An American vacation home appears to have a double advantage for Canadians: both as an investment and as a chance to escape to sunnier climates during the winter.

On the investment side, the American real estate market is still soft, so it could be a good time to buy. According to RealtyTrac Inc., which monitors foreclosures in the U.S., the number of American homes receiving a foreclosure filing will climb about 20% in 2011—even though 2010 was a record year.

David Sung, president of Nicola Wealth Management in Vancouver, B.C., notes some macro-economic conditions that may be reasons to buy. “By buying with current rather than future dollars, there is the potential for extended use in the future, and then there is also potential of asset appreciation in price over the long term,” Sung says.

“Another pro, from an investment standpoint: owning real estate outside of Canada makes for potential diversification,” Sung says. “Timing is also a factor. The U.S. real estate market may never be so low, so maybe now is the time to buy.”

It may make economic sense to have a home in the States if your client plans to stay in the same place for extended periods. Another possibility, Sung says, is if the client is going to be in the home for shorter periods, she may be able to rent the property for added income. However, if she does rent out the property, she will be subject to a 30% withholding tax on the gross rents, or will have to file a U.S. income tax return on a net-rental basis.

“Personal and economic motives are often commingled,” Sung says. “But if [your client has] more money than he needs, and doesn’t require an economic justification, then your decision is easier.” Here, pure convenience factors come into play. For instance, the client may find it attractive to have clothing, golf clubs, and tennis rackets in his vacation home so he doesn’t have to worry about carting them back and forth. If he has an extended family scattered over a wide geographical area, a U.S. home base may be convenient. “Pride of ownership may also be a part of it,” Sung says. “It may suit an investor’s ego to be able to say, ‘Oh, yes, I have a home in the States.’ ”

A good investment?

But in the wake of the credit crisis, American financial institutions are more wary of lending to anyone, never mind Canadians. If financing is available, a Canadian will likely need to put down at least 30% against the purchase price. Plus, “The costs are higher for a mortgage if you don’t live in the U.S.,” says Caroline Rheaume, a cross-border tax and estate-planning expert based in Montreal, Que. “You have to shop around. Also, Canadian branches generally won’t take a mortgage on an American property. Some Canadian banks have branches in the U.S., but you have to check the rates because they’re usually higher.”

Terry Ritchie, author of The Canadian Snowbird in America, says clients should consider avoiding a mortgage altogether. He suggests they buy in cash when possible, especially given the strength of the Canadian dollar. Instead of converting the funds at a bank, however, Ritchie recommends using wholesale currency exchange providers such as Western Union Business Solutions (business.westernunion.ca) or Knightsbridge Foreign Exchange (www.knightsbridgefx.com). Now is also a good time to hedge against future American-dollar expenses.

Rheaume would caution clients against buying American property on a whim. “They don’t always look at all the fees, such as condo fees,” she says. “Property taxes, if you don’t live in the U.S., might be higher, depending on the state. People are saying, ‘Oh, it’s not that much, the value is down, the dollar is at parity.’ More and more are interested in buying, and they sign the documents without doing too much planning.”

Planning is crucial, agrees Ritchie. “It’s also a good idea to talk to friends or associates about what you want to buy, and even go down to kick the tires,” Ritchie says. “Many Canadians are overwhelmed by the opportunities, so it’s helpful if you can establish a relationship with a good real estate firm, such as the Purple Cow Team [www.purplecowteam.com]. Real estate agents call, responding to my book, [but] many don’t even know where Toronto is. So, shop around.”

Sung points out the ongoing costs after the initial purchase. “With ownership comes a lot of responsibility,” he says. “A home requires a lot of maintenance. Ironically, I see a lot of people go to the U.S. for a vacation and spend much of their time doing maintenance and repairs.” And even if the client is only there for six weeks, the property will require maintenance all 52 weeks of the year. “Property management is expensive, especially lawn care and maintaining a swimming pool,” he says.

Even though renting out the property is an option, “It’s much harder to keep track of a renter while in another country,” Sung says. “One bad renter can send all the revenues you make from other renters out the window. In any event, you’ll probably have to hire a property manager. This costs money.”

There is also a flip side to the premise of buying cheap now and watching it appreciate in value later. “You’re never going to get a 100%-accurate crystal ball,” Sung says. “Low real-estate prices today might appreciate, but the American market has the real potential for further decreases. Moreover, whenever the prices start to appreciate, they might not get to where they were before, and other investments may appreciate faster.”

Ritchie agrees factors can easily change. “Two years ago, American real estate firms, as an incentive to encourage Canadians to buy property, offered to pay rent for a year or two,” he says. “Now that time has elapsed, and [owners] are stuck trying to find a renter. It’s hard to manage a property and attract renters if you’re in Canada and your property is in California.”

