Planning for ownership of U.S. real estate
If you have not yet received this call, you will. “My wife/husband and I were in Scottsdale/Palm Springs/Maui last week and signed a contract for a town house/single family home/condominium. How should we own it?” This article will tell you what to say.
Welcome to the US Tax System. When someone buys a property – any kind of property – in the United States, that person is buying an admission ticket to the US tax system.
• If that property is rented, the rental income will be subject to US income tax. Owners of US real estate who are not US citizens or residents (“non-US persons”) will be subject to withholding on the gross rental income at a rate of 30% (Section 1441(a) of the United States Internal Revenue Code (“Code”)).
• On sale of the property, a Canadian resident who is a non-US person will be subject to US capital gain taxation (Code Section 897(a)(1)) (currently at rates of 15%) and subject to withholding on the gross sales proceeds at a rate of 10% (Code Section 1445(a)). (Depreciation will generally be recaptured at a rate of 25%.)
• Regardless of whether the property is rented, if not sold prior to death, the fair market value of the property on the date of the Canadian resident’s death will be fully subject to US estate taxation. As a result of the Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010, the maximum estate tax rate for decedents dying in 2011 and 2012 has been reduced to 35%. Absent further Congressional action, estates of decedents dying after 2012 will be subject to a maximum rate of 55%.
Planning for Rental Real Estate. Withholding on the gross amount of rental income paid to a non-US person can be avoided by electing under Code Section 871(d) to treat the rental income as effectively connected with a US trade or business. As a result of the election, rental income net of expenses will be taxed at graduated rates of 15% to 35% (Code Section 871(b)). The Canadian resident who owns the US property will be required to file a US income tax return to report the income and expenses associated with the rental property. In order to protect the personal assets of the owner from liability claims, the property will typically be owned by either a limited partnership, limited liability partnership, or limited liability limited partnership. In such a case, the election under Code Section 871(d) is not available to the partnership, but must instead be made by the individual partners (US Treasury Regulations Section 1.871-10(d)(3)).
Avoiding US Estate Taxation. Numerous strategies have been advanced to avoid US estate taxation. A discussion of all of them is beyond the scope of this article. However, the balance of this article discusses four practical approaches available to Canadian residents and concludes with a brief explanation as to why some of the more common alternatives (corporations, partnerships, and joint ownership) are undesirable.
Sell Before Death. The simplest way to avoid US estate taxes is not to own any assets deemed present in the United States (“US situs assets”). Many Canadian residents view their ownership of a US vacation property as an asset to be held for only a limited period of time. On sale of the property, the proceeds of sale may be repatriated (after payment of US income taxes). As long as the sales proceeds are not invested in other US situs assets (for example, shares of US corporations or real or personal property located in the United States), a Canadian resident who is not a citizen of the United States has no US estate tax exposure. Because life is uncertain and the US estate tax rate severe, individuals owning US real estate for a limited period of time may consider purchase of life insurance in order to fund the payment of the US estate tax (which is due within nine months of the owner’s death).
Relying on the Treaty Exemption. For many US citizens and residents, US estate taxes are not an issue. This is because of a generous exemption which Code Section 2010 provides to each citizen and resident. Unfortunately, Code Section 2107(c) limits the US estate tax exemption which is available to non-US persons to $60,000. However, the Convention between Canada and the United States of America with Respect to Taxes on Income and on Capital (the “Tax Treaty”) allows Canadian residents to claim a portion of the US estate tax exemption (the “Treaty Exemption”). The amount which is available is determined by a fraction found in Paragraph 2(a) of Article XXIXB of the Tax Treaty. The numerator of the fraction is the total fair market value of US situs assets owned by the Canadian resident. The denominator is the total fair market value of the Canadian resident’s worldwide assets. A convenient rule of thumb is that if the Canadian resident’s worldwide assets do not exceed the amount of the US estate tax exemption available in the year of the Canadian resident’s death, there will be no US estate tax.
