Tax Implications for Canadians and All Foreign Citizens Who Own US Property
Michael W. Brooks, 41945 Boardwalk, Suite W, Palm Desert, CA 92211 firstname.lastname@example.org or call Michael at :(760) 773-0900 – (760) 898-3413 (cell)
The information contained in this presentation is provided for informational purposes only, and should not be construed as legal advice on any subject matter. No recipients of content from this presentation, clients or otherwise, should act or refrain from acting on the basis of any content included herein without seeking the appropriate legal or other professional advice on the particular facts and circumstances at issue from an attorney licensed in the recipient’s jurisdiction. The content of this presentation contains general information and may not reflect current legal developments, verdicts or settlements. Sanger & Manes, LLP expressly disclaims all liability in respect to actions taken or not taken based on any or all the contents of this presentation.
1. We are discussing Canadian Citizens and all foreign citizens, not subject to tax in the US on income they earn worldwide, but only subject to tax in the US on their “US source income”.
Which foreign citizens are subject to a tax in the US on the income they earn worldwide?
- i. Dual (US and foreign country) Citizens
- ii. US Green Card Holders
- iii. Foreign Citizens who spend over 183 days a year in the US (subject to the applicable treaty, if any) See Note below
- iv. Citizens who average over 4 months a year in the US and don’t file a closer connection statement (Form 8840).We refer to these as “Snowbirds”. If we are referring to Canadians in particular, they will be called “Canadian Snowbirds”. Note – We are describing here persons who are US residents for tax purposes (not immigration purposes, which is further down)
Note – how US tax residents are evaluated on the calendar year, unlike a review of the US immigration laws. Question : How long may a Canadian Citizen stay in the US Under US Immigration Law (remember – violate US Immigration Law and you can be suspended from entering the US for some time, even years)
Answer : (for US Immigration Law)- Up to 180 in ANY 365 days period (not evaluated on a calendar year period).Caveat – BE CARFUL, US BORDER GUARDS ARE COUNTING 30 DAYS (OR UNDER) TRIPS BACK TO CANADA, AFTER THE 180 DAY CLOCK HAS STARTED AS PART OF THE 180 DAYS SPENT IN THE US!!
EXAMPLE : Canadian couple Steve and Regina typically come to Palm Springs each year on November 1st, and then leave April 25th of the next year, careful not to violate the over 180 days in any 365 day period immigration law. This year they plan to go back to Canada for the holidays from December 12th to January 2nd, and then they will return to Palm Springs. Since they are going back for 20 days in December, Steve and Regina consider staying in Palm Springs until May 15th that year. BUT THEY SHOULD NOT DO THIS!!!! THE 20 DAYS VISIT BACK TO CANADA FOR THE HOLIDAYS COUNTS AS IF IT WERE IN THEY STAYED IN THE US. STAYING UNTIL MAY 15TH MEANS THEY WILL BE CONSIDERED AS HAVING SPEND AROUND 195 DAYS IN A 365 DAY PERIOD, WHICH VIOLATES US IMMIGRATION LAW. THEY SHOULD STILL GO HOME ON APRIL 25TH.
2. The Snowbird has, or is considering, purchasing a house in the Palm Springs area.
TAX IMPLICATIONS OF RENTING YOUR HOME
1. General Rule – The Snowbird’s tenant or property manager must withhold 30% of gross rent payments (and forward these amounts to the IRS). If tenant or prop manager fails to withhold, IRS will look to the Snowbird for withholding tax, unless a W-8ECI and 1040NR are filed (see below).
2. Optional Rule – Snowbird completes a Form W-8ECI withholding certificate and gives it to the tenant or property manger instructing them not to withhold, and then files the Form 1040NR tax return by June 15 of the next year. WHY?
Allows the taking of deductions (e.g., property taxes, mortgage interest and depreciation)
(B) Tax rate likely lower, much lower than 30%
Note: California may require an additional withholding of 7% of the gross rents.
Note: Must obtain a US taxpayer ID number (via a Form W-7) to complete a Form W-8ECI or Form 1040 NR.
TAX IMPLICATIONS OF SELLING YOUR HOME
1. General Rule
a)The purchaser must withhold 10% – 15% of the sales price for the IRS; See Exceptions below. The purchaser is personally liable for a failure to withhold (if the taxes are never paid)!!!
b) you are also subject to 3.1/5% of the sales price for California state taxes unless you show a zero gain or a loss
2. Optional Rule
File the IRS Form 8288-B (withholding certificate) (plus the Form 1040NR tax return the next year), and the California Forms 593 (plus the 540NR the next year). The IRS then approves a reduced holding rate. The Snowbird then pays a 15% tax on the difference between the sales price and the purchase price (or adjusted basis); 9.3% for California
Note 1: The IRS may take between 8 to 12 weeks to return an approved withholding certificate. You should submit the Form 8288-B well in advance of the sale’s closing.
