Claudine & Alvin
Tax Implications for
Canadians and All Foreign Citizens Who Own US Property
Michael W. Brooks, Esq. Sanger & Manes, LLP 400 S. Farrell Dr., Ste. B102 Palm Springs, CA 92262, Phone: (760) 320-7421
1.We are discussing Canadian Citizens and all foreign citizens, not subject to tax in the US on income they earn worldwide, but only subject to tax in the US on their “US source income”.
Which foreign citizens are subject to a tax in the US on the income they earn worldwide?
2. The Snowbird has, or is considering, purchasing a house in the Palm Springs area.
TAX IMPLICATIONS OF RENTING YOUR HOME
1. General Rule – The Snowbird’s tenant or property manager must withhold 30% of gross rent payments (and forward these amounts to the IRS). If tenant or prop manager fails to withhold, IRS will look to the Snowbird for withholding tax, unless a W-8ECI and 1040NR are filed (see below).
2. Optional Rule – Snowbird completes a Form W-8ECI withholding certificate and gives it to the tenant or property manger instructing them not to withhold, and then files the Form 1040NR tax return by June 15 of the next year. WHY?
Note: California may require an additional withholding of 7% of the gross rents.
Note: Must obtain a US taxpayer ID number (via a Form W-7) to complete a Form W-8ECI or Form 1040 NR.
TAX IMPLICATIONS OF SELLING YOUR US HOUSE
1. General Rule – The purchaser must withhold 10% of the sales price for the IRS; 3.3% of the sales price for California state taxes. The purchaser is personally liable for a failure to withhold (if the taxes are never paid)!!!
2. Optional Rule – File the IRS Form 8288-B (withholding certificate) (plus the Form 1040NR tax return the next year), and the California Forms 593 (plus the 540NR the next year). The IRS then approves a reduced holding rate. The Snowbird then pays a 15% tax on the difference between the sales price and the purchase price (or adjusted basis); 9.3% for California
Note 1: The IRS may take between 8 to 12 weeks to return an approved withholding certificate. You should submit the Form 8288-B well in advance of the sale’s closing.
Note 2: You should submit a Form W-7 (request for taxpayer ID number for the Snowbird) with the Form 8288-B. IRS unlikely to issue taxpayer ID # before submitting the Form 8288-B or completing the Form 1040NR.
Note 3: The purchaser need only pay to the IRS the revised withholding amount by the 20th day after the Service mails a copy of the withholding certificate, whether approved or a denied.
TAX IMPLICATIONS OF SELLING YOUR US HOUSE; EXCEPTIONS TO WITHHOLDING REQUIREMENT
The Buyer of a Snowbird’s US property does not have to withhold federal taxes if:
1. The purchase price is no more than $300,000 and the buyer “has definite plans to reside in the property” at least ½ of the time & someone will actually reside in the property over the next 2 years (i.e. not a rental prop).
2. The transaction is a non-recognition transactions (e.g., Section 1031).
3. When there is ZERO “amount realized” in the transaction.
Note- What is an “amount realized” for this purpose?
When a Snowbird transfers an encumbered property to a buyer for zero cash but with the condition that the buyer assumes the liability, withholding is required (Treas.Reg.Section1.1445-1(g)(5). But withhold what? Buyer did not pay Snowbird? Buyer must send in a cash payment to the IRS equal to 10% of the liability assumed!!!Complete the Form 8288-B to avoid this crazy result.
A WORD ABOUT TAX CREDITS
2. Does this mean Canadian Snowbirds/Snowbirds must pay double tax (once in the US and once in Canada/home country)?
Answer: Generally No . The US taxes the income and Canada (or the home country) should credit the Snowbird on the US taxes paid. However Cuba, Iran, North Korea , Sudan and Syria will not credit US taxes (and vice-versa)
CAN SNOWBIRDS USE IRC 1031?
1. General Rule 1031- Individual sells appreciated property and simultaneously (or shortly thereafter) purchases a new property of like kind. Individual need not pay tax on gain after sale of first property. Basis in first property is carried over to 2nd property.
Example. Tom purchases a Palm Desert house in 2001 for $500k. Sells it in 2006 for $1,000,0000. Shortly thereafter in 2006, Tom purchases an Indian Wells home for $1,000.000. In 2012, Tom sells Indian Wells home for $1,250,000. Assuming 1031 requirements met, what are:
Tom’s taxable income in 2006: $0
Tom’s taxable income in 2012: $750,000
2. So can Canadian Snowbirds/Snowbirds utilize Section 1031?
Answer: Technically yes, but it’s very difficult.
3. What type of property is eligible for 1031 treatment?
Answer: Property held for (a) investment or (b) productive use in a trade or business.
4. Do vacation homes qualify as either held for (a) investment or (b) productive use in a trade or business?
Answer: Unlikely. Generally, only if the Snowbird (or the Snowbird’s family) uses the vacation house not more than the greater of 14 days a year or 10% of the days the house is rented.
5.But rental properties qualify for 1031 treatment, correct?
Answer: Yes, if a Snowbird’s US rental property is exchanged for another US rental property, that transaction would qualify for 1031. Likewise, a vacation home only used for two weeks a year would qualify for 1031 exchange.
