Every winter, thousands of Canadian snowbirds pack up their bags and venture anywhere that’s warm and without snow. A common Canadian strategy is to purchase a property and rent it out until the owners can retire there for the winter months, or sell it for a profit when the market is right.
The dramatic drop in United States (U.S.) real estate values in 2008, paired with a strong Canadian dollar, prompted many Canadians to purchase a vacation property instead of renting for their snowbird vacation.
But the purchase price is just the beginning. There are many aspects to owning property outside of Canada that add to the final decision. It’s necessary to have a plan in place if something happens — like failing health or sudden death. It’s important to know the implications on both sides of the border.
Here’s some information and references to help you and your clients understand what’s happening in the snowbird market, the tax implications of owning a foreign property, and the important role estate planning plays in this endeavour.
Florida remains a popular choice for many Canadians because they can drive there in a couple of days. The 2014 National Association of Realtors (NAR) report, Profile of International Home Buyers in Florida, clearly shows Canadians remain a dominant force in the Florida real estate market. In 2014, Canadians:
- spent $2.2 billion in this market.
- were the leading international buyer.
- accounted for almost 32% of the total foreign transactions (followed by the UK at 7%).
How are they using the vacation home?
The 2014 NAR report also revealed the following insights to explain why Canadians purchased properties in Florida.
- 53% intend to use the property for vacation purposes.
- 14% plan to use it for rental or investment purposes.
- 17% will use it for both rental and vacation.
- 7% will use it solely for retirement living.
Why are they doing it?
Almost a quarter of Canadians surveyed by the Canadian Association of Retired Persons (CARP) in the 2013 Picture Perfect survey identified travel as an important aspect of their retirement. And moving to a warm location during the winter months was a priority for 17% of respondents.
When you combine their desire to be somewhere warm, the familiarity of the U.S. and the appealing price of real estate in Florida — half of all Canadians who purchased homes paid less than $200,000 — it’s easy to see the attraction.
How to help:
If your clients decide that a foreign vacation home is in their retirement plans, you can help them understand the implications. Here are some questions you can ask your clients to help them structure their purchase:
- How will you pay for it? Will you withdraw from your retirement savings? Discuss how this may affect their long-term goals.
- How do you intend to use it? Vacation home, rental, investment, retirement home? The tax implications vary depending on how it’s used.
- What’s the budget for ongoing costs? Airfare, car and gas, medical travel insurance, property maintenance and insurance, utilities, property taxes, management fees, repairs, liability if renting to others. Get them to create a budget to ensure this aligns with their retirement income.
- Do you want to rent your property to vacationers? Rental income from a U.S. property can offset purchase and operating costs, but your client should file a U.S. income tax return. When you own, rent or sell a U.S. property, there are tax implications in both the U.S. and Canada.
- Are they the sole owner of the property? If they’ve purchased a vacation property with friends or business partners, ownership in the form of a trust or limited partnership might be practical.
- What’s your exit strategy? Ensure your client has included instructions in their will or estate plan. If they die while still owning the foreign property, their executor will be required to file an estate tax return with the Internal Revenue Service (IRS), a state death tax return if applicable, and may have to pay probate fees to the state where their property is located.
Taxes payable to Canada and the destination country can vary. For the purposes of this article, we’ll focus on vacation homes in the U.S. since it’s the most common situation. Even with that, there may be separate U.S. taxes that vary from state to state. Your client may need to engage a cross-border accountant and lawyer to ensure they’re compliant.
Be aware that specified foreign property doesn’t only refer to a bricks and mortar structure. As discussed below, if your client has a foreign bank account they’ll need to report these holdings as well.
Taxation of rental income
There are two ways the IRS can tax your client’s rental income. One is to have the client’s tenant or rental agent withhold 30% of the rent for the IRS. The client won’t have to file a tax return, but 30% is usually too much. The other option applies if the client rents their property out for more than 14 days in the year. The client can report their rental income and claim deductions against it like operating expenses, condo fees, property taxes, repairs, insurance, mortgage interest and other expenses connected to the property. The client must have an Individual Taxpayer Identification Number, or ITIN (file form W-7 with the IRS to obtain an ITIN), and must give their tenant or rental agent a Form W-8ECI to let them know that they don’t need to withhold. See IRS Publication 527 for more information, and remember that expenses have to be pro-rated between rental and personal use.
In addition to filing a tax return with the IRS, Canadians must also report the same income earned from sources outside Canada on their Canadian tax return. To the extent they paid tax on that income to the foreign country, they may be able to claim a foreign tax credit. Under the Canada-United States Tax Treaty, the country where the income arises gets to tax it. In this case, the U.S. taxes the income and Canada has to offer the tax credit.
If the property is “specified foreign property” and its value exceeds $100,000, your client may also have to report it on a Form T1135: Foreign Income Verification Statement. Specified foreign property includes “tangible property” like real estate.
Foreign property shared with other individuals must be pro-rated, based on the cost of the investment, and applied to the total. Failure to file Form T1135 could result in late filing penalties of $25 per day, with a minimum of $100 to a maximum of $2,500 per year.
Taxes when selling a U.S. vacation property
When a non-resident sells a U.S. property, some of the gross sale price is withheld automatically and sent to the IRS. This tax prepayment is usually 10% and is calculated based on the sale price, not the actual gain. Essentially, it represents a prepayment of U.S. capital gains tax. The excess can be recovered by filing a U.S. return to report the sale. It’s recommended to seek the advice of a cross-border tax professional to ensure the gain is calculated correctly. Foreign tax credits can only be claimed on a Canadian tax return after it’s been filed in the U.S.
