investing in us real estate - us estate and income tax implications

Investing in U.S. Real Estate – U.S. Estate and Income Tax Implications

November 3, 2016

Ryan Gill, CPA, CA, CPA (New Hampshire)Senior Manager, TaxKPMG [email protected]

2© 2016 KPMG LLP, a Canadian limited liability partnership and a member firm of the KPMG network of independent member firms affiliated with KPMG International Cooperative (“KPMG International”), a Swiss entity. All rights reserved. The KPMG name and logo are registered trademarks or trademarks of KPMG International.

Agenda- Introduction- Residency- Forms of ownership for U.S. real estate- U.S. income taxes rules - Canadian income tax rules- U.S. estate tax - Planning to avoid or reduce U.S. estate tax- U.S. gift tax- Summary- Questions


Introduction- About me- Taxation of U.S. real estate is complex. Can likely devote

multiple university level courses to the topic.- The purpose of this presentation is to:

- Identify various forms of U.S. real estate ownership and when to use them

- Identify key issues with respect to the taxation of U.S. real estate.

- Outline planning opportunities to minimize Canadian and U.S. taxes with respect to owning U.S. real estate.


Residency- All comments in this presentation assume the individual taxpayer and spouse are

residents of Canada, and are not U.S. citizens or residents. - U.S. greencard holders are considered U.S. residents. - Canadians (non U.S. citizens) who own real estate in the U.S. and spend significant

time there may be considered resident in the U.S. under the substantial presence test: – Substantial Presence Test

- Count days of presence in the U.S.- Part of a day counts as a day- Add 100% of current year days + 1/3 of preceding year days + 1/6 of second preceding

year days. If total is 183 or more then meet Substantial Presence Test- If current year days are less than 183 but Substantial Presence Test is met, can use

Closer Connection Exception to be treated as a non-resident of the U.S.- If current year days are 183 or more then must rely on Canada-U.S. Treaty to be treated

as a non-resident of the U.S. for income tax purposes


Residency Cont’d- Substantial presence test examples:

- Assume 100 days in the U.S. each year:— 100 + (100 x 1/3) + (100 x 1/6) = 150 test not met (nothing to file if no U.S. income)

- Assume 140 days in the U.S. each year:— 140 + (140 x 1/3) + (140 x 1/6) = 210 test is met but can use Closer Connection

Exception- Assume 183 days in the U.S. in the current year (year one) and 100 days in the U.S. in

years two and three:— 183 + (100 x 1/3) + (100 x 1/6) = 233 test is met, have to rely on Canada-U.S. Treaty


Forms of Ownership for U.S. Real EstateThere is no one ownership structure for all scenarios. Each situation must be analyzed separately. An individual’s assets and objectives need to be assessed when determining the right ownership structure.

Important points to consider:1. Marital status of the individual. Does the individual’s spouse have own

funds?2. Age and health of individual and spouse.3. Individual and spouse’s net worth including type of assets held.4. The use of the real estate. 5. How long will the property be held? 6. The source of the funds to purchase the property. 7. The individual’s attitude towards tax. 8. Value of U.S. property.


Forms of Ownership for U.S. Real Estate Cont’d

Personal; Joint Tenants; and Tenants in Common:- Simple structures.- Minimizes Canadian and U.S. federal income tax. Preferential U.S. federal

capital gains tax rates (20% maximum rate in the U.S.). - State income taxes may apply (depends on where the property is located). - Alternatives with the least Canadian and U.S. tax filing requirements. This

minimizes compliance costs for clients.


Forms of Ownership for U.S. Real Estate Cont’d

Personal; Joint Tenants; and Tenants in Common Cont’d:- Estate planning considerations:

- Property held as joint tenancy is not subject to probate (survivor becomes owner).

- Property held by one individual or as tenants in common is subject to probate.- Property held by one individual or as tenants in common is transferred by will,

and potentially subject to Wills Variation Act claims. - Exposure to U.S. federal and state estate tax.- Use these alternatives if no U.S. estate tax exposure, property will be held

for short-term, or low property value.


Forms of Ownership for U.S. Real Estate Cont’dCanadian Trust:- Complex structure to properly implement. - Medium complexity with respect to Canadian and U.S. tax filing requirements.- Can minimize Canadian and U.S. income tax if structure is implemented properly.- Avoids probate and Wills Variation Act claims (estate planning considerations).- If properly structured can avoid U.S. federal and state estate tax.

