year counting as 1/3 of a day
and each day in the second prior year counting as 1/6 of a day. To illustrate graphically:
Year Days Stayed in
United States Multiplier Test
Current Year 1
Previous Year 1/3
Two Years Ago 1/6
Under the formula above, if, when multiplied by the number of days for each the current
year for which a person is attempting to determine if he or she have failed the test and the two years
immediately preceding that year, the total number of days such person has stayed (or are going to be
staying) in the United State is greater than 183, then such person will be considered a resident for
U.S. income tax purposes and subject to U.S. income tax on their worldwide income unless there is
an exception for such party’s situation. This test must be applied for each year in which a non-U.S.
citizen is present in the United States.
Under the treaty between the United States and Canada, the test is a little more relaxed since
even where an individual who is considered a resident under the substantial presence test, if (a) he
or she is not present in the United States for 183 days or more during the current year, (b) that
person is not treated as a resident if he has a “tax home” in a foreign country and (c) has a closer
Note that becoming a United States taxpayer for income tax purposes is different than becoming a United
States taxpayer for estate tax purposes and much different than becoming a U.S. resident for immigration
purposes. In fact, it is not uncommon to become a U.S. taxpayer while not being a resident for immigration
purposes. Not better or worse, simply different.
Canadian Investment in Hawaii Real Estate Page 3
connection to the foreign country than to the United States, under the “Closer Connection
Exemption,” the United States will not treat that person as a United States taxpayer.2
3. Taxation of Canadians in the United States Generally.
a. What Does it Mean if a Canadian Citizen is a U.S. Resident For Income Tax
Purposes? Once the foreign national is classified as a resident of the U.S., under its current tax
structure, the IRS will hold such foreign national’s worldwide income subject to income taxation by
the United States. This, however, is where the income tax Treaty between the United States and
Canada can come to one’s rescue. Under the Treaty, each Canada and the United States have
agreed that income generated in the host country will be taxable in that country first. The non-
source country (the one where the income was not generated) then, pursuant to the terms of the
Treaty, grants in most instances an income tax credit for the tax paid in the source country on such
income. While these credits do not always match up in terms of income and/or timing, they can go
a long way towards providing shelter for those individuals that have income in both countries.
b. Why is it Better to Not Be a U.S. Resident For Income Tax Purposes? If, on
the other hand, that individual does not meet either test (or is protected by the Closer Connection
Exemption), he or she will remain a nonresident shielding all non-United States source income from
taxation by the United States, leaving on his or her U.S. source income subject to tax by the IRS, the
U.S. taxing authority. Stated in different words, a nonresident alien Canadian citizens taxed on all
income from within the United States or all United States source income. Income from within the
United States or United States source income is generally considered to be income that is produced
by an activity or an investment in the United States. The tax imposed on such income will depend
on whether the amount received is or is not effectively connected with the conduct of a trade or
business within the United States.
4. Taxation of Real Property Owned By Canadian Citizens. As noted above, the tax owed
to the United States government by a Canadian national who is not a resident of the U.S. for
income tax purposes will depend upon its status as to whether it is effectively connected with a
trade or business or not. Where income is not effectively connected with the conduct of a trade or
business, as a general rule, a non-resident taxpayer earning such revenue is required to have a flat
withholding tax of thirty percent (30%) of the gross revenue earned from and as a result of such
activities, in other words, the rents received. Note below, though, that the Canada/U.S. Tax Treaty
modifies the withholding with respect to certain types of income received by Canadian citizens who
are not U.S. taxpayers for U.S. income tax purposes.
As a general rule, income in divided into two parts:
a. Income NOT Effectively Connected With the Conduct of a Trade or Business
Within the United States. The Code categorizes four types of income as not effectively connected
with the conduct of a trade or business. The categories are:
In order to take advantage of the closer connection exemption, it is important that any individual who
would otherwise fail the substantial presence test consider filing IRS Form 8840, The Closer Connection
Exception Statement no later than June 15th of the year following the year at issue. It is important to
understand that to qualify for the Closer Connection Exemption, the United States Internal Revenue Service
(IRS) will consider a number of factors in determining whether a taxpayer qualifies for the exemption,
including the location of the visitor’s home, family, personal belongings, routine banking activities and
organizations to which he or she belongs.
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1. Fixed or determinable, annual or periodical gains, profits and income, such as
interest, dividends, rents, royalties, wages, premiums, annuities, compensation,
remunerations, and emoluments.