In many cases, the Treaty Exemption creates a false sense of security. First, computation of the denominator is based upon US estate tax principles. The denominator will include not only the Canadian resident’s bank accounts, brokerage accounts, all forms of real and personal tangible property; it will also include the death benefits payable under policies insuring the life of the Canadian resident, as well as the account balances in the retirement plans of the Canadian resident, such as RSPs and RRSPs. Further, it is the fair market value of the Canadian resident’s US and worldwide assets which is used in computing the Treaty Exemption and US estate tax liability. (This is quite unlike the Income Tax Act’s tax on deemed dispositions at death which is imposed only on the unrealized gain inherent in the Canadian resident’s assets.)
Example 1: Mr. Smythe owns four assets.
|Canadian Residence||$1 million|
|Canadian RRSP||$1 million|
|US Property||$1 million|
|Life Insurance||$1 million|
Mr. Smythe dies on February 1, 2011. The Treaty Exemption will be $1,250,000 determined using the following fraction.
U.S. Situs Assets ($1 million) x US Estate Tax Exemption ($5 million)
Worldwide Assets ($4 million)
Because Mr. Smythe’s US property has a value of less than $1,250,000, there will be no US estate tax liability if Mr. Smythe dies in 2011.
What if Mr. Smythe dies in 2013? The second reason why the Treaty Exemption may not provide the relief anticipated is because the US estate tax exemption may be less than anticipated. Absent further Congressional action, the US estate tax exemption reverts to $1 million for decedents dying after 2012. Mr. Smythe’s US estate tax liability will be significant.
Example 2: Assume the same facts as the preceding example except that Mr. Smythe dies in 2013 when the US estate tax exemption is $1 million. The Treaty Exemption is reduced to $250,000 computed as follows.
U.S.Situs Assets ($1 million) x US Estate Tax Exemption ($1 million) Worldwide Assets ($4 million)
The value of the US property exceeds the treaty credit by $750,000. As a result, Mr. Smythe’s US estate tax liability will be $259,350.
One way in which to make the Treaty Exemption more effective is to reduce the amount of the denominator in the fraction described in Paragraph 2(a) of Article XXIXB of the Tax Treaty.
Example 3: Assume that Mr. Smythe transfers his Canadian residence, his life insurance policy, and (after withdrawal of the account balance) his Canadian RRSP to Mrs. Smythe. Despite dying in 2013 when the US estate tax exemption reverts to $1 million, Mr. Smythe still has no US estate tax problem because he has reduced the value of his worldwide assets.
U.S. itus Property ($1 million) x US Estate Tax Exemption ($1 million)
Worldwide Assets ($1 million)
By dividing assets such that the US situs property is owned by one spouse and the non-US situs assets are owned by the other spouse, the Treaty Exemption can be used most effectively. However, without further planning this solution may prove to be ineffective. Consider that if either Mr. Smythe or Mrs. Smythe dies and the survivor receives the deceased spouse’s assets, the facts of Example 2 are replicated, and the US estate tax liability will be incurred at the death of the last of Mr. and Mrs. Smythe. To avoid increasing the worldwide estate of the surviving spouse, Mr. or Mrs. Smythe may deliver the assets he or she owns to the survivor using a Trust. If the Trust is drafted properly in accord with US estate tax principles (which will determine the worldwide estate of the survivor for purposes of computing the Treaty Exemption), the result in Example 2 can be avoided and the result in Example 3 replicated.
Leveraging the US Property with Non-Recourse Debt. Not every person purchasing US real estate is married. Further, not every couple acquiring US real estate may be totally comfortable with one spouse owning only the US property and the other spouse owning all of the non-US situs assets. As an alternative, the US property may be encumbered. Code Section 2053(a)(3)(4) allows a deduction for the debts of the decedent in computing the taxable estate on which the US estate tax is assessed. For example, a mortgage encumbering the US property will reduce its value for US estate tax purposes. However, in order for the mortgage debt to be deductible on a dollar-for-dollar basis, the debt must be non-recourse (US Treasury Regulations Section 20.2106-2). That is, the lender’s only remedy is to take the US property which is secured by the mortgage in the event the borrower defaults. This type of financing may prove difficult to find, particularly in the current economic environment.
