Given how many Canadians migrate south every winter, it’s likely that you have snowbirds in your client list. Many Canadians have opted to purchase a second home in a warmer climate where they can avoid the chill of winter.
The market crash of 2008 made this even more appealing as the purchasing power of the Canadian dollar increased and many properties were available at bargain rates. Almost 10 years later, the markets are still recovering and the value of the loonie is well below par. While the attraction of heading south for the winter is still alive and well for some snowbirds, others may be looking to sell their winter vacation properties.
The purchase price of a second home is just one aspect of owning property outside of Canada. Among the many considerations, one of the most important is to have a plan in place if something happens — like failing health or sudden death. Have a conversation with clients about the implications of buying, owning, and selling a winter get-away property.
There are many rules on both sides of the border. Here’s some information and references to help you and your clients understand the trends, the tax implications of owning a foreign property, and the important role estate planning plays in this endeavour. Because the rules around these topics can be complicated, clients should also be advised to consult with a cross-border tax-planning specialist.
In the 2016 Profile of International Activity in U.S. Residential Real Estate, the National Association of Realtors (NAR) reported that Canadians remain a dominant force in the U.S. real estate market.1 In the 12-month period ending March 2016, Canadians:
- spent $8.9 billion in this market.
- were the 2nd leading international buyer – China was the leader at $27 billion.
- paid a median price of $222,310.
- paid cash for their U.S. home (73%).
- preferred homes in Florida, Arizona, California, Nevada and Texas.
How are Canadians using their vacation home?
The 2016 NAR report also revealed the following insights to explain why Canadians purchased properties.
- 48% intend to use the property for vacation purposes
- 16% plan to use it as a residential investment
- 16% will use it for both vacation and investment
- 17% will use it solely for retirement living
How can you help?
If your clients decide that a foreign vacation home is in their retirement plans, you can help them understand the financial implications. Ask clients these questions to help guide their purchase decision:
- How will you pay for it? Will you withdraw from your retirement savings? Securing a mortgage in a foreign country may take longer. Have you factored in the current exchange rate? Discuss how this may affect your long-term goals.
- How do you intend to use it? Vacation home, rental, investment, retirement home? The tax implications vary depending on how the property is used.
- What’s the budget for ongoing costs? Consider airfare, car and gas, medical travel insurance, property maintenance and insurance, utilities, property taxes, management fees, repairs, and liability if renting to others. Property insurance can be double due to the likelihood of hurricanes and floods in coastal regions. Create a budget to ensure this purchase aligns with your 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 requires Canadian buyers to 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.
- Will you be the sole owner of the property? If you’ve purchased a vacation property with friends or business partners, ownership in the form of a trust or limited partnership might be practical.
- Will you be able to meet the substantial presence requirements? If you as a Canadian stay in the U.S. longer than the allowable number of days under U.S. law, you risk creating a U.S. claim on your worldwide income. You could also be banned from entering the U.S for five years and lose provincial health-care benefits.
- What’s your exit strategy? Ensure you’ve included instructions in your will or estate plan. If you die while you still own the foreign property, your 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 your 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.
Foreign owners of U.S. rental properties must have a work visa or dual citizenship to perform maintenance work on their rental property – otherwise they could be deported
Be aware that specified foreign property doesn’t refer only 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 be claimed on a Canadian tax return only 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.
Ownership and estate considerations
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 2017 U.S. unified credit allows an estate to shelter up to $5.49 million 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 worldwide assets.
Aside from real estate owned outside the country, a Canadian’s worldwide assets may include:
- death benefits from any life insurance policies,
- 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. 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 worldwide 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 worldwide 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 worldwide 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 a spouse. A non-U.S. citizen may transfer U.S. assets worth up to $149,000 each year (2016 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 worldwide estate value).
- Own life insurance in an irrevocable life insurance trust (ILIT). The trust would have to be structured and administered so that the couple would never have any rights to the policy – technically referred to as “incidents of ownership,” which is a term that has a relatively broad scope. Setting up an ILIT can be complicated, and clients should engage a legal professional specializing in this area. 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 dies, 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.
Have an exit strategy
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.
Your clients need to consider the financial and logistical implications of owning a second home, whether it’s in Canada or abroad. Add it to your annual review list and check on how things are going with their vacation home. Make clients aware of any impact it may have on their overall financial plan and impress the importance of creating an exit strategy.
While the buying power of the Canadian dollar isn’t what it once was, the fact remains that many Canadian retirees like to escape our cold climate. It’s important that you and your clients connect with a tax specialist and cross-border lawyer to structure foreign 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 migrate.
1 Source: NAR 2016 report – Profile of International activity in US residential real estate