2. Capital gains.
3. Special statutory gain income such as capital gain distribution from employee
trusts, gains from the sale of patents, copyrights and original issue discount.
4. One-half of social security benefits.
Although interest income is considered fixed or determinable, annual or periodic income,
and subject to a flat tax rate, the Tax Reform Act of 1986 excluded interest on United States bank
deposits from United States taxation for foreign taxpayers if it is not effectively connected with the
conduct of trade of business. Code 871(i), 881(d).
Another exemption to nonresident individuals not engaged in a trade or business in the
United States are gains from the sale of personal property. Generally, foreign taxpayers will not
recognize gains from the sale of personal property. An exception to the rule is that if the
nonresident individual is physically present in the United States for 183 days or more in the taxable
year, a flat tax rate of 30% is imposed. Code 871(a)(2).
The four general categories of income not effectively connected with the conduct of a trade
or business are subject to a flat tax rate of 30 percent with no deductions allowed, except that the
U.S.-Canadian Tax Treaty provides:
A. Dividends for Canadian citizens who are nonresidents for U.S. income tax
purposes will only pay a 15% reduced withholding rate, provided they file IRS Form W-8BEN.
B. Capital gains on the sale of United States securities by Canadian citizens who
are nonresidents for U.S. income tax purposes are exempt from U.S. capital gains, again provided
they file IRS Form W-8BEN.
b. Income Effectively Connected With the Conduct of a Trade or Business
Within the United States. A nonresident alien from Canada engaged in a trade or business within
the United States shall be taxed on his taxable income which is effectively connected with the
conduct of a trade or business within the United States. Income which arises from assets used in or
from activities from a trade or business and connected with a United States trade or business is
considered effectively connected with the conduct of a trade or business. Examples of income
effectively connected with a trade or business include:
1. Compensation for personal services rendered in the United States.
2. Income derived from a partnership, if the partnership is engaged in a trade or
business in the United States.
3. Real property rental income.
4. Business operations.
If a nonresident individual must recognize gain or loss from the sale of real property in the
U.S., such gain shall be recognized as income effectively connected with the conduct of a trade or
business within the United States. Code 897(a). Income which is effectively connected with the
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conduct of a trade or business in the United States is subject to a regular graduated income tax rate.
A nonresident may deduct expenses that are connected with the conduct of a trade or business.
5. Ownership Structuring. Structure is often an issue that must be dealt with by Canadian
purchasers. As a first rule, in the past it was common for Canadian purchasers to request that their
Hawaii real property be titled in the name of a Canadian company, often a corporation or other
limited liability entity. This is definitely no longer advantageous and should be avoided at all costs.
What kinds of ownership are recommended? While tenants by the entirety, joint tenants and
tenants in severalty are acceptable, probate in the United States is much more complicated when
dealing with a Canadian citizen who has passed away. Therefore:
a. Living Trusts. Revocable Trusts are popular, but beware that in many instances
revocable trusts created in Canada are not the same as revocable trusts here and if substantial value
is present, it would not be inappropriate to recommend a separate revocable trust to hold U.S. real
b. LLCs. More and more, you see Canadian citizens acquiring their Hawaii real estate
in LLCs. Besides the obvious ability to limit their personal exposure with respect to liability that
might arise from the ownership and/or operation of such real property, the ownership through an
LLC offers ease in effecting transfers amongst family and friends. In situations where more than a
single parcel of real property in Hawaii is owned, it is not uncommon to use a structure whereby
there is a parent LLC that owns subsidiary LLCs, with each separate property residing in its own
subsidiary LLC as follows:
With such a structure, even though there is no additional tax filings for a single owner, a
single bank account at the parent LLC level with one general liability policy at the parent level
naming each subsidiary LLC as additional insureds can greatly reduce the costs of operations.
6. Selling Real Property. The rules for selling real property (except to their detriment, for
those Canadian citizens who trapped their real property in corporations that pay their own taxes and
to their benefit for taxpayers from Canada that owned property with gain before 1980 and had gains
before 1985) is similar to those rules dealing with all foreigners. HARPTA and FIRPTA will apply
in almost all situations.
7. What Does All This Mean For a Canadian Who is Purchasing Real Property?
a. Escrow. If there is a substantial deposit that is to be made to escrow by a Canadian
nonresident to purchase real property in Hawaii, urge them to file IRS Form W-8BEN with the
escrow company to exempt any interest income earned on the escrow funds from withholding.