Canadian Corporation:- Relatively simple structure.- Medium complexity with respect to Canadian and U.S. tax filing requirements.- Does not minimize Canadian and U.S. income tax since U.S. tax rates are higher for corporations

than individuals. - Can avoid U.S. federal and state estate tax if corporation is recognized as the legal and beneficial

owner of the property.- Limited liability.- Planning available to avoid probate. Subject to Wills Variation Act claims. - Canadian shareholder benefit rules apply if property for personal-use. - Consider for property that is used for rental purposes only.- Potential double tax after death.


Forms of Ownership for U.S. Real Estate Cont’dCanadian Partnership:- Complex structure with complex Canadian and U.S. tax filing requirements.- Potentially minimizes Canadian and U.S. income tax.- Can be structured to avoid U.S. federal and state estate tax.- Can be structured to limit liability.- Exposure to probate and Wills Variation Act claims.- Potential double tax without additional planning after death/sale.- Use for high value properties where trust structure is not available. Can use for

personal, rental, or personal/rental properties.

U.S. LLC:- Complex structure with complex Canadian and U.S. tax filing requirements.- High effective tax rate on net rental income and gains.- Exposure to U.S. federal and state estate tax.- Limited liability. - Exposure to probate and Wills Variation Act claims.- Canadians should never use.


Forms of Ownership for U.S. Real Estate Cont’dU.S. Corporation:

- Relatively simple structure.- Medium complexity with respect to Canadian and U.S. tax filing requirements.- High effective tax rate on net rental income and gains.- Exposure to U.S. federal and state estate tax.- Limited liability. - Canadian shareholder benefit rules apply if property for personal-use.- Planning available to avoid probate. Subject to Wills Variation Act claims.- Not recommended as more disadvantages than advantages.


U.S. Income Tax Rules

U.S. Net Rental Election- 30% withholding on gross rents. - No reduction of withholding rate under Canada-U.S. Treaty.- Can elect to be taxed on net income with graduated U.S. tax rates instead. Election

allows expenses and depreciation to be claimed which can significantly reduce U.S. tax liability.

- Available to foreign (non-U.S.) corporations, non-resident alien individuals and foreign trusts.

- Need to consider state taxation.

Depreciation- Depreciation is mandatory in the U.S. (not discretionary like Canada). Amount of

depreciation allowed reduces cost base whether claimed or not!- No deemed depreciation if property not rented.- Residential rental real estate cost recovery uses a straight-line method over 27.5 years.

Other real estate is 39 years.


U.S. Income Tax Rules Cont’d

Rental of Property which is Used Personally- U.S. has specific rules for property that is primarily personally used, primarily a rental, or both a rental and personally used. Three categories cover this: – Category 1 – Primarily PersonalIf property is rented out less than 15 days (e.g., 14 days or less) in a calendar year then property is considered a personal residence. The income from the rental, no matter how large, is excluded from income.

– Category 2 – Primarily RentalIf property is rented for 15 days or more in a year and not used for personal purposes for more than the greater of (1) 14 days; or (2) 10 percent of the total days rented, property is a rental property. Expenses must be allocated between personal and rental days if there are any personal use days during the year. Expenses may exceed revenue and the loss may be deductible subject to certain limitations.

– Category 3 – Personal/RentalIf property is rented for 15 days or more in a year AND is used for personal purposes for more than the greater of (1) 14 days; or (2) 10 percent of the total days rented, it is treated as a personal/rental use property. Rental deductions limited to income.



Disposition of U.S. Real Property - Foreign Investment in Real Property Tax Act (1980) (“FIRPTA)- Disposition of “U.S. real property interest” by a Canadian resident (e.g., Canadian

individual, Canadian corporation, Canadian trust) is subject to U.S. tax and withholding.- Gain or loss taxed at graduated U.S. tax rates.- U.S. federal withholding applies at a rate of 15% of proceeds. Some states also levy

withholding (e.g., California and Hawaii).- Can apply to reduce withholding (e.g., if loss on sale or ultimate tax liability will be less

than tax withheld).- Withholding is applied as a credit against the U.S. tax liability (if any) when U.S. tax return

is filed.



Disposition of U.S. Real Property - Foreign Investment in Real Property Tax Act (1980) (“FIRPTA) Cont’d - What is a “U.S. real property interest (USRPI)?”

- USRPI includes an interest in real property, and a U.S. corporation where 50% or more of value is U.S. real property at any time in five year period before disposition (subject to some exceptions).

- USRPI does not include shares of a Canadian corporation that owns U.S. real estate.


U.S. Income Tax Rules Cont’d- Failure to File Timely Returns

- No deductions if returns not timely filed. File returns to claim depreciation since depreciation reduces cost base whether claimed or not.

- Statute of limitations does not begin until return filed.- U.S. Identification Numbers

- Need a taxpayer identification number (ITIN) if disposing of U.S. real estate or filing U.S. tax returns. ITIN can be obtained by completing Form W-7.