Ownership of a US Property Through a Trust. Because property values may increase, because the amount of the US estate tax exemption is uncertain, because non-recourse financing may not easily be available, the most appropriate way for many Canadian residents to purchase US real estate is through a Trust. The Trust is effective because the property is not owned by the Canadian resident at the time of the resident’s death. The Trust is also advantageous in that it avoids probate, provides liability protection, preserves the owner’s control over the property by selection of a trustee, addresses the possible incapacity of the owner, and protects the heirs from US estate taxation after the owner’s death if the heirs die prior to sale of the US property.
The Trust presents two significant limitations. First, the settlor of the Trust cannot be a beneficiary. The practical reality is that in many circumstances this will mean that the Trust will be settled by one spouse for the benefit of the other spouse. As long as the beneficiary spouse survives, the settlor spouse need not pay rent in order to occupy the US property. However, once the beneficiary spouse dies or if the beneficiaries of the Trust are the children of the settlor, the settlor can only occupy the property if the children are present in the property at the same time. Otherwise, the settlor must pay a fair market rental to the Trust for the use of the property.
The second difficulty in ownership of US real estate through a Trust relates to the situs of the Trust. If the Trust is sitused in Canada, the settlor of the Trust will be taxable on the income realized from rental or sale of the property if either the settlor is the trustee (Income Tax Act (“ITA”) Section 75(2) or the settlor’s spouse is the trustee (ITA Section 74(1)). As a result US income tax paid on the rental income or proceeds from sale of the property will not be creditable in computing the Canadian income tax liability of the settlor. Consequently, a person or institution unrelated to the settlor must act as trustee of a Trust resident in Canada.
Alternatively, the Trust could be designed as a US resident Trust. ITA Section 94 attributes the income of a non-resident Trust to the Canadian resident settlor. Again, US income tax paid on rental or sale of the property will not be creditable in computing the Canadian income tax liability of the Canadian resident settlor.
As a result of the foregoing issues, Canadian residents buying US real estate will in most cases be best advised to own the property through a Canadian resident Trust with respect to which an unrelated person acts as trustee. The primary beneficiary will be the settlor’s spouse and the successor beneficiaries will most likely be the settlor’s children. If the Trust is properly drafted, there will be no US estate tax liability at the death of the settlor, the settlor’s spouse, the settlor’s children, or any other person who is a beneficiary of the Trust. (The trustee is also not subject to US estate taxation inasmuch as the trustee has pure legal title and no beneficial interest in the property the Trust owns.)
Despite whatever disadvantages or complexities may be associated with the use of a Trust to own US real estate, it provides certainty (when the Trust instrument is properly drafted) that it is effective to avoid US estate taxes without disadvantageous US income tax treatment on rental or sale of the property. In contrast, the other forms of ownership commonly utilized to bring with them serious liabilities or uncertainties in the tax treatment.
Joint Ownership. Ownership of US real estate by a husband and wife as joint tenants with rights of survivorship or tenants by the entirety results in US estate taxation of the property at the deaths of both spouses. There is no relief from US estate tax for a transfer to a spouse who is not a US citizen unless the transfer takes the form of a Qualified Domestic Trust qualifying under Code Section 2056A (Code Section 2056(d)). Even with the use of a Qualified Domestic Trust, the US estate tax arising at the death of the first spouse is merely deferred until the survivor’s death (Code Section 2056A(b)(1)(B)). Further, the US estate tax paid at the death of the first spouse is not creditable for Canadian tax purposes because the transfer to a spouse is generally exempt from the Canadian capital gains tax on deemed dispositions at death.
Corporations. The traditional approach to avoiding US estate taxation has been to own the US real estate through a corporation. If the US property is owned through a US corporation, it would be necessary to create a tiered structure in which the shares of the US corporation are owned by a foreign (presumably Canadian) corporation in order to avoid US estate taxation. Otherwise, the stock of the US corporation will be treated as US situs property for US estate tax purposes (Code Section 2104(a)). While effective if structured properly to avoid US estate taxes, ownership of US property through a corporation results in adverse income tax treatment. First, shareholder use of the property without payment of a fair market rental results in income in the form of deemed dividend distribution to the stockholder. Second, no favorable capital gains relief is provided to corporations on sale of assets, including US real estate. As a result, gain on sale of the property will be subject to US corporate tax rates of between 15% and 35%.
