The following key points should be noted regarding U.S. Estate Tax:
- Applied to fair market value (FMV) of U.S. situs assets owned at time of death.
- U.S. Estate tax has graduated rates beginning at 18% of taxable amount over $10,000 rising to 40% for over $1,000,000 of taxable estate.
- Certain deductions are available in determining taxable estate (e.g., non-recourse debt and pro-rata share of world-wide liabilities).
- U.S. situs assets include:
- US real estate, including vacation properties, rental properties, private homes and business properties.
- Tangible personal property located in the US at death, including cars, boats, jewelry and furnishings.
- Shares, Options, and Bonds of private and public U.S. corporations (including if they are held in RRSP or TFSA).
- Interest in Partnership with U.S. situs assets.
- US mutual funds including money market funds.
- Debts of U.S. persons, corporations, partnerships, trusts or government.
U.S. Income Tax, Estate Tax Legal Guidance, and Finance Considerations for Canadians purchasing and operating rental properties in the U.S.
Disclaimer – this article provides general information pertaining to Canadians have are considering, or have purchased and are operating, rental properties in the U.S. The information may not be relevant to your situation. Readers should contact their tax and legal professionals for specific advice.
The following key areas are addressed in this publication regarding Canadians owning U.S. property rentals:
1. U.S. Income Tax
2. Legal Structures
3. U.S. Estate Tax
4. U.S. Income tax, Legal and Estate Planning
U.S. Income Tax
U.S. Individual Income Tax – the basics
If you are a Canadian citizen and resident and own residential rental property in the US, you are subject to U.S. income tax on any rental income you receive from your U.S. real estate property. To comply with this Internal Revenue Service (IRS) tax reporting requirement, you may choose one of the following two methods to report the U.S. rental income to the IRS.
METHOD #1: 30% Withholding Tax on Gross Rents
You can choose to have your gross rental income taxed at a flat 30%, but using this method does not permit you to deduct any expenses from operating your rental property. Most often, this can be a very expensive option. The advantage of this method, is that you do not have to file a U.S. tax return to report this rental income. You, your tenant(s), or property manager remits the 30% directly to the IRS.
METHOD #2: Net Rental Basis
Instead of the Gross Rents method, you can elect to file a U.S. non-resident income tax return (Form 1040NR) on a net rental income basis and complete Schedule E – Supplemental Income and Loss from real estate rental. Net rental income is defined as gross rents less operating expenses. Net income is then taxed at the U.S. Individual graduated income tax brackets. Rental losses can be carried forward for 20 years. In this situation, you are taking the position that your rental income is ‘effectively connected income’ with a trade or business in the U.S. This position must be disclosed to the IRS on an annual basis with your U.S. income tax filings.
The vast majority of taxpayers will find that Method #2 – Net Rental Basis is the most tax efficient method, which in turn requires filing Form 1040NR and schedules. Taxpayers can file the tax filings themselves, or seek the assistance of an IRS registered paid tax preparer.
U.S. Tax Identification Numbers (ITIN)
In order to file a U.S. Individual tax return (Form 1040NR), the IRS requires that Canadians apply for a tax Identification Number (ITIN). The application is normally done at the time of filing the tax return, and the ITIN is valid for 3 years. IRS Certified Acceptance Agents can assist with completing the W-7 application form.
Please keep in mind that each U.S. state has its own income tax regulations which must be considered, and possibly sales tax and county tax to name a few.
Canadians purchasing a U.S. rental property must consider the appropriate legal entity to use for this purpose. The property ownership alternatives include; owning the property individually in their own name(s), U.S. trust, U.S. Corporation, or a Canadian Corporation. These are the most common forms and the pros and cons of each are as follows, along with a general comment on overall suitability for Canadian non resident aliens (NRA’s) owing real property in the U.S.
o Pro – the most basic and easy to use method is to simply own the property individually. No legal documents are required beyond the standard real estate purchase documents which include the Settlement Statement and supporting details.