Note-The US property must be exchanged for other US property; an exchange for property from another country will not qualify for IRC 1031?
US ESTATE TAX
Non-US Domiciled Canadian Snowbirds/Snowbirds are subject to the US estate tax only on their US assets owned at death
1.What US assets are subject to the US estate tax?
2. May a Canadian Snowbird exempt any portion of the US property subject to the estate tax?
Answer: Yes. In 2012, Americans may exempt $5,000,000 of their assets from the estate tax. The US/Canada Tax Treaty permits Non-US domiciled Canadians to utilize a portion of the $5,000,000 exemption as determined by the following formula:
3. Can every Snowbird exempt the same amount as a Canadian Snowbird?
Answer: No. For each Snowbird you must review the tax treaty between the US and the Snowbird’s home country. If there is no special provision on the estate tax exemption or no tax treaty with the US and the
foreign country (e.g., US-Brazil), then the Snowbird may only exempt $60,000. It is a case by case analysis depending on the home country of of the Snowbird.
4.What is the scheduled US exemption amount in 2013?
5. What is the rate of US estate tax?
Answer: For 2012, the highest rate of estate tax is 35%
For 2013, the highest rate of estate tax is 55%
STRATEGIES TO MINIMIZE THE US ESTATE TAX
1. Non-Recourse Mortgage.
2. Insurance Pays for the US Estate Tax
3. US House owned via a Foreign (not US) Corporation.
When the Snowbird dies, he does not own a US house (which is subject to the US estate tax), but owns instead shares of a foreign corporation (specifically not subject to the US estate tax).
Pros: Shares of foreign country’s corporation is not part of a US estate, so very favorable for the US estate tax.
(i) Shareholder benefit taxation in Canada and other countries (must pay tax on rental value).
(ii) Poor for US income tax purposes. When any corporation sells the house, the corporation pays 35% tax of the appreciation (instead of 15%).
US House owned via a Partnership (either US or foreign partnership). Again, when the Snowbird dies, he does not own a US house (which is subject to the US estate tax), but an interest in a foreign partnership (which may or may not be subject to the US estate tax).
Pros: Partners are taxed as individuals. So upon sale, they are entitled to the low 15% capital gains rate.
Cons: Uncertainty on whether US estate tax is imposed on value of partner’s interest. However, domicile of partners (presumably foreign) is a positive factor in partnership interest not being subject to the US estate tax, but where partnership is conducting business also important.
Important Final Partnership Note:
Partnerships may “check the box” and elect to be taxed as a corporation. Many practitioners believe a partnership electing to be taxed as a corporation is more clearly not subject to the US estate tax. However, the partnership checking the box is now subject to the higher 35% corporate tax when selling the house.
QUALIFIED DOMESTIC TRUST (QDOT)
i. Upon the death of one spouse, property in the QDOT is transferred free of tax to the other spouse (not otherwise available to non-US citizens).
ii. Avoids probate upon death of first spouse.
i. At least 1 trustee must be a citizen or bank (if QDOT holds more than $2 M, then the trust must be a US Bank, or the trustee can furnish a bond).
ii. Only legally recognized spouse for Federal US purposes qualify (i.e. no same sex spouses).
iii. No more than 35% of the value of real property in the trust can be outside of the US.
PROS AND CONS OF OWNERSHIP STRUCTURES
Structure 1 - Individually- H or W owns US house alone
Pros: Low 15% capital gains rate upon sale.
Cons: Probate required; no liability protection if rented; no protection against estate tax.
Structure 2 - Joint Tenancy- H & W owns US house as Joint Tenants
Pros: Low 15% capital gains rate upon sale; probate not required upon death of 1st spouse.
Cons: No asset protection from spouses creditors; no liability protection if rented; particularly bad for US estate tax because 1st spouse to die presumed to have purchased entire property.
Structure 3 - Community Property with Rights of Survivorship
Pros: Low 15% capital gains rate upon sale plus double step up in basis upon first spouse to die (so very good for US income tax); no California probate required upon death of 1st spouse.
Cons: No liability protection if rented; no extra protection from the US estate tax.
Structure 4 - Tenants in Common
Pros: Low 15% capital gains rate upon sale; more favorable for US estate tax than JT’s because each spouses interest in the property may be discounted due to lack of marketability of a partial interest in a house (so lower value of US assets for decedent spouse).
Cons: No liability protection if rented; must go though California probate; upon death of 1st spouse; no extra protection from the US estate tax.
Structure 5 - Via Shares of a Corporation
Pros: Asset and liability protection if rented.
Cons: Poor corporate tax rate (35%) upon sale of house (plus 2nd tax on distribution to shareholders); if a US corporation, value of US shares count as US assets subject to the estate tax; Canada has generally prohibited the use of Canadian corporations for the purpose of holding US real estate; some extra legal costs.
Structure 6 - Via Partnership Interests
Pros: Asset and liability protection if structured as a limited partnership; Low 15% capital gains rate upon sale of house (unless partnership checks the box, then taxed at 35% upon sale).
Cons: Some uncertainty as to US estate tax consequences (more certainty if elect to check the box to be taxed as a corp.); some extra legal costs.
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copyright Claudine Messika 2007