The strong Canadian dollar and the soft U.S. housing market are enticing a growing number of Canadians to purchase newly affordable vacation properties south of the border. But they should give that “great deal” careful consideration.

“We’re getting a lot of calls about opportunities in the U.S. It’s a hot topic,” says Ruth Spetz, tax and estate planning lawyer and partner with Borden Ladner Gervais LLP in Calgary. But, she cautions, it’s essential for a client to get good advice before signing a purchase contract: “If an individual goes ahead and enters a binding contract, it may no longer be possible to implement many tax-planning strategies. Your client has to understand that what works for property in Canada won’t necessarily work for property in the U.S.”

For example, she notes, a common estate planning technique in Canada to avoid probate taxes is to structure ownership of the property as joint tenants, which includes the right of survivorship. This means each spouse has an undivided, one-half interest in the property. If one dies before the other, the interest of the deceased spouse passes directly to the surviving spouse without incurring taxes.

But in the U.S., this strategy can result in double taxation. “The U.S. government wants proof as to whose money went into buying the property,” Spetz says. “If the wife contributed [all] the money to buy the property, her estate will have to pay estate taxes based upon 100% of the value of the property upon her death, and the husband’s estate will be taxed again upon his death.”

If your client wants to buy a vacation home in the U.S., you need to review the client’s overall financial and estate plans and those of his or her spouse. “And the advisor needs the answers to a number of questions to determine how much U.S. estate taxes the client will have to pay on the property,” Spetz says. “What assets does each spouse own? How were they accumulated — through earnings, capital gains, stock options? What are the worldwide assets of each spouse? What percentage of these are in U.S. assets? What credits or exemptions are available to each spouse?”

Another thing U.S.-bound clients aren’t asking about but should, says Prashant Patel, vice president of high net-worth support with Royal Bank of Canada in Toronto, concerns U.S. income taxes and filing requirements if the clients plan to spend a lot of time stateside.

“If they spend more than four months in the U.S. in any year,” Patel says, “they may be considered ‘resident aliens.’”

Canadians are considered resident aliens if they pass the “substantial presence” test for a calendar year. To meet this test, clients must be in the U.S. for at least 31 days during the current year and 183 days during a three-year period that includes the current year and the two previous years. To calculate this, you count all the days spent in the U.S. in the current year, one-third of the days in the previous year and one-sixth of the days in the year before that.

“In general, if your client spends more than four months in the U.S. in any calendar year, he or she will be considered a resident alien,” Patel says. Resident aliens are subject to U.S. tax rules and may be taxed on their worldwide income, while non-resident aliens do not have to pay taxes on their worldwide income.

In addition, non-resident aliens who receive income from renting their U.S. property or who realize capital gains on its sale have to file a U.S. income tax return and will be taxed in the U.S. on this income.

“Also, clients may not be aware,” Patel adds, “that when they sell their U.S. property, the purchaser will have to withhold 10% of the sale proceeds unless the property is less than US$300,000 in value and the purchaser will use it as a primary residence.”

The client will also have to report the sale to the Canada Revenue Agency and may have to pay capital gains taxes.

“Currency exchange rates aside and assuming there are no state income taxes,” Patel says, “if the capital gain on a U.S. property is US$100,000, the Internal Revenue Service has the first right of taxation on it. With the current long-term capital gains rate in the U.S. on property held for more than one year of 15%, that would mean US$15,000. The client will have to report the same $100,000 gain on his or her Canadian income tax return and in Ontario, where the capital gains rate is 23%. That means capital gains taxes of $23,000. Because the client has already paid $15,000 in the U.S. and, under the Canada/U.S. Income Tax Convention, is allowed a credit for taxes already paid in the other country, the amount owing in Canada will be $8,000.”

@page_break@But the biggest hit may come after your client dies — in the form of estate taxes. “Canadian tax law imposes a tax [only] on the appreciation in the value of assets held at death,” says Heather Evans, tax partner with Deloitte & Touche LLP in Toronto. This means the cost of acquiring the asset can be subtracted from its value. But the U.S. has an estate tax based on the full market value of U.S. assets on the date of death.

