Ice storms, snowstorms, and throw in a polar vortex. Even by Canadian standards, this winter has been brutal. Your client has had enough, and decides to purchase a property down south.
Why not propose Arizona or Florida? That’s where most Canadians buy in the U.S. due to affordability and the warmer climate, says Fred Cooper, a senior vice-president at Toll Brothers, a New York City-based luxury homebuilder.
“They’re more resort-like and are considered destinations for second home buyers,” he says.
Cooper suggests the Naples, Orlando or Palm Beach areas in Florida. Properties range from $300,000 to $2.5 million, depending on location. Prime spots are near the waterfront, city or a golf course.
“It’s a good time to buy in the U.S.,” he adds. “The economy is just starting to recover and you’ve got a shortage of production.
“If you’re able to buy a house in one of the markets where everyone wants to live, and you’re looking for a longer-term investment, then it’s an interesting time to invest during the early stages of the housing recovery.”
Rent, hold or flip?
Of course there are income tax considerations, but the client’s exposure varies depending on his or her plans for the property. An investor buying property with the intention of renting it out has to file form 1040NR, a U.S. non-resident income tax return. On it, he’ll report gross income from the property but can deduct expenses, including insurance, utilities, mortgage interest, property taxes, repairs and maintenance.
Unlike Canada, however, the U.S. requires taxpayers to depreciate the value of rental properties, says Terry Ritchie, director of cross-border wealth services at Cardinal Point Wealth Management in Calgary. That’s a good thing, because it lowers the tax bill.
To calculate the depreciation, take the full value of the building (excluding the value of the lot it sits on), and divide it by 27.5, the number of years the IRS sets as the useful life of a rental property.
“You have the income [and] expenses, and then you throw the depreciation number in there, and you might have a loss,” says Ritchie.
He adds, “But you still have to file an annual tax return. If you don’t then the IRS can file it for you, and they won’t deduct expenses. So you’ll end up paying tax on the full rent.”
Ensure clients file both U.S. and Canadian tax returns, which must include all U.S. property. In Canada, use form T1135, the foreign income verification statement.
“You’re obligated to disclose the fair market value of the property and the income that’s generated,” says Ritchie. “If you fail to do so, CRA will assess a penalty—the maximum is $2,500.”
If your client’s buying with the intention to flip the property—doing significant renovations to boost value and then selling it quickly to a new owner—advise him to keep copies of all expenses incurred.
“That’s going to bring up costs,” he says. “So when he sells, he’ll only pay tax on the difference between the adjusted cost base and the sale price.”
He’ll still have to pay a capital gains tax on the sale, but the expenses help offset that gain. If he flips in less than a year, the rate is between 10% and 39.6%, depending on the sales price. If the property is held longer, the rate is 15%. Also explain the IRS will withhold the tax when he sells, so having those receipts becomes doubly important as he can recoup those costs as part of a tax refund when filing for the year.
This was the case for one Calgary snowbird, who purchased a $740,000 Scottsdale, Ariz. property in 2007. He decided to sell in 2011, knowing the market value would be below what he’d paid, thanks to the recession. Still, he got $650,000. But he didn’t realize he’d end up with even less: the IRS took 10%, leaving him with $585,000.
“If you’re a foreign national and you’re going to sell real property, whether it has a gain or loss, there’s going to be a withholding tax,” explains Ritchie.
The Foreign Investment Real Property Tax Act (FIRPTA) deems that if the property exceeds $300,000, or the purchaser is not using it as a residence for more than 50% of the year, IRS can withhold 10% on the sales proceeds.
Before closing the sale, the client should’ve filed form 8288-B, which tells the IRS the original purchase price and the cost of any renovations made during ownership.
“You’ve got to include copies of all receipts and a statement that reconciles how you determined your cost base, or your adjusted cost basis.”
Also, the client must fill out a standard sales agreement issued by the state real estate board.
If the IRS finds the client didn’t make any money on the property, meaning there’s no gain, then Ritchie says the agency may issue a certificate that will reduce or eliminate the 10% withholding.