That being said, if there are multiple owners, a contract should be in place detailing the capital contribution of each owner, profit sharing, and cash out calculations in the event of property sale, or death or incapacitation of an owner.
Further to this, a Will and Living Will should be in place for each owner.
o Con – in the event of death of the owner, the property must be ‘probated’. In some states such as Florida, the probate fees can be high, and the length of time to complete the probate process can be very long. This can result in undue delays in the sale of the property.
o Con – no creditor protection against potential lawsuits.
o Overall – suitable structure for owners with one property who want to keep it simple.
• U.S. Revocable Trust (owned by ‘grantor’ – individual):
o Pro – Creditor protection.
o Pro – ‘Disregarded entity’ – taxed as individual.
o Pro – Avoids probate.
o Cons – banks not enamored with U.S. Trusts – difficult to ensure collateral.
o Cons – if children are named as beneficiaries, may create income tax issues.
o Overall – suitable structure for owners who wish to avoid Florida probate issues.
• U.S. Corporation:
o Canadians should NOT establish a U.S. corporation in which to hold there U.S. property rentals. The reasons are as follows:
o Con – U.S. Limited Liability Corporation (LLC) – these entities are referred to as ‘flow-through’ entities. Although the LLC is a corporation, the entities are designed such that all of the income earned within the corporation is reported on the individual’s U.S. income tax return, hence the term ‘flow-through’. However, this creates a potential double taxation problem for Canadian taxpayers. The Canada Revenue Agency does not accept the flow-through nature of the U.S. LLC. Any taxes paid by the individual on their U.S. individual income tax return as a result of the LLC income, cannot be deducted in Canada as a foreign tax credit on their Canadian individual income tax return. The primary reason – CRA views the taxes paid as a corporate taxes, emanating from the U.S. LLC, and does not allow foreign corporate taxes to be deducted on individual’s income tax returns.
o Con –U.S. Corporation (C-Corps) – these corporations do not have the flow-through characteristics of a U.S. LLC. Instead, income is taxed within the C-Corporation, at U.S. corporate tax rates, which, depending upon the situation, might be significantly higher than Canadian corporate tax rates.
Con – Capital gains on the sale of shares of a U.S. C-Corp, which have greater than 50% of the FMV of their assets in U.S. real property – must report the gain on a U.S. foreign income tax return. Once again, U.S. corporate tax rates are significantly higher than Canadian corporate tax rates.
Con – CRA has ‘look-through’ rules known as FAPI – foreign accrual property income – which essentially require that the a portion of income of a ‘controlled foreign entity’ (the U.S. C-Corp), be included on the Canadian owner’s individual income tax return. The result is that the Canadian owner will be taxed as if the income was earned individually.
o Pro – creditor protection.
o Overall – not an ideal structure Canadian NRA’s due to higher U.S. corporate income tax.
• Canadian corporation:
o Pro – creditor protection.
o Con – rental property is considered to be a ‘Permanent Establishment’ in the U.S. and as such, the Canadian corporation will be required to file a U.S. foreign corporate income tax return (Form 1120F and schedules), and be taxed at U.S. corporate tax rates. U.S. taxes paid may be used as a foreign tax credit to reduce Canadian corporate taxes. Keep in mind that U.S. corporate tax rates are significantly higher than Canadian corporate tax rates, and the foreign tax credit will be the lesser of the Canadian corporate taxes payable on the same income, or the foreign taxes paid. The result is that a portion of the U.S. taxes quite likely will not be deductible. Essentially, the Canadian corporation will end up paying the U.S. corporate tax rate.
o Overall – not an ideal structure Canadian NRA’s due to higher U.S. foreign corporate income tax.
U.S. Estate Tax
U.S. Estate Tax – the basics
The U.S. has an ‘Estate tax’ which is a tax based on the value of a taxpayer’s U.S. property at the time of their death. The U.S. Estate tax is completely separate from U.S. income taxes and is applicable to U.S. citizens and U.S. persons, as well as to Canadians who own U.S. property.