Note 2: You should submit a Form W-7 (request for taxpayer ID number for the Snowbird) with the Form 8288-B. IRS unlikely to issue taxpayer ID # before submitting the Form 8288-B or completing the Form 1040NR.
Note 3: The purchaser need only pay to the IRS the revised withholding amount by the 20th day after the Service mails a copy of the withholding certificate, whether approved or a denied.
EXCEPTIONS TO WITHHOLDING REQUIREMENT
Starting February 17, 2016, the Buyer of a Snowbird’s US property will withhold $$ % of the selling price based on the 3 possible outcome
2. The transaction is a non-recognition transactions (e.g., Section 1031).
3. When there is ZERO “amount realized” in the transaction.
Note- What is an “amount realized” for this purpose?
The cash paid, or to be paid;
The fair market value of other property transferred, or to be transferred, and
The outstanding amount of any liability assumed by the transferree (but see foreclosure exception).
When a Snowbird transfers an encumbered property to a buyer for zero cash but with the condition that the buyer assumes the liability, withholding is required (Treas.Reg.Section1.1445-1(g)(5). But withhold what? Buyer did not pay Snowbird? Buyer must send in a cash payment to the IRS equal to 10% of the liability assumed!!!Complete the Form 8288-B to avoid this crazy result.
A WORD ABOUT TAX CREDITS
1. Do Canadian Snowbirds/Snowbirds have to pay tax in Canada (or the home country of the Snowbird) on income from renting or selling their US property?
2. Does this mean Canadian Snowbirds/Snowbirds must pay double tax (once in the US and once in Canada/home country)?
Answer: Generally No . The US taxes the income and Canada (or the home country) should credit the Snowbird on the US taxes paid. However Cuba, Iran, North Korea , Sudan and Syria will not credit US taxes (and vice-versa)
CAN SNOWBIRDS USE IRC 1031?
1. General Rule 1031- Individual sells appreciated property and simultaneously (or shortly thereafter) purchases a new property of like kind. Individual need not pay tax on gain after sale of first property. Basis in first property is carried over to 2nd property.
Example. Tom purchases a Palm Desert house in 2001 for $500K. Sells it in 2006 for $1,000,0000. Shortly thereafter in 2006, Tom purchases an Indian Wells home for $1,000.000. In 2012, Tom sells Indian Wells home for $1,250,000. Assuming 1031 requirements met, what are:
Tom’s taxable income in 2006: $0
Tom’s taxable income in 2012: $750,000
2. So can Canadian Snowbirds/Snowbirds utilize Section 1031?
Answer: Technically yes, but it’s very difficult.
3. What type of property is eligible for 1031 treatment?
Answer: Property held for (a) investment or (b) productive use in a trade or business.
4. Do vacation homes qualify as either held for (a) investment or (b) productive use in a trade or business?
Answer: Unlikely. Generally, only if the Snowbird (or the Snowbird’s family) uses the vacation house not more than the greater of 14 days a year or 10% of the days the house is rented.
5. But rental properties qualify for 1031 treatment, correct?
Answer: Yes, if a Snowbird’s US rental property is exchanged for another US rental property, that transaction would qualify for 1031. Likewise, a vacation home only used for two weeks a year would qualify for 1031 exchange.
Note-The US property must be exchanged for other US property; an exchange for property from another country will not qualify for IRC 1031?
US ESTATE TAX – PROBATE – HOW TO AVOID IT
The US Estate Tax is a death tax imposed on Americans (on the value of their assets worldwide) and possibly on Canadians, but only if the Canadian owns US property at death (US property is US real estate or securities of US corporations) . If so, the tax imposed is generally 30-40% of the value of US property owned at death.
1. What US assets are subject to the US estate tax?
Tangible personal property located in the US (boat, jewelry, art)
Shares of US company stock (no matter where owned, but not including US shares owned via Canadian/foreign country mutual funds)
2. Does the current US/Canada Tax Treaty offers Canadians relief from the US Estate Tax?
Answer: YES (this is very important). As per the US-Canada Tax Treaty, if the Canadian Snowbird does not own more than $5,340,000 in worldwide assets/dollars, then no matter the value of the US house, the Canadian Snowbird IS NOT subject to the US estate tax (even if they own a Palm Springs mansion!!!) So most Canadian Snowbirds are not subject to the US estate tax-period!
3. California Probate – Avoid IT!!
Question :What is California Probate?
Answer : Probate is the California process whereby a California court orders the Canadian snowbird’s US house to be distributed to their designated beneficiary(ies). Depending on how you own your California home, probate may be required after the death of one spouse, or the second spouse, or not required after the death of either spouse if a trust is utilized.