U.S. estate taxes, Evans adds, are currently applied on the fair market value of all U.S. assets on the date of death at rates ranging from 18% on estates of less than US$10,000 to 45% on estates of more than US$2 million. U.S. assets also include stock in U.S. corporations, debt issued by U.S. persons and certain U.S. partnership interests.

But not everyone will be caught by U.S. estate taxes, Patel says: “That’s why it’s important to run the numbers to assess what your client’s exposure will be.”

If your client’s worldwide estate is less than US$200,000, he or she will be exempt. And if the U.S. real estate is less than US$60,000, he or she is exempt. “But if the client buys a U.S. property today and dies next week, there may not be a capital gain,” Patel says, “but the estate will be taxed on its fair market value at the time of death.”

There is a credit available to Canadians to offset U.S. estate taxes.

U.S. tax legislation passed in 2001 has been gradually reducing U.S. estate taxes for citizens and residents, and Canadians receive a pro-rated credit equal to the portion that the U.S. property is of the deceased’s worldwide income. With the current exemption for U.S. citizens or residents of US$2 million, Evans says, the estate of a Canadian who has a net worth of US$25 million and who owned a US$2.5-million property would be entitled to one-tenth of the credit, or US$200,000.

Next year, the exemption for U.S. citizens or residents will increase to US$3.5 million, but the legislation holds a sunset clause that will re-establish the taxes under the 2001 rules in 2010, which will exempt only the first US$1 million from estate taxes.

“The U.S. Congress will step in at that point and make some changes to the legislation to prevent this from happening,” says Patel. “But it’s important that your high net-worth clients plan for the worst-case scenario.”

The U.S. imposes gift taxes at the same rate as estate taxes. So, your client can’t skirt estate taxes by giving the property away during his or her lifetime. But there are strategies that can reduce or even eliminate U.S. estate taxes for some Canadians. For real estate of more modest value, perhaps less than US$750,000, Evans says, it may be appropriate for your client to purchase the property directly (individual ownership) and buy life insurance to pay the estate taxes if death occurs before it is sold.

Another strategy is to use a non-recourse mortgage. “With a non-recourse mortgage on a U.S. property, each dollar of the mortgage reduces the value of the property at the time of death by US$1,” Evans says. “So, a property purchased for US$100,000 with a US$50,000 mortgage will be valued at US$50,000.”

The drawback to non-recourse mortgages is that the shelter they provide from estate taxes is incomplete.

“Because the financing is non-recourse,” Evans adds, “it would not be commercially normal to encumber the entire property, so some portion will remain subject to estate taxes. And, as the property appreciates and the mortgage is discharged, this exposure increases.”

A vehicle that Evans says is appropriate for U.S. properties valued at more than US$1 million is the use of a Canadian and/or a U.S. discretionary trust structured to keep the property out of your client’s estate. The client can use the property during his or her lifetime, but after death it goes to the beneficiaries — the children or grandchildren. Because your client cannot be a beneficiary of the trust or have control over it, the success of such an arrangement depends largely on how good a relationship your client has with his or her children or grandchildren.

In the past, it was common to shelter property in the U.S. through corporate ownership. But, Patel says, that this is no longer a good idea. The CRA now imputes a taxable shareholder benefit equal to the fair market rent your client would pay for use of the property.

Evans says many of your clients will want to finance their U.S. purchases through their Canadian financial institutions, although they may find currency exchange rates problematic; their mortgage payments will be in C$ while their property values will be in U.S. currency. Some Canadian banks do not provide mortgages on U.S. real estate, but clients could tap into lines of credit from their Canadian banks secured on their Canadian homes to purchase the U.S. properties. But, again, if your clients are troubled by currency differences, they’ll face loan payments in C$ while their property values will be in US$. Patel suggests obtaining financing in the U.S., such as non-recourse mortgages offered by RBC Bank USA.

For clients whose U.S. property will be part of their estates, Patel recommends having their wills reviewed by a lawyer in the state in which they purchase the property.

“And your clients should have power of attorney documents drafted in that state,” he adds. “If they become incapacitated, they will have individuals with valid power of attorney to make decisions on the U.S. property on their behalf.” IE