Partnerships. Although partnership interests are not identified in Code Section 2104 as property deemed to be within the United States for US estate tax purposes, partnership interests are also not identified in Code Section 2105 as a non-US situs for US estate tax purposes. This uncertainty regarding holding US real estate through a partnership as an effective way to avoid US estate tax suggests that this approach should only be used if the Canadian resident is willing to request a private letter ruling from the Internal Revenue Service. The author’s informal conversations with representatives of the Internal Revenue Service suggest that the Service continues to be unwilling to rule on this issue (see Revenue Procedure 91-6, 1991-1 C.B. 431) or will not rule favorably if a ruling request were to be granted.
US Real Estate Q&A with Robert E. Ward
Q: I live in Canada and am a Canadian citizen. If I purchase a property in the United States will I be subject to United States taxes?
A: Yes. If the US property which you own is rented, you will be subject to US income taxation on the rental income. Even if you use the US property exclusively as a vacation residence, any US property owned at death will be subject to US estate taxation.
Q: How can I be subject to US income taxation when the expenses I am paying (for example, real property taxes, maintenance and upkeep, and mortgage interest) exceed the rental income I receive?
A: Absent special election, rents received by a person who is not a citizen or resident of the United States are subject to a withholding tax imposed at a 30% rate on the gross rental income (without reduction for otherwise deductible expenses associated with the property).
Q: How can I avoid the 30% withholding tax?
A: The United States revenue laws allow owners of US real estate who are not citizens or residents of the United States to elect to be treated as engaged in a US trade or business. The election creates an annual obligation to file a US income tax return but allows the non-US investor to compute his or her US income tax liability on a net basis (reducing gross rental income by deductible expenses including depreciation).
Q: If I do not lease or rent my property to others, do I have any US tax obligations?
A: Yes. If at your death you own US real estate, you will be subject to a US estate tax.
Q: How is the US estate tax different than the tax which I pay to Canada at my death?
A: US estate tax is different in many respects from Canada’s deemed disposition at death tax. Two of the most important differences are, first, the rates at which US estate taxes are imposed: Federal rates range from 18% to 45%, plus the state in which the property is located may also impose a state estate tax. Second, US estate taxes are assessed on the entire fair market value of the property. In contrast, Canada’s deemed disposition at death tax only taxes the gain that would be realized if the property were sold.
Q: I can avoid the taxes that I would otherwise pay to the Canada Revenue Authority at my death simply by leaving the property which I own to my spouse. Will this avoid US estate taxes, as well?
A: No, unless your spouse is a US citizen.
Q: Are there any strategies which will allow me to avoid US estate taxes?
A: Yes. However, taking advantage of these strategies requires planning. In order for that planning to be successful, in many cases it must be undertaken before the US property is purchased.
Q: How can I find out what I should do to avoid US income taxes and US estate taxes?
A: It is imperative that you consult a tax advisor experienced in US tax matters, preferably a lawyer or accountant with a practice based in the United States that advises non-US persons regarding ownership of US real estate.
Robert E. Ward has practiced as a tax attorney for 30 years. He is a principal in the law firm of Robert E. Ward and Associates, P.C., which has offices in Bethesda, Maryland and Vancouver, British Columbia. Robert E. Ward and Associates, P.C. provides tax, business, and estate planning services and represents taxpayers before the Internal Revenue Service and the United States Tax Court. The firm focuses on providing tax planning and representation to owners of privately-held businesses, integrating business succession planning with personal estate planning needs. The firm also provides advice to citizens and residents of the United States who wish to expatriate so as to escape the US tax system and assists clients in establishing foreign asset protection trusts, public and private tax-exempt charitable organizations, and all forms of business entities, both domestic and foreign. Working closely with Canadian legal counsel and tax advisors, the firm offers these same services for individuals and businesses residing in Canada who acquire U.S. assets or engage in U.S. investment and business activities.