For U.S. U.S. U.S. citizens and U.S. persons the U.S. estate tax kicks when the fair market value of their worldwide estate is over approximately $5.5 million USD. The corresponding U.S. tax credit to eliminate U.S. Estate tax is known as the ‘Unified Credit’ and for 2017 is $2,141,800 USD.
For Canadians, the U.S. Estate tax threshold is $60,000 USD the corresponding unified tax credit is $13,000. However, the tax treaty between the U.S. and Canada entitles Canadian residents to the same unified credit as a US person, but only on a pro-rated based on the ratio of US situs assets to worldwide assets. This calculation may or may not result in a U.S. Estate tax owing – it depends on the value and composition of the U.S. property as a proportion to the Canadian’s worldwide income, along with marital status among other factors. Please review your particular situation with a cross-border tax professional.
The following key points should be noted regarding U.S. Estate Tax:
1. Applied to fair market value (FMV) of U.S. situs assets owned at time of death.
2. U.S. Estate tax has graduated rates beginning at 18% of taxable amount over $10,000 rising to 40% for over $1,000,000 of taxable estate.
3. Certain deductions are available in determining taxable estate (e.g., non-recourse debt and pro-rata share of world-wide liabilities).
4. U.S. situs assets include:
a. US real estate, including vacation properties, rental properties, private homes and business properties.
b. Tangible personal property located in the US at death, including cars, boats, jewelry and furnishings.
c. Shares, Options, and Bonds of private and public U.S. corporations (including if they are held in RRSP or TFSA).
d. Interest in Partnership with U.S. situs assets.
e. US mutual funds including money market funds.
f. Debts of U.S. persons, corporations, partnerships, trusts or government.
5. U.S. situs assets does not include:
a. U.S. bank accounts.
b. Treasury bills.
c. Certain non-U.S. mutual funds with investments in U.S. securities.
d. Certain foreign trusts holding U.S. real estate.
e. American Depository Receipts (ADR).
6. Step up in cost base to FMV at time of death for U.S. income tax purposes (even if exempt from U.S. estate tax).
7. Each alien individual is entitled to exclusion (prorated).
8. U.S. citizens and residents are allowed ~ $5,500,000 USD.
9. Canadians not domiciled in U.S. are allowed $60,000 USD.
10. Canada / U.S. Tax Treaty allows for further credits:
a. Prorate U.S. exemption based on U.S. situs assets over world-wide assets (gross estate).
b. Proration of the exemption is only allowed if all information is provided.
c. Less than $1,200,000 (US) world-wide estate FMV (gross estate) then only real estate and business assets are subject to estate tax.
d. Marital credit equal to unified credit available if property transferred to spouse ($13,000 of tax or $60,000 of U.S. Situs assets.
e. Credit for U.S. estate tax against Canadian income tax on U.S. source income is allowed in year of death.
11. U.S. Estate tax is based on ‘domicile’, rather than residency tests.
A deceased Canadian resident is required to file a US Estate Tax Return (Form 706-NA) if their U.S. situs assets at death are greater than $60,000. The estate tax return is due 9 months after the date of death, although the executor can request an automatic six-month extension of the time to file (which does not extend the time to pay). If a deceased is claiming any Treaty credits (such as the enhanced unified credit and marital credit), the executor will also be required to file a Treaty Based Return (Form 8833).
Once again, please review your particular situation with a cross-border tax professional.
Please note – the U.S. Administration has proposed to repeal the US estate tax. No draft legislation has been released as of Oct 26, 2017.
U.S. Income tax, Legal and Estate Planning
There are many tax planning opportunities available for Canadians with U.S. property, including U.S. real estate. Various legal structures were discussed previously, many of which are not suitable for Canadian NRAs. The following is a very brief overview of some legal structures that should be considered. This should be reviewed with cross-border legal and tax professionals. Our firm would be pleased to coordinate with legal firms that have expertise in this area, and of course our firm can support you with cross-border income tax guidance.