Probate Is Expensive. The estate of the Canadian Snowbird in probate will pay ordinary fees and likely extraordinary fees as well.
What are Ordinary Fees and How Much Are They? There are ordinary fees (which are statutory). Every probate will include these fees. Ordinary fees cost approximately 3% to 4% of the property being probated value in California. These are the minimum fees that will be required in every case.
What are Extraordinary Fees and How Much Are They? Extraordinary fees are likely in any international probate, because of the tax issues (and the requirements of the attorney to invoke various provisions of the US-Canada Tax Treaty) involved. They will be charged by the attorneys normal hourly rates. Extraordinary fees are likely to be in the thousands of dollars in every US-Canada Probate
How long does California Probate Take? Probably no less than a year or a year and a half, and maybe longer
Any other Negatives about Probate? Yes it makes your finances public record
What likely is the best ownership form to avoid California Probate on death of H&W ? –
THE CANADIAN IRREVOCABLE TRUST
ONLY MATTERS IF THE CANADIAN OWNS MORE THAN $5,340,000 IN VALUE OF WORLDWIDE ASSETS PLUS OWNS SIZEABLE US ASSETS(LIKE A BIG HOUSE IN THE US)
Pros : many cross-border practitioners believe (for the estate tax determination) the Canadian Snowbird does not own a US house, but rather has an interest in a Canadian Trust (which owns a US house). So when the Canadian Snowbird dies he or she does not own a US house for the purposes of the US estate tax . $0 estate tax upon death.
As good as a Canadian Corporation for estate tax protection, but no rental payments required (at least until death or divorce) and no high corporate tax rate upon sale (the real problem with corporations is the high US tax owed on the sale of a house).
Probably avoids US probate (but US counsel (e.g. Sanger & Manes) must review the Canadian Trust to ensure it contains the proper language to avoid US probate!!).
Cons: Several :
Little Us estate tax concern if put into place prior to the house purchase (although there is a US gift/estate tax concern if put into place after the original purchase).
It’s an irrevocable trust – NO GOING BACK
Only H or W can be connected to the trust, the other IS NOT. So if H&W get divorced (or if H or W dies) , the NON connected spouse must pay rent to use the home.
IF trust is still in place after 21 years, the property must undergo a “deemed disposition” for Canadian tax purposes (i.e. the underlying property is deemed sold after 21 years, and any deemed gain is cap gain for Canadian tax purposes).
Note : Sanger and Manes LLP, prepares Canadian Irrevocable Trusts in conjunction with Canadian Counsel
THE US REVOCABLE TRUST
The US Revocable Trust. Likely to be the best option for Canadians who are NOT subject to the US Estate Tax (e.g. Canadian Snowbird who have less than %5,430,000, per person worldwide assets , but who don’t want their heirs to have to pay excessive California Court and Attorney costs, plus have a year or longer wait , just to inherit a house in California).
Pros : Several :
Unquestionably avoids California probate (i.e. Cal court proceeding ) upon death of H&W – remember- probate will cost a minimum of 3% to 4% of asset value (plus additional costs likely international context), plus probate can take over a year to transfer property to beneficiaries. By using a US Trust, property is transferred to beneficiaries in a around 4 months (plus non US court involvement required!)
It’s a revocable trust – undo the trust if you like; amend the trust if you like, put more houses in the trust if you like.
H & W are trustees. No rent required to use the house in the case of divorce or death of H& W
Income tax exactly as if H&W (or other owner (s) owned with no trust.
No US filings , maintenance or costs (other than initial setup) until both H&W pass away
Property can be transferred to kids without having to risk putting them on title earlier in the game.
Note : Sanger and Manes, LLP drafts US Revocable Trusts for Canadian Snowbirds. Trusts will generally contain QDOT provision to protect against subsequent estate tax exposure, if ever. Standard price is approximately $2500 per trust. Phone : 760 320 7421 (Michael Brooks )
STRATEGIES TO MINIMIZE THE US ESTATE TAX
1. Insurance Pays for the US Estate Tax
A. What is it? Snowbird purchases life insurance to pay for US estate tax upon death.
B. What does it accomplish? The cost of insurance can be considerably cheaper than the estate tax itself.
2. US House owned via a Foreign (not US) Corporation.
When the Snowbird dies, he does not own a US house (which is subject to the US estate tax), but owns instead shares of a foreign corporation (specifically not subject to the US estate tax).
Pros: Shares of foreign country’s corporation is not part of a US estate, so very favorable for the US estate tax.
(i) Shareholder benefit taxation in Canada and other countries (must pay tax on rental value).
(ii) Poor for US income tax purposes. When any corporation sells the house, the corporation pays 35% tax of the appreciation (instead of 15%).
