The strong loonie and the soft U.S. housing market have sent some Canadians shopping for vacation or rental property south of the border. Your clients may be planning such a purchase, and it is your job to alert them to the various issues that need to be considered when buying real estate in the U.S.
"You can pick up some very good deals," said Andrey Pavlov, associate professor of finance at Simon Fraser University in Burnaby, B.C., who specializes in real estate. "In Florida, a one-bedroom condo with a great view in a nice building can go for US$175,000. That’s much cheaper than Vancouver where I live. This may be the right time for Canadians to invest in U.S. property – as long as they do their homework."
Your client may need financing for the purchase, but many American banks won’t provide mortgages to foreigners unless they have established U.S. credit history. One option is taking out a mortgage or a home equity line of credit at a Canadian bank against the home in Canada, and paying cash for the U.S. property. And some Canadian banks have U.S. subsidiaries that may be helpful.
Harris Bank, Bank of Montreal’s U.S. arm, and RBC Bank USA, a subsidiary of Royal Bank of Canada, offer mortgages on U.S. properties to Canadians who are existing clients of the Canadian institution.
Clients who plan to generate income by renting out the property when they are in Canada need to know that the rent they collect must be declared as U.S. income. "And they can only deduct the interest costs of the mortgage from their U.S. income tax if they had U.S. financing," said
Jack Courtney, assistant vice-president of advanced financial planning at Investors Group Inc. in Winnipeg.
"And the rental agency has to withhold a high portion of the gross rent – 30% – for remittance to the Internal Revenue Service," he added. "Your client will need to make an appropriate filing to the IRS to have the withholding rate reduced to approximate his actual tax liability."
Your client will also have to consider how he will hold the property. A common estate planning strategy in Canada to avoid probate tax is to structure ownership of the property as joint tenants, which includes the right of survivorship. This means each spouse has an undivided, one-half interest in the property. Upon the death of the first spouse, the interest of the deceased passes directly to the survivor without incurring taxes.
But in the U.S., the strategy can result in double taxation, notes
Frank Di Pietro, Toronto-based director of tax and estate planning at Mackenzie Financial Corp.
"Canadians may assume, because the U.S. property is in two names, that only half its value will fall into the estate for tax purposes," he said. "But, unless it can be proven that both spouses each contributed their own funds to buy the property – and that may be difficult to do, especially if the property was purchased years ago – the IRS will assume it was owned by the first to die. And when the second spouse dies, the property will be taxed again as part of her estate."
A better strategy, Mr. Di Pietro said, is to hold the property in joint tenancy. "Then, when the first spouse dies, only 50% of the value of the U.S. property will be included in his estate for tax purposes."
U.S. estate tax
One of the biggest nightmares facing families of Canadians who own U.S. vacation homes is the estate tax that may be due on them. While Canadian tax law imposes a tax only on the appreciation of the value of assets held at death, the U.S. estate tax is based on the fair market value of all U.S. assets on the date of death. If your client plans to buy a home in the U.S., you’ll need to review his financial and estate plans, and those of his spouse, determine the worldwide assets of each and the percentage of these that are in U.S. assets.
"If your client’s worldwide estate is less than US$5 million, it will be exempt from U.S. estate tax should he die in 2011 or 2012," Mr. Courtney said. "We don’t know what will happen after that, but if the U.S. Congress doesn’t pass legislation for 2013, the current legislation holds a sunset clause that will re-establish the tax under the 2001 rules, which will mean that only the first US$1 million of his worldwide estate will be exempt from estate tax."
A credit is available under the Canada-U.S. Tax Treaty to offset part of the U.S. estate tax for estates of over US$5 million. "The portion that is not shielded by the credit is exposed to a 35% tax hit in 2011 and 2012," Mr. Courtney said.
And it’s not only vacation homes that are subject to U.S. estate tax. It can also take a big bite out of an estate if a Canadian dies owning U.S.-situated assets, such as shares of U.S. corporations and U.S. business assets.
