There’s more to buying U.S. real estate than finding a deal

(May 2008) While the sub-prime meltdown has been a disaster for stock markets, it’s been a boon for snowbirds. The S&P/Case-Shiller home-price index, which tracks changes in real estate value changes in 20 metropolitan regions across the United States, dropped 12.7% in April, which means more affordable housing for sun-loving Canadians.

But buying a home in Florida requires a bit more thought than slapping down a cheque and moving into the first ocean-front dwelling your client sees. There are a number of tax rules that need to be discussed with your restless retirees before they make the move south.

In America, high-net-worth Canadians will have to pay a potentially hefty estate tax when they die. The price tag could run into the millions, but thanks to a Canada-U.S. treaty, the tax hit doesn’t have to affect your clients if they’re willing to buy a property worth less than $2 million. (That number encompasses all worldwide assets, so if your client has a $1 million house and another million in U.S. investments, the estate tax would still apply.)

In 2008, the highest estate tax rate is 45%, with the unified credit amount — or the credit Canadians get to offset estate tax — at $780,000. That means a client who has a $2 million estate or greater, would receive a $780,000 credit to offset estate taxes.

That number is changing, though. In 2009, the tax credit will jump to a whopping $1,455,800. The next year there will be no estate tax, so anyone who passes away in 2010 won’t have to pay the federal government a dime. However, in 2011, the credit will be dramatically reduced to $345,800, while the highest estate tax rate will be increased to 55%.

Jim Yager, a partner with KMPG’s international executive service, says the way the estate tax is supposed to change in the coming years will likely be altered when a new president enters the White House. “They have to fix it,” he says. “Think of it. Someone who is sitting on his deathbed in December 2009 has to pay taxes if he dies. If he passes away in 2010, he saves money. So the family is going to say ‘let’s prop the guy up, keep him alive for another month.’ If they did such a good job and he lives to January 2011, he will have to pay even more, so they’ll have to pull the plug. U.S. congress isn’t going to allow that to happen.”

Luckily, there are ways to mitigate the estate tax burden. One option Yager suggests is non-recourse debt financing. A non-recourse mortgage allows the lender to have recourse only on the property mortgaged. That means if a snowbird defaults on a payment there will be no punishment — other than the property being seized — if the home doesn’t cover all the debt. Basically, if someone dies and defaults on the payments, the home is taken by the mortgage company, so no estate tax is paid. Needless to say, that’s not an option most mortgage companies offer.

Another option is to borrow money on a non-recourse basis from a spouse. “Assume a wife has $100,000 to invest in a U.S. vacation home,” writes Yager in a U.S-Canada tax document. “Instead of investing directly, she could loan her husband the money on a non-recourse basis to acquire the property.”

When the husband dies, there will be no value in the estate, since he would have deducted the non-recourse debt from the value of the property. If the wife passes away there’s also no value in the estate as the loan is not American property itself.

Yager says there could be Canadian tax issues with this, since the wife could have interest income — assuming it’s a “true debt” as Yager calls it — that she needs to claim.

It’s also a problem if the property appreciates significantly, or if the debt is repaid. “Should the property substantially appreciate in value, and/or the principal of the debt be repaid, the debt will offset less of the value of the property,” he says.

Another way to reduce estate taxes is by “splitting interest.” Here, a buyer would acquire a life interest in a U.S. property, while the children would get the house’s remainder interest. There’s no estate tax on life interest, so if the parent dies, nothing needs to be paid. If the children die, estate tax will be assessed on the value of the remainder interest.

Setting this up isn’t as easy as it sounds, though. Yager explains that a split interest arrangement usually involves a trust or partnership structure. “That structure may result in significant complexities,” he says. “However, the tax savings may be worthwhile for certain family situations.”

Estate tax isn’t the only government gouge clients need to worry about. If clients sell a U.S. property, they will have to pay a 15% capital gains tax, as long as they’ve held the property for at least a year. They also have to pay capital gains at a 23% rate in Canada when they sell their American home. Luckily, there is a Canadian credit that will cover the American capital gains portion, so clients will only have to fork over their cash to the CRA.

State income tax is another concern, though not in all cases. Florida, Nevada and Texas are just three hot spots that don’t have any state income tax, and for places that do have that tax, the rate is not uniform.

While tax implications are definitely something to talk to a client about, other considerations should be taken into account before making a purchase down south.

Wayne Robinson, president of Sharbot Lake, Ontario-based W.A. Robinson & Associates, says currency risk could be a big problem for wannabe American homeowners. “What happens is a client buys a house in Florida. You’re holding it in U.S. dollars, so you’d be really happy if the Canadian dollar drops.” Of course, with wild currency fluctuations, even if economists think the U.S. dollar will strengthen, you never know what could happen.

Many Canadians also don’t realize that owning a home in the U.S. can be a much different experience from nestling into a cottage on the shores of Lake Winnipeg. “Termites or hurricanes — these are things we don’t think about in Canada, but they’re real,” says Robinson.

In fact, Robinson has a client who had to buy termite insurance in the States. “I didn’t even know there was such a thing,” he says.

He also points out that property disputes in America are handled differently from the way they are in Canada. “Americans on average are more in your face on an issue than Canadians are,” he explains. “Canadians talk about it, mediate, talk about it, resolve it and talk some more. There are differences on how problems are solved, and property causes a lot of problems.”

Robinson says there are other issues that need to be discussed, such as the cost of health insurance, but maybe the number one topic of conversation an advisor should have with the client is about the U.S. market in general — there’s a good chance home prices could still drop. “People who bought homes could all be winners,” he says, “but property might still go down 20%.”

And, like any investment craze, if your client’s neighbour and all his friends are jumping on the home-buying bandwagon, it might be worth thinking twice about leaving the Great White North.

Robinson says it’s entirely possible that all the people clamouring for cheap American real estate might come to regret their purchase 10 years from now. “People in their 60s might be keen to buy today, but a decade from now they’re not going to want another property, and they’re probably not going to retire in the States. So they’re going to say, ‘why did we did we do that?’ ”

If, after all this is taken into account and clients are still eager to escape the Canadian winter, then go out any buy them a bottle of champagne they can sip on their very own Floridian veranda. But you might want to make one final suggestion before they go. Says Robinson: “Renting is still a great deal.”

Filed by Bryan Borzykowski, Advisor.ca, bryan.borzykowski@advisor.rogers.com

(05/12/08)

Bryan Borzykowski