In recent years, the high Canadian dollar and the fall in United States housing prices has encouraged Canadians to buy US vacation properties. However, Canadians should be aware of the tax consequences of owning a US vacation home before making a purchase. One of the most important considerations is potential exposure to US estate tax.
US Estate Tax
US estate tax is a tax on the estate of a deceased individual. It is commonly and pejoratively known as the “death tax”. The US estate tax can apply to Canadians who hold certain US assets, for example, real property located in the US. A Canadian who buys a US vacation home is, therefore, potentially exposing his or her estate to taxation in the US.
US estate tax can be a significant sum of money because it is imposed on the value of assets rather than any gain that has accrued on the assets over the course of the deceased’s ownership of the property. A US vacation home with a value in the millions can attract several hundred thousand dollars in tax under the current US estate tax regime.
The exact amount of US estate tax payable in future years is unpredictable because of the vagaries of the US political system. US politicians have been constantly tinkering with the tax in recent years. In 2009, the maximum US estate tax rate was 45%. The tax was temporarily repealed in 2010 before being re-enacted in December of that year. Currently, the maximum US estate tax rate is 35%. The maximum US estate tax rate is set to jump to 55% in 2013, unless new legislation is passed.
Various deductions and tax credits can be claimed in order to reduce the amount of US estate tax payable. Canadians can take advantage of some of these deductions and credits. However, the value of the most important credit has been subject to constant change in recent years, making it difficult to predict the value of the credits an estate will have to off-set the tax.
How Can Canadians Avoid US Estate Tax?
In the past, Canadians used a “single-purpose corporation” to hold a US vacation property. It was generally accepted that Canadians could avoid US estate tax with this structure. The Canada Revenue Agency (“CRA”) allowed for this practice by not applying the shareholder benefit rules in such circumstances. However, the CRA reversed its administrative position for post-2004 acquisitions of US real property.
Today, a Canadian who uses a corporation to hold a US vacation home may have a shareholder benefit included in his or her income and subject to Canadian income tax. The amount of the shareholder benefit is the value of the benefit the corporation is providing to the shareholder by allowing the shareholder to use the US vacation home. One way the CRA determines this amount is by using the fair market rental value of the vacation home. Another method is income being imputed based on the return on investment that the corporation would otherwise get from the use of its money. Either method can result in a large, unexpected Canadian income tax bill.
Now that single-purpose corporations are no longer an attractive planning tool, one of the most popular ways to hold US vacation property in a manner that avoids US estate tax is through a trust. However, there are several drawbacks with using a trust. The most notable drawback being that the settlor (i.e. the person who provides funds to set up the trust) may be required to relinquish any possible control over or interest in the trust and the vacation home.
There is also a possibility that US estate tax can be avoided by using a partnership to hold the US vacation home. However, this strategy is complex and highly uncertain, and generally requires there to be a profit motive. Another option is to hold the US vacation home personally and leave it to a surviving spouse. If done properly, this can at least delay the payment of the US estate tax. However, this cannot be done by simply making a bequest of the US vacation home to a spouse; several Canadian and US legal requirements must first be satisfied.
Given the complexities involved, Canadians thinking of buying a US vacation home should put serious thought into how to structure the transaction. It is recommended that Canadians consult with both Canadian and US tax experts. It is especially important to consult a US tax expert to confirm the applicable US estate tax rates, deductions, and credits that may apply in an individual’s particular circumstances.