This form is only filed with payors such as banks and escrow companies and not with the IRS.
b. Rental Income/Improvement/Expense Bank Accounts. When acquiring real
property in the United States, it is not uncommon for Canadian citizens to open a bank or
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brokerage account in which they may want to keep some funds, whether for real property for their
own account or for rental. Once again, urge them to file IRS Form W-8BEN with the escrow
company in order to exempt any interest income earned on the escrow funds from withholding.
c. To Be Effectively Connected or Not?
i. Rental Property in Hawaii. In almost all instances in owning Hawaii real
property it will be beneficial for a Canadian citizen who is a nonresident for U.S. income tax
purposes to hold their real property for rental purposes as “effectively connected.” In such
situation, rather than the flat 30% withholding tax on gross rents collected, the Canadian citizen will
elect to be taxed as a business in the United States. Once elected, even though he or she will now
be required to annually file IRS Form 1040NR (and State Form N-15), they will be able to net their
expenses related to the real property, including depreciation against the gross rents collected and
only pay U.S. income tax on the net income from the property, if any.3 One disadvantage of being a
foreign taxpayer is that while a U.S. married couple may file a single return (IRS Form 1040) for
their joint income, U.S. law requires each foreign national to file IRS Form 1040NR separately,
therefore requiring two returns if the property is owned in both names. This is done by preparing
and filing IRS Form W-8ECI with each of the parties with whom the Canadian nonresident is doing
business: their bank, their rental collection agent, etc. This form is not filed with the IRS.
ii. Non-Rental Property in Hawaii. For Canadian nonresidents who acquire
real property in Hawaii solely for personal use, it normally makes sense to consider treating the
situation as not effectively connected to a trade or business. In that instance, the Canadian would
file IRS Form W-8BEN with their bank and other agents. This form is not filed with the IRS.
It is strongly suggested that Canadian buyers get appropriate accounting/bookkeeping/tax
preparation. The statute of limitations does not ever begin to run if no returns are ever filed.
d. General Excise/TAT Licenses and Filing. More foreign owners get into trouble
with the State of Hawaii over failure to file (or in a number of cases, even obtain) general excise tax
returns. The State is looking for these and will catch a foreign owner, at the very latest, when they
attempt to sell or otherwise transfer their Hawaii real property. As with the income tax filings that
may be required of a Canadian owner of Hawaii real property, recommend that they get appropriate
accounting/bookkeeping/tax preparation help to minimize their liability from their failure to file.
Remember, like the income tax, the statute of limitations does not ever begin to run if no returns
are ever filed.
e. Mortgages. It is important to note that mortgages are structured differently in
Canada than in the U.S. While mortgages in Canada are oftentimes nonrecourse in nature, that is
the exception in Hawaii. This leads to the question as to whether a Canadian purchasing real estate
in Hawaii should consider financing in Canada against their Canadian real property or whether they
It is important that a Canadian owning real property in Hawaii not avoid filing the required IRS Form
1040NR and State Form N-15. The IRS has a rule that permits them to disallow any rental expenses 16
months after the normal filing deadline of June 15th when there is no return filed.
It is also important to note that if a taxpayer is going to be filing IRS Form 1040NR, they will need to obtain
a ITIN (International Taxpayer Identification Number) which is similar to an American social security
number. Canadian taxpayers should not use their Canadian Social Insurance Number. While ITINs were in
the past easy to apply for, now they are not issued by the IRS until a first income tax return is filed.
Canadian Investment in Hawaii Real Estate Page 7
should attempt to finance in Hawaii with a U.S. lender. Two points should be made here. First, if
a Canadian is going to finance against their Canadian property, they should consider asking their
Canadian lender to also take a mortgage against their Hawaii property, as this will present the
Canadian owner with the ability to deduct interest paid on the loan against any income earned if
they elect to be effectively connected with respect to that real property. Otherwise, the mortgage
interest will not be able to be deducted in determining such taxpayer’s net income for U.S. income
tax purposes. Second, note that the restrictions by U.S. banks on foreign borrowers have been
getting more and more strict. If a loan is necessary or advisable in the U.S., begin early and
understand that rates may be a little higher than that available to U.S. borrowers and the loan to
value of the property permitted by such U.S. lenders is generally lower when dealing with foreign
We hope this memorandum has been helpful. The information provided regarding this
complex issue is general in nature and not intended as specific advice. Please feel free to contact us
if you have any specific questions.