Have a U.S. property? The tax man cometh
As a retired manager with the Royal Bank of Canada and the owner of a second home in Phoenix, Bill Mcfarlane has two perspectives on tax issues related to U.S. real estate. He and his wife, Dianne, got expert advice, but he knows from his banking work that many Canadian sunbelt buyers take the homepurchase plunge with little or no tax planning.
“We were concerned first and foremost around potential estate tax issues,” so they talked to a tax lawyer to minimize exposure before buying. “You can get advice from a U.S. lawyer but a lot of it doesn’t apply to Canadians.”
One thing is certain for all Canadians who buy homes south of the border, he says:“at some time or another, we will all have to deal with the IRS (United States Internal Revenue Service).”
Regina tax lawyer George Nystrom, of Miller Thomson LLP, agrees estate tax is the first area of concern. If you die owning a home in the United States your estate could face a significant tax hit – especially under proposed amendments to estate tax law. Known in the U.S. as ‘death tax’, it is levied on the estate of anyone owning assets valued at more than $60,000 in the U.S. and applies to worldwide net worth. American citizens are granted an exemption of $5 million and ‘aliens’ are given a prorated exemption, based on the percentage of net worth that’s held in the U.S., explains Crystal Taylor, another tax lawyer at Miller Thomson LLP in Saskatoon.
For Canadians, this means that if you have worldwide assets of $2 million and own a home in Phoenix valued at $200,000, you hold 10 percent of your net worth in the U.S. and are entitled to 10 per cent of the exemption allowed to U.S. citizens. This works out to $500,000 under the current law. This is far above the value of your U.S. home, so no estate tax is owing upon your death. (If you own U.S. securities, these are also counted and a large portfolio could
change the tax owing.)
But the level of exemption is about to change. Nystrom says the current proposal before legislators would reduce the exemption for American citizens from $5 million to $1 million in worldwide assets as of 2013. In the case of a Canadian with total assets of $2 million and a U.S. home worth $200,000, the resulting 10 per cent exemption on a $1 million ceiling would work out to $100,000, leaving $100,000 of real estate value exposed to state and federal estate tax.
The federal estate tax is graduated between 24 and 35 per cent and Arizona has imposed no estate tax since 2005. So your estate could be liable for $24,000 or more in U.S. estate tax. And if your property appreciated in value to $300,000 before your death, your estate could owe $48,000 or more to the IRS. If your heirs plan to sell the home, they can pay taxes from the proceeds of the sale. But if they want to keep the property in the family, they will have to find some other way to pay the taxes.
Lyle Bouvier, another tax lawyer at Miller Thomson LLP in Saskatoon, says such calculations assume the current proposal passes into law without change, and that’s far from certain.
“The proposal is to move to a $1 million exemption but you really never know. The last time they changed it, the expectation was an exemption of $3.5 million. But they made it $5 million. At this point, it’s just speculation,” Bouvier says. He recommends buying the second home through a trust or partnership that lives on after the death of the individual and prevents the property becoming part of the estate.
Taylor adds that giving the property to your children before your death doesn’t work because that triggers a U.S. gift tax similar to the estate tax. But she says some clients have deferred the estate tax problem for a generation by having children make the initial property purchase and allowing parents ‘generous use’ of the home.
Montreal tax lawyer David Altro, who assisted the Mcfarlanes, says he regularly creates cross-border irrevocable trusts, or C-BITS, as the best solution to estate taxes.
“When Canadians die with U.S. real estate (it’s usually because) they want to leave it to their kids.” So they need a trust or other means of ensuring children aren’t burdened with a big tax bill.
The simplest solution to estate tax is to sell your U.S. property before you die, but this means dealing with capital gains taxation in the U.S. Selling U.S. real estate – and possibly paying capital gains – is also a growing concern for Canadians because many bought in recent months on the expectation depressed U.S. housing prices would rebound within some number of years and generate a profit.
He is skeptical about the chances of any large gain in U.S. real estate values in the short to medium term. Still, even if there is no capital gain, capital gains taxation is likely to be an issue.
The sale of a U.S. property requires filing a U.S. tax return and a payment of tax on any capital gain (after deductions for upgrades to the property). And anyone who buys a U.S. property from an ‘alien’ must, by law, withhold 10 per cent of the purchase price and remit it to the government to cover capital gains by the seller.
Nystrom says anyone selling in today’s market is unlikely to see a significant capital gain but will still face having 10 per cent of the sale price of their property withheld by the title company that functions as a middleman between buyer and seller in U.S. residential real estate transactions. The alien seller can claim this money back on a U.S. income tax form and wait up to a year for a tax refund or he or she can make an application in advance of the sale to have the withholding amount reduced.
Regardless of how much is eventually paid to the U.S. tax man, most Canadians will be taxable in Canada on their worldwide income, including proceeds of that U.S. second home sale. But Taylor says they can claim the U.S. payment as a deduction against the tax owing in Canada, thus avoiding double taxation.
Mcfarlane says he considered renting his Phoenix property on a part-time basis, or even buying a second property as a full-time rental. But he says he learned that aliens are required by law to retain an agency to handle rentals and he said he was also less than eager to create a situation that required filing income tax returns in two countries every year.