Apologies in advance… this is lengthy and a little technical but it’s a complex topic! Notwithstanding the recent weakening of the Canadian dollar, the decline in the value of US real estate may still present some attractive buying opportunities for Canadians.
The acquisition of US real estate by a Canadian resident not only has Canadian tax implications, but may also create US income, gift and estate tax consequences.
The sale or rental of US real estate by a Canadian resident requires that the Canadian have or obtain a US Individual Taxpayer Identification Number (“ITIN”) and is required to be obtained prior to the US tax reporting of the income. The application for an ITIN is IRS Form W-7.
There are a number of alternatives in which US real estate may be acquired and owned; each resulting in specific tax consequences and benefits. These alternative forms of ownership include individual, joint, trust, partnership and corporation.
A Canadian resident who is not a US citizen and is not domiciled in the US is subject to US estate tax on the fair market value of “US-situs” assets held by the individual at the date of death. A Canadian resident may become a US resident for US income tax purposes if he or she obtains a US green card or if the “substantial presence” test is met. The substantial presence test is met where a person is physically present in the US on at least 31 days in the current year AND 183 days during the 3-year period that includes the current year and the 2 immediately preceding years counting:
- All the days you were in the US in the current year, and
- One-third of the days you were in the US in the first preceding year, and
- One-sixth of the days you were in the US in the second preceding year.
However, the “closer connection” exception may be available to a non-resident of the US who meets the substantial presence test (IRS form 8840), as long as he or she (1) maintains a tax home in a foreign country, (2) has a closer connection to a foreign country, and (3) is present in the US for fewer than 183 days during the current calendar year.
With respect to Canadian residents who are neither US citizens nor US domiciliaries, their US estate tax exposure is isolated to their “US-situs” assets, including US real estate held personally. Therefore, where US real estate is held directly by a Canadian individual, US estate tax exposure may exist.
The Canada – US Treaty may exempt the Canadian individual from US estate tax through the “prorated unified credit” provided that the fair market value of his or her worldwide gross estate is less than US$2 million for 2008 and US$3.5 million for 2009. Furthermore, if the Canadian individual is married and the US situs assets pass to a surviving Canadian spouse, the US$2 million (or US$3.5 million for 2009) threshold is increased to approximately US$4 million (or US$7 million for 2009) under the Treaty.
Notwithstanding that a foreign tax credit in Canada may be available with respect to US estate tax paid, the utilization of a foreign tax credit will be limited or unavailable if there is little or no US source income in the year of death reported on the Canadian tax return of the decedent. The current maximum US estate tax rate is 45% on taxable estates greater than US$2 million in 2008 (or US$3.5 million for 2009).
Using the example of a single Canadian with a US vacation home worth US$500,000 and worldwide assets (including the US vacation home) with a fair market value US$5 million, US estate tax exposure is approximately US$80,000 (using 2008 rates). Using the identical example above, but assuming that the Canadian resident is married to another Canadian resident (and leaves the property to the spouse), US estate tax would be nil (through the utilization of the Treaty prorated unified credit and the Treaty marital credit).
Joint ownership is a common form of real estate ownership between spouses and family members. Notwithstanding that joint tenancy simplifies the transfer of real estate upon death it is not an effective form of ownership for US estate tax purposes. The common misconception with respect to 50/50 joint ownership (between spouses for example), is that only the decedent’s 50% interest in the US real estate forms part of their US gross estate. However, for foreign individuals, this is only the case if the surviving joint owner can establish that he or she contributed his or her own funds with respect to the purchase price of the US real estate.
The use of a non-recourse mortgage on the acquisition of US real estate may result in the deduction of the mortgage from the fair market value of the US real estate for US estate tax purposes. However, obtaining such a mortgage might be difficult, and there are the higher interest costs to consider.
Some structures utilized to own US real estate and mitigate US estate taxes include certain Canadian corporations, trusts and partnerships. Such structures also carry increased administrative and compliance costs. Where a Canadian corporation is used and the US real estate is used personally by the shareholder, a taxable shareholder benefit may result in Canada, and the US may look through the corporate structure for purposes of applying US estate tax. This will often, if not always, eliminate the Canadian corporate alternative. In addition, any net rental income, or capital gains on the sale of the US real estate will result in additional layer of taxation at the corporate level. These tax rates are generally higher than if the US real estate was held personally.
An alternative to a Canadian corporate vehicle is a Canadian partnership. However, where the US real estate is to be utilized solely for personal use, a partnership may cease to exist under Canadian law on the basis that the endeavor is non-commercial in nature. The partners and not the partnership will be subject to tax, thereby accessing the personal tax rates. Also, the shareholder benefit rules should not apply to the Canadian partnership. For US purposes, the partnership may be treated as either a partnership or corporation depending on whether a “check the box” election is made. In this regard, it may be possible to retroactively “check the box” to elect to treat the partnership as a corporation prior to the death of a partner in an effort to mitigate US estate tax exposure.
Another structure that can be used to mitigate US estate tax involves purchasing the US real estate through a Canadian resident discretionary trust. The trust would be created and funded by a family member for the benefit of his or her spouse and family. Sufficient cash would be contributed to the trust (by the settling/contributing family member) to facilitate the trust’s purchase of the US real estate. In order for this structure to work, the settling/contributing family member cannot be a trustee, or beneficiary of the trust, nor can he/she enjoy any of the financial benefits of the trust or affect the enjoyment of any of the beneficiaries.
As Canadian residents, we are taxed on worldwide income for Canadian tax purposes. Therefore, if you rent out US real estate, the net rental income will be subject to tax in Canada. In addition to the Canadian tax on US source rental income, the US will also tax the rental income either as a 30% withholding tax on gross rents, or on net rental income through the filing of a US non-resident income tax return. Where the US real estate generates positive net rental income, a US state income tax return may also be required.
When selling US real estate, Canadians are not only subject to Canadian tax on the gain, but subject to US federal, and state if applicable, income tax. The disposition of US real estate often triggers a US tax return filing requirement regardless if there was no gain or profit on the sale. Foreign exchange gains and losses, as applicable, would also be factored into the computation of the gain or loss on the sale of the US real estate.
The sale of US real estate may also result in US federal and state withholding tax being withheld on the gross sale proceeds. The withholding tax can be used to offset any US tax liability triggered on the sale, and is claimed when filing the US tax returns.
As can be seen from the discussion above, the attractiveness of taking advantage of the depressed US real estate market, or escaping the Canadian winters, needs to be balanced with a full understanding of the related Canadian and US tax consequences. We would be pleased to discuss the tax implications of the various alternative structures available with respect to the acquisition and ownership of US real estate with you.