It took his client months of back and forth with the IRS to straighten out the mess, but he eventually scored a full refund, adds Ritchie. “But he had money sitting with the U.S. treasury for months, and he wasn’t earning a stitch of interest on it.”
Inherit or bequeath
For Nadja Ibrahim, tax partner at PwC in Calgary, the main question she gets from clients is over what’ll happen if they die holding a property. The answer is simple, but they don’t want to hear it: They’ll be subject to U.S. estate tax for the fair market value.
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The rate varies from 18% to 40%, depending on the property’s value. If it’s a million-dollar home, clients will likely be hit with the highest rate.
Canadians, however, are entitled to credit on U.S. assets due to the Canada-U.S. Tax Treaty.
Here’s how it works. A U.S. citizen’s eligible for a $5.34 million exemption on her entire estate. Ibrahim says this means she can shelter property and other assets valued up to that amount, so she’ll get a tax credit of up to $2,081,800.
To determine the credit amount, take the value of all U.S. property, including real estate and stocks, and divide it by the total value of all worldwide assets. Then multiply that number by the $2,081,800 credit (see “Estate tax calculation,” below).
Estate tax calculation
Source: Nadja Ibrahim, tax partner at PwC
“If your worldwide assets as a Canadian are under that $5.34 [million exemption], the credit will always wipe out your tax bill,” says Ibrahim. “Still, once you own property worth $60,000, you have to file an estate tax return on death, even if you owe nothing.”
Sometimes clients gift the property to children before they die. But the U.S. gift tax is comparable to estate tax rates. Doing this also causes the client to give up the credit.
Instead, Ibrahim suggests, tell the client to sell the property to his adult child at fair market value. This way, he can simply report a capital gain.
Some couples try to get around the tax consequences by buying a property and putting their children on title. It doesn’t work.
“[They think] when I die, I’ll only own a portion of that property, but there’s a gift tax issue because the kids didn’t purchase the property with their own money.” Instead, use a family trust. Say a husband puts money into a trust to benefit his wife and kids. The trust will then buy the property and, if worded correctly, can shelter it from U.S. gift and estate tax. A trust also can be used to purchase multiple properties, adds Ibrahim.
If it’s a commercial property, consider purchasing it through a partnership. This way, an owner isn’t alone in doing time-consuming tasks like collecting rental income and responding to tenants. Each partner, though, will have to file a tax return to report the income.
The other option is to purchase through a Canadian company, says Ibrahim. “If the company has a true business purpose and it’s not a sham, it will protect you from estate tax.”
The IRS deems a company legitimate if it’s a separately incorporated entity. For instance, the company must own the property, as well as other investments, collect rent and file U.S. taxes.
But if the company sells the property, then the capital gains rate is up to 35%. So for income tax purposes, purchasing through a partnership is usually better because clients will be taxed at the individual rate if they sell.
Buying outside North America
Experts say popular destinations for Canadians to own and rent out property include Turks and Caicos, and the Cayman Islands.
In part, that’s because there is no income tax or capital gains in these countries. But there are other types of taxes, including stamp duty. This is a graduated tax that’s charged up front. The rate varies, but if the property is between $500,000 to $1 million, clients should expect to pay 4% to 10%, says N. Gregory McNally, an international tax lawyer at N. Gregory McNally & Associates Ltd. in Toronto.
In Panama, while there is no stamp duty because they have income tax and capital gains, there’s a sales tax. McNally’s client found this out the hard way. He’d purchased a Panama villa for $240,000 in 2008, and sold it for $260,000 in 2013. He was hit with a 5%—or $13,000—sales tax. Plus, he’d fallen behind on his property tax and owed another $10,000.
“He sold it for just slightly more than what he paid but when he netted the tax, he ended up with less in his pocket.”
Another item to watch is property management fees, which can take a 40% to 60% bite out of rental income. “That’s a way bigger issue than tax,” warns McNally. In his client’s case, he used an independent company that charged only 25% on the $300-per-night rental income.
So encourage clients to calculate all costs before buying, including items like purchase price, potential rental income, taxes and property management fees.