Structuring Options for a Canadian Owning U.S. Vacation Property

With the Canadian dollar hovering around a seven-year high compared to the U.S. dollar and the recent significant increase in home equity values in Canada, more Canadians are now looking to purchase a second vacation property. Many of these Canadians long to escape the country’s dreaded winters and are considering buying their vacation property in the U.S., especially in sunshine states such as Florida, Arizona, Texas, Nevada, and California. This article addresses the high-level advantages and disadvantages of various structuring options for Canadians (who are not U.S. persons for U.S. income and estate tax purposes) looking to acquire U.S. vacation property.

As a quick summary,

• There should be no annual income tax implications to a Canadian who owns U.S. real property if the property is solely for personal use and not rented out. The U.S. real property should not even have to be reported on a Canadian’s T1135 – Foreign Income Verification Statement if used solely for personal use.
• A Canadian who dies personally owning U.S. real property is subject to both the Canadian deemed disposition tax on the property’s accrued capital gain as well as the U.S. estate tax on the fair market value of the property. U.S. estate tax is typically higher than the Canadian deemed disposition tax, as it is calculated on the fair market value of the property rather than the property’s accrued capital gain.
• A Canadian who sells, or gifts U.S. real property should be subject to the Foreign Investment in Real Property Act of 1980 (FIRPTA), which can require the purchaser of the U.S. real property to withhold and remit a percentage of the sale price of the property. The default FIRPTA percentage is 15% of the gross sales price (fair market value). However, this can be reduced with additional filings or under certain circumstances. A Canadian would have to file a U.S. tax return in the year of sale or gift to recover any excess FIRPTA withholding tax from the Internal Revenue Service (IRS). The net tax payable to the IRS should be able to be utilized as a foreign tax credit on the Canadian tax return, subject to the Canadian income generated on the sale. Note that the gain/loss for Canadian and U.S. tax purposes may be different based on the foreign exchange rates on purchase and sale. Further, if the property is sold for a loss, a U.S. tax return is still required to be filed with the IRS.

Structure # 1 – Personal Ownership

Advantages:

• Simplest option.
• Lowest set-up costs and annual compliance fees.

Disadvantages:

• No liability and asset protection.
• U.S. real property can be governed by different U.S. state ownership rules, such as the community. property or community property with rights of survivorship rules.
• U.S. real property is subject to probate fees on death if not held in joint tenancy with rights of survivorship or through the use of a beneficiary deed available in certain U.S. states.
• U.S. real property is subject to U.S. estate tax on death.
• Even if no U.S. estate tax exists, if the value of the U.S. real property interest exceeds USD$60,000, a U.S. estate tax return, along with full disclosure of the decedent’s worldwide estate, is required to be provided to the IRS.

Planning Considerations:

• Canada-U.S. Tax Treaty credits. The enhanced unified credit and/or the marital credit can help to reduce or eliminate U.S. estate tax for a Canadian.
• Qualified Domestic Trust (QDOT). The U.S. does not allow a spousal rollover when the surviving spouse is not a U.S. citizen. However, a tax-deferred rollover of the property can occur to a QDOT, which will effectively defer the U.S. estate tax until the time of distribution from the QDOT or the death of the surviving spouse. For a trust to qualify as a QDOT, the surviving spouse must receive the income from the trust at least annually, no person other than the surviving spouse can be a beneficiary during the spouse’s lifetime, and at least one trustee must be a U.S. citizen or a U.S. domestic corporation.
• Life insurance. A Canadian’s anticipated U.S. estate tax can be funded through a life insurance policy. The cost of any insurance policy should be weighed against the ability to pay the anticipated U.S. estate tax from other assets. The cost of the insurance policy may change over time as the property value increases and can become increasingly more expensive as age increases or health decreases.
• Non-recourse debt. For U.S. estate tax purposes, the value of a non-recourse mortgage on U.S. real property is deducted against the property’s value. It should therefore reduce the U.S. estate tax payable. It can be difficult as a Canadian to obtain a large mortgage from an arm’s-length lender (e.g., bank or credit union), and any non-arm’s-length mortgages should be on commercial terms to avoid further issues.

Structure # 2 – Canadian Discretionary Trust

Advantages:

• U.S. real property should not be subject to U.S. estate tax on death (the trust continues to exist).
• U.S. real property should not be subject to probate fees on death.
• Liability and asset protection for the beneficiaries of the trust.

Disadvantages:

• The purchaser of the U.S. real property generally cannot be a beneficiary of the trust or have a general power of appointment over the assets of the trust. The purchaser must effectively give away the property to the trust’s beneficiaries and hand over control of the property to the trustee(s).
• The purchaser of the U.S. real property may be forced to pay fair market value rent for use of the U.S. real property should the beneficiary(ies) of the trust predecease the purchaser.
• Canadian attribution rules need to be considered.
• The trust will be subject to a deemed disposition of its assets (including the U.S. real property) for proceeds equal to fair market value on the 21^st anniversary of the trust’s creation, and each subsequent 21-year anniversary. Planning can alleviate this deemed disposition.
• The Canadian trust must be established before the U.S. real property is purchased.
• Increased set-up costs and annual compliance fees.

Structure # 3 – Canadian Corporation

Advantages:

• U.S. real property should not be subject to U.S. estate tax on death (the corporation continues to exist).
• U.S. real property should not be subject to probate fees on death.
• Liability and asset protection for the shareholders of the corporation.

Disadvantages:

• Canadian taxable shareholder benefits may be generated with the personal use of the U.S real property.
• Double taxation or increased capital gains taxation can result upon the sale of U.S. real property.
• Increased set-up costs and annual compliance fees.