Canadians have been acquiring real estate in the United States for years. However due to the current strength of the Canadian dollar and the significant drop in real estate prices in certain parts of the U.S., Canadians have been more attracted to the U.S. real estate market.
Accordingly, it is important that Canadians who plan to acquire U.S. real estate understand the tax implications and potential tax exposure associated with owning such estate. There are various alternative structures available to own U.S. real estate that one should consider to potentially minimize any tax exposure.
Overview of Tax Implications
Rental income received from U.S. real estate owned by a non-U.S. resident is generally taxed at a 30% withholding tax. There is an election (“ECI election”) that the non-U.S. resident can file to treat the rental income as income effectively connected with the conduct of a U.S. trade or business. The advantage of the ECI election is that certain tax deductions are allowed including, property taxes, interest, maintenance costs and depreciation. The net rental income is taxed at the graduated rates ranging from 10% to 35%.
As a resident of Canada, the taxpayer will also be required to report the net rental income earned from the U.S. real estate in Canada. A foreign tax credit for the U.S. tax paid is available to offset all or a portion of the Canadian income tax otherwise payable on the net rental income.
Sale of U.S. Real Estate
Buyers purchasing U.S. real estate from non U.S. residents are generally required to withhold 10% of the purchase price and remit this amount to the IRS. An application to reduce the withholding tax can be made by filing Form 8288-B such that the reduced rate is based on an estimated amount of U.S. tax that would actually arise on the gain from the disposition of the estate.
The non-U.S. resident will be required to file a U.S. federal income tax return (and state, if applicable) to report the disposition and pay any additional taxes if the withholding tax is not sufficient, or claim a refund if the withholding tax was in excess of the actual tax liability.
The present maximum federal long term capital gains tax rate for taxpayers that are individuals, trusts, estates and partnerships which have owned U.S. real estate for more than one year has been increased from 15% to 20% for 2011.
As a resident of Canada, the taxpayer will also be required to report the capital gain from the disposition of the U.S. real estate in Canada. A foreign tax credit for the U.S. tax paid is available to offset all or a portion of the Canadian income tax otherwise payable on the taxable portion of the capital gain. Consideration should also be given to the availability of the principle residence exemption where the estate is held for personal use.
U.S. Estate Tax
The U.S. imposes a federal tax on the taxable estate of a decedent who was not a U.S. citizen or domiciliary for transfers of real estate upon death. In 2010 there was no U.S. estate tax and as of January 1, 2011 the U.S. estate tax was to have been reinstated in accordance with the 2001 situation; an estate tax rate of 55% and an exemption of $1 million U.S.
However, as a result of negotiation to preserve tax cuts, an amendment was agreed to for the U.S. estate tax to impose a rate of 35% on estates larger than 5 million dollars U.S. for an individual and 10 million dollars U.S. for couples for the next two years. For non-U.S. residents, the exemption is pro-rated based on the value of their U.S. estate over their world-wide estate value.
For Canadian residents who had concerns over the U.S. estate tax, this amendment is welcome news. Essentially individual Canadians who own U.S. real estate and have world-wide assets with a value of less than 5 million dollars U.S., no longer need to be as concerned about U.S. estate taxes.
Indirect Ownership Through a Canadian Corporation
Holding U.S. real estate in a single purpose Canadian corporation was once a common method for Canadians to hold U.S. properties. Until 2004, it was Canada Revenue Agency’s administrative position not to assess a shareholder benefit for a shareholder’s rent-free use of the estate. This position has been reversed and subject to some grandfather rules, a taxable benefit may now be assessed. In addition, the IRS has indicated that they may disregard the corporation as providing insulation of its U.S. real estate from U.S. estate tax at the shareholder’s death.
Holding the U.S. real estate in a corporation may also have negative tax implications on rental income and capital gains on the disposition of the estate.
(i) Where U.S. real estate is held solely by a non-U.S. resident consideration should be given to the estimated U.S. estate tax exposure associated with the real estate as this method of ownership may not provide the taxpayer with much shelter from U.S. estate tax.
