Non-arm's length sale of Canadian cottage

[Anonymous]

Sixteen years ago my spouse (born in US but also holding Canadian citizenship) inherited a cottage in Canada from a parent, a naturalized US citizen born in Canada. 

Question 1: should this asset have been reported to the IRS? If father was NOT a US citizen I think it would have been needed to, but I hope weren’t required to because he was a US citizen. Spouse does have Canadian bank account and we file the FBAR with US treasury when account balance exceeds $10,000 during a calendar year.

After buy outs from other siblings at the time of inheritance my spouse ended up with a 40% share, with one other sibling holding a 60% share.

Assessed total value of cottage at time of transfer 16 years ago was CAN$500,000. (Numbers are representational only).

The other sibling is a Canadian citizen who lives 30 min from cottage and looks after it. That sibling coordinated many improvements over the years, with most projects being handled by nearby relatives who did expert and competent work. However, record keeping (receipts etc.) often lacking. 

After some soul-searching last year while doing estate planning, my spouse (who has no children) decided to sell the 40% share to the other sibling (who has a son that wishes to keep cottage in the family and will inherit it). 

The latest appraisal was CAN$1,000,000.  Spouse agreed to sell share to sibling for CAN$300,000.

Total improvements CAN$100,000.  They split the improvement costs 50:50. Sibling provided spreadsheet listing improvements and values but no dates.

2022 Canadian taxes were handled by a Canadian accountant.

Per instructions from Canada Revenue Agency, because the sale was non arms-length, the assessed value of spouse’s 40% share (CAN$400,000) was used when calculating capital gains, not actual sale price of CAN$300,000.

At time of transfer in the fall of 2022, a Compliance Certificate T2062 was filed with CRA.  

On 2022 Canadian T1 Tax form (which has been completed) the amount withheld on T2068 Compliance Certificate was CAN$40,000. 

Spouse will receive a CAN$20,000 refund in 2023 (if T1 is accepted).

Question 2 and 3: In calculating capital gain, should the assessed value of CAN$400,000 be used for US taxes as well, or actual sale price of CAN$300,000.  Is the CAN$100,000 difference considered a gift that needs to be reported to IRS on form 709?

Question 4.  If receipts and dates are lacking for improvements should those be excluded?  Or can I use the best estimated date range and then use the least advantageous exchange rate for the est. date range when calculating improvements in US dollars?  Are photos of the improvement adequate to document the improvement (new floors, windows, plumbing, electrical, retaining wall, new deck, etc.).

Question 5: For US 2022 taxes, is the amount withheld by CRA in 2022 (CAN$40,000) used for foreign tax credit?

Question 6: Will refund of CAN$20,000 be reported next year on US 2023 taxes?  Will other details of sale carry over from 2022 US tax form?

Anything else to be aware of with this tax event?  I may have more questions when I actually try to enter the values into Turbotax premier 2022.

Thank you—1shed.

[DaveF1006 · Accepted solution]

No.  Foreign Real Estate holdings are not required to be reported on an FBAR nor on a 8938 because it is not a specified foreign financial asset.  

If the father died and willed the estate to your wife and brother, her cost basis at the time of the inheritance is ($500,000) X (.4) + $50,000= $250,000. The capital gains would be $150,000 in this case.($400,000-150,000). Here you will report the actual proceeds from the sale., which is $400,000. The $100,000 difference does not need to be reported as a gift.

Keep in mind this is all reported in US dollars.  To calculate correctly, you would need to know the conversion rate at the time of the inheritance and at the time of the sale.  In this case, you may need to do some homework to calculate the historical currency conversion rates between these two events as well as when the improvements were made. To simplify it some, you might wish to take an average rate over the 16 year period between the inherited and sell dates. 

No, no additional information is not normally documented as the IRS has relied on best faith estimates. This doesn't mean though that if you are audited, they won't ask for it so keep whatever photos and other proof handy if you are asked for it. As far as conversion rates, I have briefly mentioned it already.  You may wish to use a conservative average for the period of time the improvements were made.

Yes, you would use the $40,000 converted to USD to report the foreign tax credit. You would use the date of the sale to determine the USD conversion.

Her Canadian tax refund is not reported as taxable income on her US return. Please reach out if you have addtional questions.

[Anonymous]

Thank you Dave for answering this and for the other answers you have given on similar topics!