Many retirees and other Canadians fly to Florida or other locations in the
southern United States for several months out of the year. However, the
Internal Revenue Service (IRS) may have a few unpleasant surprises for
the unwary. Below we provide a brief overview of the potential tax pitfalls — and
how to avoid them — when visiting the US for several months out
of the year. We also summarize the rules for renting out or selling one’s
real estate in the US and set out strategies to minimize the effect of
US estate taxes.
Residence Rules
Canadian
snowbirds who stay for long periods of time in the US
should be aware of the requirements for the physical
presence test, lest they be considered a US resident
for income tax purposes. If that happens, a Canadian
will be required to file a US tax return and may be
required to file a US income tax return to report income
from all sources, including income from Canada. If a
foreign national has never spent more than 121 days
in the US in any tax year, he or she will never be considered
a US resident under the substantial presence test.
Renting Your Property
Snowbirds who rent out their Florida condo or other real
estate located in the US should beware: a withholding tax
of 30% normally applies to the gross amount of any rent paid
to a resident of Canada on real estate located in the US
Unlike withholding taxes on interest and dividends, this
tax is not reduced by the Canada-US tax treaty.
One way for Canadians to avoid the 30% gross withholding
tax is to file a US tax return and elect to pay tax on net
rental income. The Canadian resident can then receive a refund
for any taxes withheld, to the extent the withholding amount
exceeds the tax payable. This is most likely to be advantageous
where one incurs significant expenses (mortgage interest,
maintenance, insurance, property management, property taxes,
etc.), as tax at the graduated rates will likely be substantially
lower than the 30% withholding tax.
Once
elected, the net rental income method applies for all future
years and may be revoked only in limited circumstances.
The election applies to all of an individual’s rental
real estate in the US. Also note that state tax (and possibly
city tax) may be payable on the rental income, if the election
is made on the federal return. Once the election is made,
the taxpayer should provide IRS Form W-8ECI to the tenant,
and the 30% withholding will not be required.
Selling Your Property
If a
Canadian sells real estate located in the US, a withholding
tax of 10% of the gross sales price is normally payable under
the Foreign Investment in Real Property Tax Act of 1980 (FIRPTA).
The tax withheld can be offset against the US income tax
payable on any gain realized on the sale and refunded if
it exceeds the tax liability. The 10% withholding requirement
on the gross sales price applies regardless of the seller’s
adjusted basis in the property.
There
are two exceptions to FIRPTA’s 10% withholding
requirement which may reduce or eliminate the requirement.
- Exception 1: Sales price less than US $300,000
Withholding
under FIRPTA will not apply if the property is sold
for less than US $300,000, and the purchaser intends
to use it as a residence. The buyer need not be a
US resident. For this exception to apply, the purchaser
must have definite plans to reside at the property
for at least half of the time that the property is
in use during each of the two years following the
sale.
- Exception 2: Withholding certificate
The
second exception allows for reduced, or eliminated withholding,
where the Canadian obtains a “withholding certificate” from
the IRS on the basis that the expected US tax liability will
be less than 10% of the sales price. The certificate will
indicate what amount of tax should be withheld by the purchaser
rather than the full 10%.
If an
application for a withholding certificate with respect
to a transfer of a US real property interest is submitted
to the IRS but has not been received at the time of the transfer,
the buyer must withhold 10 percent of the amount realized.
However, the amount withheld, or a lesser amount as determined
by the IRS, need not be reported and paid to the IRS until
the 20th day following the IRS's final determination regarding
the application. Therefore, the buyer’s legal representative
would generally hold the 10% withholding in an escrow account
until the withholding certificate is received and then refund
the seller the amount permitted pursuant to the withholding
certificate. If the seller does not apply for the withholding
certificate, he or she must wait until after year-end to
file a tax return to claim a refund for the excess of the
withholding amount over the ultimate tax liability.
Filing Requirements
For income tax purposes, a Canadian must file a US federal
tax return and report the gain on the sale of US real estate.
