Vacation Spots

Owen Marshall is a partner is a consulting engineering firm that specializes in municipal work. “You look well rested,” I told him.

“I’ve been on holiday,” Owen said. “My brother lent me his condo in Northern California for a month, and I took the whole family down for an extended break.”

“You had a good time?”

“A brilliant time. Hank, I really like it down there. In fact, that’s why I came to see you. I’m thinking of buying a condo in my brother’s building.”

“Sounds nice.”

“But my brother mentioned that there are tax problems with owning U.S. real estate. He told me he has a corporation that owns his property.”

“Your brother was referring to U.S. estate taxes. Traditionally the U.S. has levied a tax on the capital assets owned at death by a taxpayer.”

“We have the same thing in Canada, don’t we?”

“Not exactly. Under our rules, a capital gain is triggered on death. So if you have an asset worth $1 million that originally cost $600,000, you’ll pay tax on the gain of $400,000. Under U.S. rules, you’d pay tax on the entire value of the asset — $1 million — assuming, of course, that you’re liable to pay tax in the first place. Normally, Canadians don’t pay U.S. taxes, but U.S. estate taxes are levied on U.S. assets owned by non-U.S. people. Your brother set up a special corporation to own his condo to avoid death taxes. Since a corporation never dies, the idea is that it won’t be subject to estate tax.”

“So I guess I should incorporate a company to own the condo.”

“No, I don’t think you should. There are Canadian problems with holding personal use assets in a company. Generally Canada Revenue Agency will tax you on a shareholder benefit if you use a corporate-owned asset for personal use. Because of the U.S. tax situation, Canada Revenue Agency in the past recognized the value of setting up a special corporation to own U.S. assets. Those corporations were called single purpose corporations, or SPCs, since their sole use was to own U.S. assets. However, because of changes in U.S. law, Canada Revenue Agency will no longer waive its ability to tax shareholders whose U.S. assets are owned in a corporation. Canada Revenue Agency has grandfathered SPCs that existed before 2005, so your brother’s plan will still work — at least to avoid Canadian tax problems.

“Also,” I added, “on the U.S. side, SPCs may be an inefficient way to hold real estate.”

“Why?”

“Two reasons. First of all, when an individual owns real estate, he’s subject to a 15 per cent U.S. tax on any capital gain. A company is subject to tax at 35 per cent.”

“That’s brutal.”

“Yes. And now there’s a considerable risk that the U.S. Internal Revenue Service (IRS) may deny the validity of the SPC structure and apply U.S. estate tax to the owner of the company.”

“Can they do that?”

“They have been floating the idea. For that reason, your brother will have to think about how he’s holding his U.S. property.”

“I’ll mention it to him. And obviously, using a company is a bad idea for me. But what about this law change? Have changes in U.S. laws made it more attractive for me to own real estate personally?”

“Possibly. Under U.S. rules, you may be able to avoid U.S. estate tax if your property is of modest value and your estate is not too large. However, to be eligible for that exemption, your entire worldwide estate must be disclosed to the Internal Revenue Service. When computing your U.S. estate, you’ll have to include most of the U.S. assets you own.”

“All U.S. assets? What about U.S. stocks, do they count as U.S. assets?”

“Most of them would fall into your U.S. estate.”

“So what should I do?”

“I think your best bet is setting up a family trust to own the property.”

“Why a trust?”

“A trust can solve a lot of problems. By using a properly structured trust, you can avoid the problems associated with the personal use of company-owned assets in Canada. You’ll avoid the risk that the Internal Revenue Service will look through a Canadian company as though it weren’t there — and seek to apply estate taxes to you personally. A trust will also permit you to avoid the high capital gains tax rate on corporately owned assets in the U.S.”

“What tax rate would a trust pay?”

“If the trust realizes a capital gain on the sale of the property, it would pay U.S. income tax at the 15 per cent individual rate, not the 35 per cent corporate rate. The key to all this is that you must structure the trust properly to keep the asset out of your estate.”

“How would I do that?”

“If you’re the settlor of the trust, you shouldn’t be a beneficiary or hold a general power to appoint trustees. Also the trust may need an independent trustee.”

“That sounds expensive.”

“Not when you consider the value of a significant piece of real estate. If you use a knowledgeable lawyer, the fees won’t be too high.”

“What about my brother’s company?”

“That should be re-evaluated. As I said, the Canadian rules on SPCs are grandfathered. But he may have other U.S. problems and if he’s going to realize a gain on the sale of the property, his taxes could be much higher than if he owned the property personally.”

Hank Bulmash, MBA, CA is a principal of Bulmash Cullemore, chartered accountants of Toronto. E-mail Hank at hank@businesslab.ca