Where the non-U.S. resident is married, the individual should consider amending his/her Will to provide for the real estate to be transferred to a Qualified Domestic Trust (QDOT) for U.S. tax purposes and a Spousal Trust for Canadian purposes. As a result, both the U.S. estate tax and the Canadian income tax associated with the real estate would be deferred to the death of the surviving spouse.
If a QDOT is required, the QDOT election must be made by the executor and the following conditions must be met:
The trust must be for a non citizen spouse’s benefit and must provide that any distributions of principal will be subject to the trustee withholding the estate tax due on distribution.One trustee must be a U.S. citizen or U.S. corporation.If the QDOT assets exceed $2 million, then one of the trustees must be a U.S. bank and a bond or letter of credit to IRS may be required to be posted in the amount of 65% of the value of the trust assets to secure the payment of tax.
In addition to the above, the use of a bypass trust could be used to ensure that the U.S. real estate is not included in the estates of the surviving heirs. However, depending on how much shelter there is under the pro-rated exemptions, the taxpayer may by subject to U.S. estate tax upon his or her death. The by-pass trust is based on the idea that the beneficiary has no extensive control over the trust and cannot withdraw the principal.
(ii) Holding real estate in joint tenancy with right of survivorship is a common estate planning method to avoid probate and administrative and other legal issues associated with transferring legal title. However this type of ownership removes the flexibility to use certain panning strategies to minimize or defer U.S. estate tax. Since real estate held as joint tenants automatically transfers to the surviving spouse upon death, there is no opportunity to defer or mitigate the U.S. estate tax through the use of a QDOT or by pass trust. In addition, U.S. estate tax exposure may not be deferred to the death of the surviving spouse.
(iii) Another alternative to minimize the estate tax is to hold the real estate as tenants in common., whereby upon death of a tenant, his or her share of the real estate does not pass to the other tenants but can pass to persons selected in the Will providing the flexibility to use a QDOT or by-pass trust to defer or mitigate U.S. estate tax.
(iv) Other planning alternative to reduce the estate tax is the use of a non-recourse mortgage financing. A non-recourse mortgage allows for the full amount of the mortgage to reduce the amount in the estate and could therefore be used as a planning tool to minimize the U.S. estate tax exposure in respect of the U.S. real estate. The disadvantages associated with acquiring a non-recourse mortgage include, amongst others, the interest rate of such a mortgage is generally higher than for a conventional recourse mortgage.
(v) Acquiring a life insurance policy to fund the payment of any U.S. estate tax exposure to the estate of the individual is another alternative. Life insurance may be preferred where it is anticipated that there will not be enough liquidity to fund the U.S. estate tax. The problem with using life insurance is that the death benefit associated with the life insurance would be included in the decedent’s world-wide estate for U.S. tax purposes, thus reducing the available exemptions.
Provided the trust is properly structured, holding U.S. real estate in a resident discretionary inter-vivos trust should avoid U.S. estate tax at the time of the non-U.S. resident person’s death (settlor/beneficiary).
The use of a Trust is especially beneficial when used by a married couple and implemented prior to the purchase of the estate. Under this structure, one spouse (the grantor) creates the Trust for the benefit of his/her spouse and children and funds it with the amount of cash to purchase the real estate. The grantor spouse cannot be a beneficiary or trustee and cannot have a reversionary interest.
The disadvantage of the Trust is that the grantor’s ability to use the real estate is entirely dependant on his spouse, who is a beneficiary. If the beneficiary spouse predeceases the grantor and the grantor wants to use the real estate thereafter, the grantor should lease the real estate from the Trust in order to keep it outside his or her estate. If there is a divorce, the grantor will lose access to, and any value associated with, the real estate.
When using this structure one needs to consider the potential taxable benefit assessments by Canada Revenue Agency especially in situations where the real estate is not totally a personal use estate.
The trust should also be structured such that the attribution rules for Canadian tax purposes are not applicable. Otherwise, the U.S. and Canadian tax obligations would be payable by different taxpayers and a foreign tax credit may not be available.