Canadians have long been interested in owning U.S. real estate—for personal use and/or as an investment. With the struggling U.S. economy and strong Canadian dollar, U.S. properties have become more affordable, causing interest in such real estate, especially in the Sun Belt, to be at its highest level in recent memory.
Once a property has been selected and the price negotiated, the next question typically is: how should the real estate be held, personally or through an entity? Unfortunately, there is no single strategy or structure that works for every situation.
While Canadians need to understand all U.S. income tax considerations of owning U.S. real estate (e.g., how rental income and the capital gain on the sale are taxed), it’s the U.S. estate tax that appears to drive many decisions on how U.S. real estate should be owned.
U.S. estate tax
The U.S. Internal Revenue Service (IRS) imposes an estate tax on Canadians who own U.S. property at the time of their death. Under current rules, this tax applies when the value of the Canadian individual’s worldwide estate exceeds $5 million (all currency figures are in U.S. dollars) and the U.S. property is valued at more than $60,000. The estate tax currently has a top rate of 35%. This threshold and the rate will remain in effect through 2012, at which time the U.S. Congress will have to enact legislation that extends the current rules or make changes as they see fit.
The ownership decision should be made with the goal of minimizing the impact of the estate tax. The most common types of ownership are:
• Direct ownership as an individual
• Indirect ownership through a Canadian corporation
• Ownership through a Canadian trust
Direct ownership is the simplest way for a Canadian individual, who is neither a U.S. citizen nor a U.S. resident, to own U.S. real estate.
Ownership by an individual should be considered when the value of the property or the worldwide estate is below the thresholds discussed above. Even if the thresholds are exceeded, some Canadians still choose to own the property individually if they decide that the exposure to the U.S. estate tax is not significant compared to the costs of setting up and maintaining other ownership vehicles.
Because each individual is allowed his or her threshold amount, ownership of the property can be split between spouses and others (e.g., other family members). Various planning techniques can be used in this scenario to minimize the taxable estate and to maximize the number of exemptions available. Careful attention should be paid to ensure that the individual’s will is consistent with any tax planning.
Indirect ownership through a Canadian corporation
It was once very common to own personal-use real estate in the U.S. through a single-purpose Canadian corporation. It was thought that this strategy would avoid the U.S. estate tax since the property wouldn’t be held by the individual. In 2004, the Canada Revenue Agency indicated that the shareholder of such a corporation would be taxable on the deemed benefit of using a property owned by a corporation, a decision that effectively ended this ownership strategy.
Ownership through a Canadian trust
Ownership through a Canadian trust has become a more common technique for eliminating exposure to the estate tax. While implementation and maintenance costs are not minimal, they can be insignificant compared to the potential U.S. estate tax savings.
The Canadian trust alternative can be beneficial for a married couple. Under this form of ownership, one spouse (the settlor) creates the trust for the benefit of the other spouse and children. The settlor funds the trust with cash to purchase the real estate and cannot be a beneficiary or trustee nor have an interest in the capital of the trust.
Although there is some flexibility, there are disadvantages to this type of ownership, which arise from the settlor’s inability to control the trust or to benefit from any trust distributions of money or property. Also, if the settlor is predeceased by the spouse and ownership of the property is continued by the trust, the settlor must pay rent to the trust in order to remain at arm’s length from it so that the IRS cannot deem that the settlor owns the trust property personally.
Unprotected exposure to the Sun Belt may be harmful
It is imperative that anyone who considers investing in a U.S. property seek out U.S. estate tax planning advice in advance of the purchase. Unfortunately, there is no single solution that is best for everyone. A plan that minimizes tax can be complex, but this shouldn’t dissuade Canadians from making what they believe to be an otherwise sound investment.