The strong Canadian dollar, coupled with the subprime mortgage crisis in the United States, has created new economic opportunities for Canadians interested in making an investment in Florida real estate. The benefits of being able to escape to a warmer climate during the winter months are certainly notable as well. But before you sign on the dotted line, there are a number of U.S. tax considerations that should be considered.

If a Canadian citizen/resident owns US real property at his or her death, that property is "U.S. situs" property and thus potentially subject to US estate tax (on the full value of the property, and at rates up to 45% in 2008). Under the Internal Revenue Code, the estate of a non resident, non citizen (NRA) of the US is allowed a "unified credit" that exempts only $60,000 (USD) of U.S. situs property from US estate tax. Under the Canada-United States tax treaty, however, a Canadian’s estate qualifies for a potentially greater exemption (the “prorated exemption”), based on the following formula:

2008 tax exemption allowable to US citizen    X    Value of U.S. situs assets
                    (currently $2MM)                            Value of Worldwide estate

The Treaty also allows a marital exemption equal to the prorated exemption. Therefore, if a Canadian citizen dies owning U.S.-situs assets and leaves them to his or her spouse in a manner that would qualify for the U.S. marital deduction if the surviving spouse were a US citizen, the exemption amount is effectively doubled. There also is a mechanism under the Treaty for crediting the U.S. estate tax against the Canadian gains tax imposed at death. As in Canada, the United States endeavors to defer taxation until the surviving spouse’s death.

In some cases, planning for use of the Treaty prorated exemption and marital exemption can alleviate most or all of the U.S. estate tax exposure at the owner’s death. However, that usually requires drafting a new Will to create a testamentary trust for the surviving spouse that holds the property after the owner dies, to keep the property from estate tax at the second death. In other cases, however, a couple’s assets are so significant that the potential exemption amounts are not sufficient to protect against U.S. estate tax exposure.

Assume, for example, that Mr. and Mrs. Smith are both Canadian citizens and residents. Mr. Smith dies owning a house in Florida worth US$1 million, his only US-situs asset. His worldwide estate totals US$10 million. His Will leaves his assets outright to Mrs. Smith. Mr. Smith’s prorated exemption under the Treaty allows $200,000 of assets to pass free of estate tax calculated as follows:

                                                                            $1,000,000
                 $2,000,000                          X    (Mr. Smith’s U.S.-situs assets)
(2008 tax exemption for a U.S. citizen)                   $10,000,000
                                                                 (Mr. Smith’s worldwide estate)

Even though Mr. Smith’s exemption can be doubled to $400,000 by virtue of the treaty’s marital exemption, $600,000 of his US property remains exposed to U.S. estate tax. Furthermore, if Mrs. Smith owns all or a portion of the property at her death, it is likely to attract US estate tax again in her estate.

US estate tax exposure in both Mr. Smith’s and Mrs. Smith’s estates may be avoided through the proper use of a residence trust. A residence trust can be used in many situations, but it works most effectively for a married couple. The structure avoids the inclusion of the US real property in either spouse’s estate for US estate tax purposes if specific requirements are met.

With the residence trust approach, one spouse would be the settlor/grantor of the trust and contribute all the funds towards the purchase of the property. The trust would be for the benefit of the grantor's spouse and descendants, and the trust would acquire the property. The trust agreement generally would provide that (1) the beneficiary spouse is the trustee (the grantor spouse can not be the trustee), (2) the beneficiary spouse and descendants have lifetime rent-free use of the property, and (3) distributions from the trust can be made to the beneficiaries subject to an ascertainable standard. The property needs to be purchased by the residence trust at the outset, and cannot be transferred to such a trust thereafter without raising U.S. income, gift and (other) estate tax issues.

The residence trust also has significant U.S. income tax advantages as it potentially allows the long term capital gains rate (applicable to property held for more than one year) to be available on a sale. This rate is presently 15% federally, whereas the ordinary income and short term capital gains rates for individuals are at a maximum rate of 35% federally. Ownership of U.S. real property by a corporation, for example, does not permit use of a lower capital gains rate on a sale of the property — instead, the regular corporate rate (34% federal) applies. In Florida, there is also a state income tax for corporations but not individuals. Therefore, there is a significant tax rate differential on a sale of capital gain property by an individual (15%, federal only) as opposed to a corporation (about 40%, federal and state). The residence trust also has creditor protection benefits.

There are certain disadvantages with the residence trust approach in the event of divorce or if the beneficiary spouse dies before the grantor spouse. These disadvantages can be minimized with proper drafting of the trust agreement.

If the property is going to be rented to third parties, a limited partnership should be considered in conjunction with the residence trust approach to give the owners additional liability protection.

The Florida real estate market welcomes you with open arms and with appropriate planning you can keep your U.S. tax and liability exposure to a minimum.

By Leslie R. Kellogg

This article first appeared in The Northwood Stephens Prespective, spring 2008. Reprinted with permission.