The resulting tax will be offset by the FIRPTA tax withheld.
An individual may also be subject to state income tax withholding
and filing requirements. Some states do not have a state
income tax on individuals, including Florida, Texas, Washington,
South Dakota and Alaska.
If an individual owned the property and has been resident
in Canada since before September 27, 1980 he or she can likely
take advantage of the Canada-US tax treaty to reduce the
gain. In such a case, only the gain accruing since January
1, 1985 will be taxed. This transitional rule does not apply
to business properties that are part of a permanent establishment
in the US
To claim the benefit under the treaty, a Canadian should
make the claim on a US tax return and include a statement
containing certain specific information about the transaction.
US tax on the sale of US property will generate a foreign
tax credit that may be used to reduce the Canadian tax on
the sale. However, if the amount of the gain taxed in Canada
is reduced due to the principal residence exemption, the
foreign tax credit available may be limited. Additionally,
a strengthening Canadian dollar in relation to the US dollar
may result in a larger taxable gain in the US than in Canada.
The opposite is true if the Canadian dollar declines in value
from the date of acquisition.
Minimizing Estate Taxes
US estate
taxes can impose a burden on the estate of Canadians who
own US real estate at death. See Chapter 8, “US
Estate Tax for Canadians”, for an overviews the estate
tax rules. Here are some planning ideas.
Hold Property Through a Canadian Corporation
One
solution to US estate tax is to hold real estate in
a Canadian corporation rather than personally. Since
shares of a Canadian corporation are not considered
property situated within the U.S, no US estate tax will
apply. Ordinarily, if the US real estate is used personally
by a Canadian shareholder, the Canadian would have to
recognize a taxable benefit for Canadian tax purposes
equal to the value of the rental usage of the property,
unless the shareholder pays the rental value to the
corporation. The Canada Revenue Agency (CRA) used to
have a liberal administrative policy not to assess a
taxable shareholder benefit for personal use of a corporate-owned
US vacation property, if it was owned by a “single
purpose corporation” that met certain requirements.
However, the CRA revoked this policy for property acquired
by or transferred to a single purpose corporation after
2004. Single purpose corporations properly structured
to acquire US real estate prior to 2005 continue to
be covered by CRA’s prior policy.
For US estate tax purposes, there may be an issue as to
whether the IRS will respect the single purpose corporation
as the true owner of the property. If the single purpose
corporation is the nominal owner of the property on behalf
of the Canadian shareholder or the corporation is deemed
to be the owner on behalf of a shareholder, the IRS may ignore
the corporation for estate tax purposes. Consequently, the
shareholder of a single purpose corporation may be exposed
to the US estate tax, regardless of the corporate ownership
of the property. This exposure is exacerbated for single
purpose corporations, because compliance with CRA guidelines
(for property acquired prior to 2005) effectively causes
the corporation to be viewed as a mere nominee of the shareholder.
Owning US real estate through a corporation can significantly
increase the income tax arising from the sale of US real
estate. Current US federal tax law provides a maximum income
tax rate of 15% on long-term capital gains (gains from the
sale of capital assets held for at least 12 months). There
are no preferential rates for capital gains recognized by
a corporation. The federal corporate tax rate on such gains
can be as high as 35%. Further, some states impose a higher
tax rate on gains of a corporation. For example, although
Florida has no individual income tax, it imposes tax at a
rate of 5.5% on corporations realizing capital gains on Florida
real estate. Therefore, the federal and Florida tax rate
on the sale of a Florida vacation home could exceed 40% if
sold by a corporation but would generally be limited to 15%
if sold by an individual.
Although these taxes may be less than the potential US estate
tax, the ultimate cost of the Canadian corporate structure
should be weighed against the potential benefits. The likelihood
of selling the property prior to death should also be considered.
Split Interest
A technique to reduce exposure to the US estate tax is split
interest ownership of the property. Under such an arrangement,
an individual would acquire a life interest in US property,
and his or her children would acquire the remainder interest
in the property. Upon the death of the individual, there
would be no estate tax on the life interest, since the life
interest would have no value on death. However, should the
children die while holding a remainder interest, the estate
tax would be assessed on the value of the remainder interest.