- Corporations need Employer Identification Number (EIN) if disposing of U.S. real estate or filing U.S. tax returns. EIN can be obtained by completing Form SS-4.



Example – Disposition of U.S. Property Married non-resident alien sells U.S. real property located in Washington state. Non-resident alien must file married filing separate status on U.S. return since she is married.

Proceeds of sale $1,000,000 (FIRPTA withholding at a rate of 15%: $150,000)Assume long term capital gain on property: $ 200,000

U.S. Federal TaxCapital Gain $ 200,000Personal Exemption (4,050)Taxable Income $ 195,950

REGULAR TAX CALCULATION ALTERNATIVE MINIMUM TAX CALCULATIONTotal Taxable Income $ 195,950 Alternative Minimum Taxable Income $ 200,000 *Capital Gains Tax on $37,650 @ 0% 0 Tax on $37,650 @ 0% 0Capital Gains on $158,300 @ 15% 23,745 Tax on $162,350 @ 15% 24,353Total Regular Tax $ 23,745 Total AMT $ 24,353

Total Tax $ 24,353 **Credit for FIRPTA withholding (150,000)Refund $ 125,647

Effective Rate: 12.18%.

*No personal exemption for AMT purposes

**Federal tax is equal to the regular tax plus the additional AMT amount.


Canadian Income Tax Rules

Canadian Shareholder Benefits- Generally the use of corporate property = shareholder benefit unless FMV rent paid.- If acquired for business purposes, the benefit = FMV rent for days used. If cannot prove

that property acquired for business purpose, then the benefit = FMV rent for all days available for use.

- If FMV rent not appropriate measure then shareholder benefit based on normal rate of return plus operating costs related to property. This can be much higher than FMV rent.

- Single Purpose Corporation relief no longer available. Former CRA administrative position.

Canadian Foreign Tax Credits- U.S. has the first right to tax income and gains from U.S. real estate.- Canada provides foreign tax credit. Foreign tax credit allowed in Canada for U.S. federal

and state tax.- Foreign tax credit limited to lesser of Canadian or U.S. tax on U.S. source income.- Unused foreign tax credits on property income cannot be carried forward or back.


Canadian Income Tax Rules Cont’d

Foreign Exchange- Relevant in determining gain / loss for Canadian income tax purposes.- Convert cost of U.S. property to Canadian dollars at exchange rate in effect at time of

purchase.- Convert proceeds to Canadian dollars at exchange rate in effect at time of sale.- Convert improvements at exchange rate in effect at time the improvements were

made.Example: Personal-use U.S. property purchased in 2001 when U.S. dollar was strong relative to the Canadian dollar. Property sold in 2016 when Canadian dollar had appreciated against the U.S. dollar.

U.S. CanadaProceeds 2016 US$1,000,000 Proceeds 1,000,000 x 1.33 Cdn$1,330,000Cost 2001 US$1,000,000* Cost 1,000,000 x 1.50 Cdn$1,500,000*U.S. Gain $ Nil Canadian Capital Loss $ (170,000)(Canadian loss is not deductible because personal use property).


U.S. Estate Tax- Maximum U.S. federal estate tax rate of 40% with an annually inflation adjusted $5

million exclusion for estates of decedents dying after December 31, 2012. For 2016 the exclusion is $5,450,000. For 2017, the exclusion is expected to be $5,490,000.

- Some states have estate tax (e.g., Washington, Hawaii, New York).- Applies to FMV of property (not gain) at death. No deemed disposition on death for

U.S. purposes. Step up in cost base to FMV at death (no U.S. federal or state income tax on gain).

- For non-U.S. citizens/residents, estate tax applies on U.S. situs property. U.S. situs property includes U.S. real estate, shares of U.S. corporations, U.S. bonds, etc... This includes U.S. situs property held in RRSPs, TFSAs, RESPs, alter-ego trusts, joint-partner trusts, etc…

- Different rules apply to U.S. citizens/residents.- Compliance: Estate tax return: Form 706-NA for non-resident individuals, due nine

months after death.


U.S. Estate Tax Cont’d- Canada-U.S. Treaty Protocol provides credit to Canadian residents to reduce estate

tax. For 2016 prorate $5,450,000 U.S. exemption ($2,125,800 credit) based on U.S. situs assets over worldwide assets (gross estate). For 2017, exemption is expected to be $5,490,000 ($2,141,800 credit). See next page for example.


U.S. Estate Tax Cont’dESTATE TAX EXAMPLE- A & B own California real estate as tenants in common - Each contributed half of purchase price- FMV of U.S. real estate is $8,000,000.- FMV of worldwide assets totals U.S. $20,000,000. These assets are owned by each 50/50 so each

individual has assets of U.S. $10,000,000.