The state of estates

There are several tax implications of purchasing an American home. If the property is sold down the line for a gain (or loss), a Canadian owner must file American federal, state (if applicable), and Canadian tax returns. American federal capital gains tax is 15%. “Most states don’t have capital gains tax, but you have to check,” says Rheaume. “And the 15% applies to the entire gain. In Canada, you also have to report the gain, so you have to figure out the fair market value in $Cdn versus the cost in $Cdn. Half the gain is taxable in Canada.” Canadians can also claim a foreign tax credit for the American taxes paid.

Another consideration is U.S. estate tax, which the American government reduced from 45% and a worldwide basic estate tax exemption of $3.5 million to 35% and a worldwide exemption of $5 million in December 2010. Under the Canada/U.S. tax treaty and the additional credit available to married couples, a single Canadian would not face estate tax if his or her worldwide estate is less than US$5 million and a married couple would not face estate tax if their worldwide estate is less than US$10 million. They could still have to file an American estate tax return, though, if the value of the American situs assets exceeds US$60,000.

These levels are in effect until the end of 2012. “But for 2013, you don’t know what is going to happen,” says Rheaume. “So what people have to think about is if there are changes in the exemption, will they have exposure?” Another factor to consider is the estate of the surviving spouse could be above the single exemption.

To minimize estate tax exposure, the method of purchasing the property matters, says Rheaume. “If the exposure is minimal—the client is young and may sell the property in the future—the client may buy it personally or with a spouse or family member, as joint tenants. As long as everyone pays for his or her share of the purchase price and keeps proof of the payment, you may be able to minimize U.S. estate tax.”

But if the client is close to or already has exposure to the U.S. estate tax on his worldwide estate, establishing a trust to purchase the property may be the best option. Rheaume explains the client would establish an irrevocable, discretionary Canadian trust and transfer the funds to buy the property into the trust. “So now the trust has the money and buys the real estate,” says Rheaume. That means the client no longer has exposure to U.S. estate tax. “But the person transferring the money inside the trust cannot be a beneficiary or a trustee of the trust. So they lose control over the money and over the property that the trust is now buying.”

Rheaume gives an example using a $500,000 property. “Let’s say your clients are married. The husband has the money and he transfers $500,000 into the trust, and the trust buys the real estate. The spouse and their children are the beneficiaries. Under U.S. law, because they are married, the husband is entitled to use the property without having to pay rent. But upon the wife’s death, because the children are beneficiaries, if the husband wants to use the property, he will have to pay rent.”

A trust works well when a client is prepared to give up property and the money altogether in exchange for reducing the estate’s value to the point of eliminating the U.S. estate tax. However, if the client wants to get the property back, he or she will be exposed to estate tax once more. As well, unwinding the trust to regain control of the property creates another issue: gift tax.

Let’s say the client created the trust and made his 25-year-old daughter the beneficiary. If the client changes his mind, he’ll have to unwind the trust. When his daughter gives back the property to your client, his daughter will have to pay U.S. gift tax because she is gifting a U.S. situs asset.

Other options

With all the inherent hassles, is buying an American vacation home worth it? Sung doesn’t think so.

“As an investment manager, real estate is an important part of our portfolio,” Sung says. “But even though residential properties look like a sweet spot, unless your personal desires predominate, they aren’t good investments. I would instead advise my clients to consider high-grade commercial properties—industrial, retail power centres, or even mini-storage lockers—any type of real estate that produces a high amount of cash flow. Residential properties [tend to] generate no more than half the amount of cash flow, more likely less.”

Suppose the client has $400,000 he is thinking of investing in a vacation home, but instead he buys a high-grade commercial property, says Sung. With a vacation home, he would be getting no yearly cash flow. But from the commercial property he would be getting $30,000 a month. With a fairly high tax rate, he’d be left with $19,000 a month. Divide that $19,000 by 30, Sung says, “and you’re looking at $633 a day. That’s pretty much as much as he would spend if he were travelling and not tied to any one location.”

As an example, Sung cites his partner, CEO John Nicola. The firm has investments in mini-storage lockers, and when Nicola takes his six-week vacation in Maui, Hawaii, as he’s done for the past 20 years, he stores his bicycle, tennis racket and other belongings in a mini-facility, and rents his vacation retreat. “John rented the same home for many years, but recently switched to a different place, which was fresher and less expensive,” says Sung. “Because he was only renting, he was able to easily make the switch.”

It’s easy when considering the purchase of a vacation home to confuse personal motives with financial realities.

“But it’s important to sort the two out,” Sung says. “And that’s one of our jobs as advisors. If personal, motives are more important than the financial ones, then a client buying a residential property may be a good thing. But from an investment perspecitive, I there are better options.”

DIPS IN MEDIAN VALUE FOR A CONDO SINCE 2006

  • From $182,000 to $73,000 in Phoenix, AZ

  • From $369,000 to $218,000 in Palm Springs, CA

  • From $292,000 to $64,000 in Las Vegas, NV

  • From $292,000 to $83,000 in Florida.

    In the past, snowbirds from eastern Canada tended to go to Florida, and those in western Canada to Arizona and California. An increase in onerous property tax laws in Florida has resulted in more of a migration from eastern Canada to the western United States.

    Source: Terry Ritchie