US House owned via a Partnership (either US or foreign partnership). Again, when the Snowbird dies, he does not own a US house (which is subject to the US estate tax), but an interest in a foreign partnership (which may or may not be subject to the US estate tax).
Pros: Partners are taxed as individuals. So upon sale, they are entitled to the low 15% capital gains rate.
Cons: Uncertainty on whether US estate tax is imposed on value of partner’s interest. However, domicile of partners (presumably foreign) is a positive factor in partnership interest not being subject to the US estate tax, but where partnership is conducting business also important.
Important Final Partnership Note:
Partnerships may “check the box” and elect to be taxed as a corporation. Many practitioners believe a partnership electing to be taxed as a corporation is more clearly not subject to the US estate tax. However, the partnership checking the box is now subject to the higher 35% corporate tax when selling the house.
QUALIFIED DOMESTIC TRUST (QDOT)
A.What is it? A trust which holds the Snowbird’s US property.
B.What does it accomplish?
i. Upon the death of one spouse, property in the QDOT is transferred free of tax to the other spouse (not otherwise available to non-US citizens).
ii. Avoids probate upon death of first spouse.
C. What are QDOT requirements?
i. At least 1 trustee must be a citizen or bank (if QDOT holds more than $2 M, then the trust must be a US Bank, or the trustee can furnish a bond).
ii. Only legally recognized spouse for Federal US purposes qualify (i.e. no same sex spouses).
iii. No more than 35% of the value of real property in the trust can be outside of the US.
PROS AND CONS OF OWNERSHIP STRUCTURES
Let’s review the various ways a Canadian can own a house in California- SIDE NOTE : THINK TWICE BEFORE PUTTING YOURS KIDS ON TITLE
Highly typical Scenario : H&W purchase a palm Springs Home and wish to leave the home to their children when they pass away;
Question: Should H&W put the children on title (whether as additional joint tenants or tenants in common)?
Answer : It is a BAD IDEA. If a child has creditors, gets in an accident and owes and judgment, or gets divorced and owes $$$ to the ex-spouse, a lien will be put on the house and H&W could lose their house due to the financial problems of the child.
Suggestion : H&W should put the house in a US revocable trust. Upon H&W death, the house passes to the children with no risk of children’s creditors/ex-spouses putting a lien on the house. Plus , trusts avoid costly California court/probate fees to transfer the house to the children.
Structure 1 – Individually- H or W owns US house alone
Pros: Low 15% capital gains rate upon sale.
Cons: Probate required upon your death (bad); no liability protection for Canadians if house rented; no protection against estate tax.
Structure 2 – Joint Tenancy- H & W owns US house as Joint Tenants
Pros: Low 15% capital gains rate upon sale plus a double step up in basis upon first spouse to die (so very good for US income tax); No California probate required upon death of 1st spouse. (but required upon 2nd to die).
Cons: No liability protection if rented; No extra protection from US estate tax. probate required on second spouse (or joint tenant) to die.
Structure 3 – Community Property with Rights of Survivorship
Pros: Low 15% capital gains rate upon sale plus double step up in basis upon first spouse to die (so very good for US income tax); no California probate required upon death of 1st spouse.
Cons: No liability protection if rented; no extra protection from the US estate tax. Probate still required upon 2nd spouse to die. No extra protection from the US estate tax.
Structure 4 – Tenants in Common
Pros: Low 15% capital gains rate upon sale; portion distributed according to will (or trust) of 1st to die, does not automatically go to remaining owners of the house. Good for unrelated business owners of the house.
Cons: No liability protection if rented; must go though California probate; upon death of 1st co-tenant (although there is an exception for spouses; no extra protection from the US estate tax.
Structure 5 – Via Shares of a Corporation
Pros: Asset and liability protection if rented.(if corporation is registered to do business in California). No Cal PRobate required on death of H or W. IF OWNED VIA A CANADIAN CORPORATION, THE VALUE OF THE US HOUSE DOES NOT COUNT AS A US ASSET SUBJECT TO THE ESTATE TAX.
Cons: Poor corporate tax rate (35%) upon sale of house (plus 2nd tax on distribution to shareholders (VERY BAD INCOME TAX RESULTS UPON SALE); if a US corporation, value of US shares count as US assets subject to the estate tax;(so very wealthy Canadian should not own Cal house via a US Corporation). Must pay monthly rent to use your own house.
Structure 6 – Via Partnership Interests
Pros: Asset and liability protection if structured as a limited partnership; Low 15% capital gains rate upon sale of house
Cons: NO PROTECTION FROM US ESTATE TAX (don’t believe the hype, the value of the houses owned via a limited partnership do count as US assets for the purposes of the Canadian partner’s estate tax computation, even if it is a Canadian Partnership .