Gifting property or assets during the client’s lifetime is not a way to avoid paying estate tax, he added, because the U.S. imposes gift taxes at the same rate as estate tax.
The client could sell the property during his lifetime. The long-term capital gains rate in the U.S. on property held for more than one year is 15%, plus state taxes. "The client will also need to report the sale to the Canada Revenue Agency," Mr. Courtney said, "and claim a foreign tax credit against the capital gains tax he paid on it in the U.S."
A strategy he favours is having a client gift some of his Canadian assets to his spouse in order to drive down the value of his worldwide assets to under US$5 million. "Another strategy," he said, "is buying life insurance to enable the children to pay the estate tax."
But life insurance can be a two-edged sword, Mr. Di Pietro noted. "The payout could be considered part of the client’s worldwide estate."
For clients who hope to get U.S. mortgages to finance their real estate purchases, he suggests looking into non-recourse mortgages because each dollar of the mortgage will reduce the value of the property at the time of death by US$1. So a property purchased for US$100,000 with a US$50,000 mortgage will be valued at US$50,000.
Mr. Di Pietro also suggests setting up a discretionary trust structured to keep the property out of the client’s estate. The client can use the property during his lifetime, but after his death it goes to his beneficiaries, usually his children or grandchildren. "Because the client cannot be a beneficiary of the trust or have control over it, the success of such an arrangement depends on how good a relationship the client has with the beneficiaries," he said.
Setting up a Canadian partnership with family members is another option, he said. "The property is held by the partnership and goes directly to the partners upon the client’s death."
But both trusts and partnerships can be expensive to set up and maintain, he noted.
When budgeting to purchase a U.S. property, your client will need to factor in legal fees and closing costs in, which can be as much as three time higher than they are in Canada.
Mr. Di Pietro said the client will also need to ensure that his U.S. property is protected against natural disasters, such as hurricanes and floods in Florida. "This will make the cost of property insurance in some states higher than what we pay in Canada," he said.
Those who plan to rent out their properties will need to purchase liability insurance from a U.S. insurer.
And make sure your client and his family don’t forget to purchase travel insurance, because provincial health plans only pay a fraction of the costs of medical services outside Canada. Clients may assume they’re covered under insurance included with their credit cards, but length of stay outside Canada is a common limitation to this type of coverage, and they won’t be covered if they’re away longer than the specified period. It’s also important to know what kind of coverage they’re buying. Stability periods for pre-existing medical conditions differ from insurer to insurer. And some insurers may not cover some riskier activities such as scuba diving.
Clients should also know that they won’t be able to spend unlimited amounts of time at their U.S. vacation homes. Canadians are considered resident aliens in the U.S. if they pass the "substantial presence" test for a calendar year. And if they do, they’ll have to file a U.S. tax return and they’ll be taxed on their worldwide income.
They’ll pass this test if they are in the U.S. for at least 31 days during the current year and 183 days during a three-year period that includes the current year and the two previous years. To calculate this, they’ll need to count all the days spent in the U.S. in the current year, one-third of the days in the previous year and one-sixth of the days in the year before that.
"In general, if your client spends more than four months in the U.S. in any calendar year, he’ll be considered a resident alien," Mr. Di Pietro said. "The U.S. is desperate for tax dollars and the IRS is tracking foreigners’ presence in the country. The B-2 visas issued to foreigners who enter the U.S. for vacation purposes are granted for six months, but vacationers who stay that length of time could find themselves in trouble under the substantial presence test."
To buy or to rent?
"How much time is your client going to spend in the U.S. every year?" Mr. Di Pietro asked. "If he’s only going to be there for a few weeks, he may be better off renting."
Dr. Pavlov suggests comparing the cost of renting with the cost of ownership – mortgage payments, property tax, property insurance and utilities. "Renting usually comes out cheaper unless your client is going to be spending a lot of time at the U.S. home – and Canadians can’t spend more than four months in the U.S.
"And how much appreciation can he expect on the property?" he added. "He’ll need to have a fairly long timeframe, at least 10 years, to see significant appreciation."