Of course, half the capital gain must be reported as income on the Canadian tax return. Again, foreign tax credits are available to reduce or eliminate the double taxation that arises from having to pay capital gains tax to two governments on the sale of the same property.
U.S. estate taxes can be as high as 40% of the fair market value of all U.S. assets owned. If your client personally owns more than $60,000 of U.S. assets when they die, their executor is required to file a U.S. estate tax return. Canadians may still be exempt if the value of their worldwide net worth is less than the unified credit amount. The unified credit allows an estate to shelter up to $5.43 million (2015 amount, indexed annually for inflation) from estate tax. Under the tax treaty, Canadians are allowed a pro-rata unified credit, based on the proportion that their U.S. assets bear to their world-wide assets. Many Canadians are surprised to learn that the death benefits from any life insurance policies they own are treated as assets in determining the value of their world-wide assets.
Aside from real estate owned outside the country a Canadian’s U.S. assets may include:
- any tangible property – furniture and appliances in their vacation home, and
- intangible personal property they personally own, like U.S. pension plans and shares in U.S. companies.
In addition to U.S. federal estate taxes, some states also have an estate tax — Florida doesn’t.
Here are some strategies to help your client reduce or eliminate the impact of the federal estate tax:
- Title property in one spouse’s name. If a couple’s U.S. assets are owned by the spouse with the lower world-wide asset value, more of the pro-rata unified credit can be available at that spouse’s death to shelter the asset from estate tax. This strategy has limits, though. If the lower asset spouse dies first, the surviving spouse may then acquire the property and may have the same estate tax problem as before.
- Reduce the value of the world-wide estate by transferring non-U.S. assets. A Canadian resident is not subject to U.S. gift tax on transfers of non-U.S. assets. Accordingly, if a Canadian resident with estate tax exposure on their U.S. assets can shift ownership of their other assets to someone else, or transfer any future growth in those assets to someone else (for example, through an estate freeze) they can reduce the value of their world-wide estate and increase the size of their pro-rata unified credit. Remember that Canadian capital gains tax may apply to the transfer, and the attribution rules may also apply on any income that the transferred asset earns.
- Reduce the value of U.S. assets by transferring U.S. intangible assets. There is no gift tax on the transfer of intangible assets, but there is estate tax. It can therefore make sense to give away intangible U.S. assets during life to avoid their inclusion in the estate at death. Remember that Canadian capital gains tax may apply to the transfer, and the attribution rules may also apply on any income that the transferred asset earns.
- Transfer U.S. assets to spouse. A non-U.S. citizen may transfer U.S. assets worth up to $147,000 each year (2015 amount, indexed to inflation) to their spouse without having to pay gift tax on the transfer. Such transfers could be part of a strategy to maximize the pro-rata credit that each spouse could use at death, or to transfer the estate tax burden from one spouse to the other (for example, to the spouse with the lower world-wide estate value).
- Own life insurance in an irrevocable trust. The trust would have to be structured and administered so that the couple would never have any rights to the policy. At death, the proceeds could be used to make up for the trust beneficiaries — typically the couple’s children — what they would lose to estate taxes.
Though they may seem natural to a Canadian, some ownership strategies may not work well:
- Joint ownership. If neither spouse is a U.S. citizen, there is a presumption in U.S. law that the first spouse to die owned all the property. Their executor would have to include the full value of the U.S. property in the estate of the first to die and potentially pay estate taxes. When the surviving spouse died, they too would be treated as the owner, and their executor would have to include the value of the asset in their estate. It’s possible that estate tax would have to be paid twice.
- Special purpose Canadian corporation owns the vacation property. The strategy relies on the fact that the vacation property is owned by a corporation, not by the corporation’s shareholders. When a shareholder dies, the vacation property will still be owned by the corporation, which will continue after the death of its shareholders. Since the corporation is not a U.S. corporation, there will be no U.S. estate tax consequences. But the CRA says that they’ll assess a shareholder benefit each time a shareholder or guest uses the vacation property, equal to the rent the shareholder would have charged to a stranger. Further, the Internal Revenue Code says that the IRS can “look through” the corporation to determine that the real owner of the property is the one who created the corporation, transferred a U.S. vacation property to it, and that that person’s estate needs to include the value of the vacation property as an asset for estate tax purposes.
- Canadian trust owns the vacation property. The owner irrevocably transfers the vacation property to a trust for the benefit of their spouse and children, with the right to use it rent-free for life. However, the trust would be subject to Canada’s 21-year deemed disposition rule, which could trigger capital gains tax on the vacation property at 21 years. The 21-year rule doesn’t apply to alter ego or spousal trusts, but other considerations do, such as having to be age 65 or over to use such a trust. Further, if the owner’s spouse died first, the owner would have to pay fair market rent to the trust to avoid its being included as an asset for U.S. estate tax purposes.
If clients would like to leave the home to their children, then one suggestion is to transfer ownership while they’re still alive. Capital gains are triggered, and possibly gift taxes, but any increase in the vacation property’s value will go to the children. Make it a priority to include the division of the vacation home amongst heirs in the estate plan. Talk to your clients about having a plan to sell their vacation home and identify professionals who can help with this process. There are also variations on the strategies noted above that could help your clients.
Have an exit strategy
Your clients need to consider the financial and logistical implications of owning a second home. It’s something to add to your annual review list. Check on how things are going with their vacation home and the impact it may be having on their overall financial plan. Having an exit strategy is important to their financial well-being.
It’s crucial that you and your clients connect with a tax specialist and cross-border lawyer to structure U.S. ownership efficiently. Once you clarify the tax rates and thresholds that apply to your client, you can address any concerns to the impact on their estate. The time to have the conversation is now, before they fly south.