1. Personal Ownership
A. Personal Ownership with Will Planning
Personal ownership may be appropriate for a Canadian non resident aliens (NRAs) if the individual’s US estate tax liability can be managed or eliminated through the application of the unified and marital credits available under the Treaty. Will planning using a “restricted” spousal trust is appropriate where US property is owned personally and a significant US estate tax liability does not arise until the surviving spouse’s death. Income tax is taxed on an individual income tax return.
B. Spousal Ownership
Spousal ownership is most effective if there is a significant difference in the net worth of the two spouses, and the spouse with the lower net worth is likely to die first. Income tax is taxed on an individual income tax return.
C. Personal Ownership with Life Insurance
Alternatively, if the above will planning is not appropriate in the client’s circumstances, personal ownership can be combined with a term life insurance policy to cover an individual’s U.S. estate tax liability. Keep in mind that the insurance coverage may need to be adjusted if the value of the property increases or decreases significantly over time. As well, the cost of the insurance should be weighed against the potential estate tax liability. Since insurance proceeds on the life of a Canadian NRA are not US situs property, the proceeds will not be subject to US estate tax; however, the insurance proceeds will reduce the deceased’s unified credit amount because the amount will be included in the value of the deceased’s worldwide estate for purposes of determining Treaty credits. Income tax is taxed on an individual income tax return.
D. Personal Ownership with a Non-Recourse Mortgage
Alternatively, personal ownership can be combined with non-recourse debt. For U.S. estate tax purposes, the value of a non-recourse mortgage is netted against the value of the property when determining the value of US situs property. Since US estate tax is based on the amount of equity in US property, obtaining a non-recourse loan (mortgage) to help finance the property can reduce the liability for US estate tax. Income tax is taxed on an individual income tax return.
2. Joint Ownership
Ownership as joint tenants with rights of survivorship is not a recommended form of ownership for Canadian NRAs who own US real estate for several reasons. Instead, they should own the property as ‘tenants in common’. With this type of ownership, each spouse is only subject to estate tax on 50% of value of the property. Income tax is taxed on an individual income tax return.
3. U.S. Revocable Trust (owned by ‘grantor’ – individual)
As mentioned previously, a U.S. Revocable Trust offer creditor protection and can avoid probate issues. From a U.S. Estate tax perspective however, a U.S. Revocable Trust does not offer any relief, so this would need to be considered in conjunction with other factors for the Canadian NRA. Income tax is taxed on an individual income tax return.
4. Canadian Discretionary Trust
An alternative ownership option is to use an irrevocable Canadian discretionary trust to own U.S. real estate. If the trust is structured properly, no U.S. estate tax will be payable when either spouse dies. Generally, the trust should be set up before the purchase of the property; therefore it is not an option for real estate that is already owned before the trust is created.
Once again, all of the above structures should be reviewed with legal and tax professionals, to determine the appropriate structure. A simple structure might be all that is required. On the other hand, some investors / property owners might require a more robust structure to plan. We recommend scheduling an appointment with us so we can to discuss your investment plans, and provide you with specific guidance pertaining to income tax, legal structures, U.S. Estate tax and financing.
A brief word about financing. Canadian investors often need to finance the purchase of their U.S. property. Two common alternatives; a) using their Canadian Line of Credit (denominated in Canadian dollars), and b) borrowing from a U.S. bank (denominated in U.S. dollars). Our experience with Canadian NRA clients is that borrowing from a U.S. bank is problematic, primarily because U.S. banks view foreign borrowers as more risky. Another consideration is the exchange fluctuations between U.S. and Canadian dollars. U.S. dollar loan (principal and interest) must be repaid in US dollars. This can create cash flow issues if the rental property is incurring USD losses and must be supported by cash injections from the Canadian owners from their Canadian Line of Credit.
We hope you have found this article helpful. We encourage you to contact your legal and tax cross-border professionals when planning your U.S. property investment. Our firm would be please to support you – and we look forward to hearing from you and supporting you.