Generally, the children can obtain term life insurance at
low costs (due to their age) to protect them from estate
tax exposure.
A split interest arrangement usually involves a trust or
partnership structure. The structure may result in significant
complexities. However, the tax savings may be worthwhile
for certain family situations.
Non-recourse Debt Financing
A non-recourse
mortgage outstanding on US real estate reduces the value
of the property included in an individual’s
taxable estate. A non-recourse mortgage is one that entitles
the lender to have recourse only against the property mortgaged.
If an individual defaults on payment, the mortgaged property
can be seized, but there will be no further liability if
the value of the property does not satisfy the debt.
However,
it may be difficult to obtain a mortgage on a non-recourse
basis. Consequently, it may be necessary to seek other
sources. One possible source of non-recourse financing
may be a spouse. For example, assume a wife has $100,000
to invest in a US vacation home. Instead of investing
directly, she could loan her husband $100,000 on a non-recourse
basis to acquire the property. Should he die, there
will be no value in the estate, since he will deduct
the non-recourse debt from the value of the property
situated in the US. If she dies, there will be no value
in the estate since the loan is not property situated
in the US. In order to be respected as true debt, the
debt should have commercial characteristics such as
a market rate of interest and repayment terms. This
may create a problem since the wife would have interest
income for Canadian tax purposes and the husband would
have no interest expense deduction. Since the US rules
do not specify that the funds received from the mortgage
must be used to acquire the US property, it may be possible
for the husband to acquire investment assets with the
funds received, which may allow for a deductible carrying
charge for Canadian tax purposes.
Another
problem with non-recourse debt is that the debt does
not increase as the property appreciates. Consequently,
should the property substantially appreciate in value
and/or the principal of the debt be repaid, the debt
will offset less of the value of the property.
Partnership Structure
Although this is an unsettled area of law, it is arguable
that a Canadian partnership holding personal-use US real
property is not property situated in the US and therefore
will shelter the Canadian partner from US estate tax.
Another
strategy is for such a partnership to elect “corporate” status
for US tax purposes, such that the partnership will be considered
a foreign corporation for US tax purposes and therefore exempt
from US estate tax; in order to make this election, the partnership
must have some business activities beyond just the holding
of personal-use real estate. One attractive feature of this
strategy is that, since the partnership will continue to
be recognized as a partnership for Canadian tax purposes,
the Canadian partner will not have a “shareholder benefit” (as
this only applies to shareholders of a corporation). However,
since the partnership will be considered a corporation for
US tax purposes, the tax arising from the sale of the property
will not be eligible for the lower individual tax rates.
Under
certain circumstances, it may be possible to elect “corporate
status” for US tax purposes after the date of death
of the partner; this will allow individual income tax rates
on the sale of the property before death and also provide
insulation from the estate tax on death. This is a complex
strategy that requires extreme care in both planning and
implementation.
Review US Estate Tax Plans
Although
the US-Canada tax treaty reduces the US estate tax bite
for many Canadians holding US property – generally
those with total estates under US $2 million – it will
not provide complete relief for larger estates and others.
Although insurance proceeds of a Canadian are not subject
to US estate tax, the insurance proceeds can substantially
increase the value of a decedent’s estate at death.
It is important to assess the impact of the US estate tax
on a Canadian resident’s death and consider the available
strategies to minimize both Canadian and US death taxes.
A properly drafted will is a minimum. In many cases, careful
estate planning should be considered well in advance of acquisitions
of US situs property.
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information contained herein is of a general nature and
is not intended to address the circumstances of any particular individual
or entity. Although we endeavor to provide accurate and
timely information, there can be no guarantee that such information
is accurate as of the date it is received or that it
will continue to be accurate in the future. No one should act on such information
without appropriate professional advice after a thorough
examination
of the particular situation.
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© 2006 KPMG LLP, the
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