A dies in 2016 and transfers property to childrenGross estate in U.S. (1/2 of $8,000,000 property) $4,000,000

Treaty Estate tax credit prorated based on worldwide assets: ($4,000,000) / 10,000,000 x $2,125,800 = $850,320

Estate tax on $4,000,000 (using graduated rates) = $ 1,545,800Credit from above (max) (850,320)Federal estate tax liability $ 695,480 *

*May be used as a credit in Canada against Canadian federal income tax on U.S. source income in the year of death (including deemed disposition gain). Cost base to children of half inherited is $4,000,000 for U.S. and Canadian tax purposes.No state estate tax in California. Only U.S. federal estate tax applies.


Planning to Avoid or Reduce U.S. Estate Tax1. Planning - Keep worldwide assets under $5,450,000 (2016) exemption amount. 2017

exemption amount is expected to be $5,490,000. 2. Planning - Split worldwide assets with spouse to maximum Treaty credit amount

($2,125,800 credit):3. Planning - Use a Canadian corporation to hold U.S. real estate:

- Shares of a Canadian corporation are not U.S. situs property.

- Unlimited liability company is not a corporation for U.S. tax purposes unless check-the-box election filed.

- Canadian shareholder benefit rules create issues in Canada when personal-use property is held.

- High combined Canadian and U.S. effective tax rate when earning rental income and capital gains.

4. Planning - Use life insurance to fund estate tax liability:- Non-residents of the U.S. are not subject to U.S. estate tax on life insurance proceeds.

- Generally, purchasers of U.S. real estate have cash or liquid assets available to fund estate tax liability so life insurance is not necessary to provide cash.

- Life insurance proceeds included in worldwide assets to determine pro-rata Treaty credit.


Planning to Avoid or Reduce U.S. Estate Tax Cont’d5. Planning – Disposition prior to death:- No ownership at time of death = no U.S. estate tax.

- Gain on sale before death is taxable in Canada and the U.S.

- Sale without full and adequate consideration does not avoid U.S. estate tax.

6. Planning – Gift prior to death:- Gift tax > estate tax.

- No foreign tax credits or Treaty relief. Can result in double tax.

- No property cost base adjustment.

- Never recommended.

7. Planning – Reverse hybrid strategy:- Canadian limited partnership acquires U.S. real estate and elects to be treated as a corporation in the U.S.

- No shareholder benefit rules.

- No U.S. estate tax.

- High corporate tax rates in the U.S.

- Complex structure to establish correctly.


Planning to Avoid or Reduce U.S. Estate Tax Cont’d8. Planning – Use Canadian trust to acquire property:- No U.S. estate tax as long as creator and beneficiaries not treated as owners of property.- Establish and fund trust before property is identified and acquired.- Transferring cash to trust after property has already been identified may result in U.S. gift

tax.- Transfer of U.S. property to trust results in either U.S. gift tax or estate tax.- Creator of trust cannot be a beneficiary or trustee of the trust. - Children can be remainder beneficiaries while spouse has life interest. Should defer U.S.

estate tax to children’s generation.- 21-year rule in Canada.- Do not use alter-ego or spousal trusts because of double tax risk.

9. Planning – Donate property to U.S. charity:- Donation by individual to U.S. charity is deductible for U.S. estate tax purposes.- Donation (specific property) must be specified in will.


U.S. Gift Tax- Maximum gift tax rate is 40%. Same rates as estate tax. - Residents vs. Non-residents. Non-residents of U.S. subject to gift tax on gifts of

certain U.S. property (includes U.S. real estate but not intangible property such as shares of U.S. corporations).

- No Treaty relief.- U.S. gift tax not creditable in Canada. - Gifting of U.S. real estate is not recommended.


Summary - Top Ten1. Get all facts about client’s situation and understand client’s objectives

prior to determining ownership structure. 2. Also calculate U.S. estate tax exposure before determining ownership

structure.3. Consider alternatives before purchase. Less costly and painful than trying

undertake planning after purchase. 4. File U.S. tax returns for rental property. May have to file U.S. federal, state,

and possibly local tax returns.5. Consider U.S. federal, state and local tax, and Canadian tax implications. 6. Claim depreciation on U.S. tax returns for rental property. Depreciation

reduces cost base of property regardless of whether claimed or not. 7. Do not gift U.S. real estate.8. Do not invest using U.S. LLC.9. Do not hold U.S. real estate in U.S. revocable trust. Do not hold U.S. real

estate in joint-partner or alter-ego trusts unless no estate tax exposure. 10. Keep foreign exchange fluctuations in mind.


QUESTIONS?

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