Buying U.S. property? Five options for reducing taxes
Tim Cestnick is president and CEO of WaterStreet Family Wealth Counsel and author of 101 Tax Secrets for Canadians.
If you're going to buy real estate, be sure to complete proper due diligence. Consider speaking to your potential neighbours about the area first. My uncle did this very thing when he was looking to purchase a home in upscale West Vancouver a few years ago.
He learned that the neighbourhood had been experiencing many thefts over a three-year period. He decided to move into the neighbourhood anyway because only petty things were taken: things like garbage cans, lawn ornaments, and doormats (one family reported having each of their 14 replacement doormats stolen as well). It turns out the thieves were a sixtysomething neighbour and his son.
I raise the issue because thousands of Canadian are looking to buy real estate in the United States. In addition to asking about stolen garden gnomes, be sure to visit a tax pro to talk about avoiding the U.S. estate tax. Last week, I shared some planning ideas (tgam.ca/DiIH). Today, let me finish the topic.
Consider these ideas for dealing with a U.S. estate tax problem:
Prior to 2005, many Canadians would simply hold their U.S. real estate inside a Canadian corporation. Since the corporation owning the U.S. property doesn't die with its shareholder, there is no death that triggers the U.S. estate tax. Prior to 2005, our government used to allow this planning without assessing a taxable benefit on the shareholders of the corporation. Today, you'd face a taxable benefit for using a vacation property owned by your corporation, which generally makes this structure a bad idea.
2. Establish a partnership.
Setting up a partnership to hold your U.S. real estate can have some benefits over a corporation. Not only will the nasty taxable benefit not apply, but if the property happens to earn income there can be tax savings. Simply put, the combined Canadian and U.S. tax on investment income, including rents and capital gains, will be higher with a corporation than a partnership. Now, I should mention that the partnership idea comes with some risk - however small it might be. It's possible that the U.S. Internal Revenue Service (IRS) could claim that the partnership interest you own should be considered a U.S. asset, subject to the U.S. estate tax, if it derives most of its value from U.S. real estate.
3. Use a family trust.
Owning a U.S. property in a trust can help to side-step the U.S. estate tax. You'll need to acquire the property in the trust as opposed to buying the property first and then transferring it to a trust (there's a U.S. gift tax - the cousin to the estate tax - which could apply on a transfer like this). The terms of the trust will have to be established so that you don't have a right to take the property from the trust for yourself, although you can enjoy use of the property. You'll need to visit a professional with expertise in these types of trusts to set it up properly; it will likely be a separate trust with different terms than a typical family trust.
4. Set up a hybrid entity.
It's possible to set up a Canadian partnership that will be treated as a partnership in Canada and as a corporation in the United States (by electing to receive this treatment when filing in the U.S.). This hybrid entity will avoid the taxable benefit issue in Canada that corporations create (mentioned above) and can avoid U.S. estate tax since, at the time of death, you'll be considered by the IRS to own Canadian corporate shares, not U.S. real estate. Be aware, however, that a sale of the property prior to your death could result in higher capital gains taxes in the U.S. than in the case of a partnership or owning the property personally.
5. Buy life insurance.
Finally, buying life insurance to cover a U.S. estate tax bill can be another way to deal with the tax hit. The amount of the death benefit could impact the amount of U.S. estate tax since the proceeds on death will be included in your gross worldwide estate and could reduce the tax credit (called the "unified credit") you'd otherwise be entitled to. Still, this option can be a good one if you're insurable.