Canadians have long sought to escape harsh winters by spending time in the American Sunbelt. In recent years, with the dollar near parity, the depressed US real estate values, and a relatively strong Canadian economy, Snowbirds have shown stronger interest than ever in purchasing that winter get-away. The perennial question remains, however: what is the best way to own US real estate?
As usual, the answer is rarely straightforward. Each prospective buyer has a unique set of facts and different objectives to consider. Furthermore, the US real property laws, probate and incapacity are all governed at the State level, which means that the same strategy may not be appropriate in different States. This article focuses on Arizona law, and describes some of the options available to Canadian buyers of personal use properties, with a consideration of the advantages and disadvantages of each.
A key issue that Canadians need to be aware of when buying real estate in Arizona are what happens to the property in the event of incapacity or death of an owner. Of course, the federal tax treatment of different structures under the Internal Revenue Code (the “Code”) is also a relevant consideration.
When Arizona real estate is owned in an individual’s personal name they may encounter problems in the event of incapacity due to illness or injury. Without proper planning, properties will be frozen if the owner or co-owner becomes incapacitated, and the family will have to apply to the court to have a Guardian or Conservator appointed to act on the incapacitated person’s behalf. This is an expensive and time consuming legal procedure that comes at a time when the family reasonably has more important matters on their minds.
Similarly, when the owner of Arizona real estate dies, his or her will must be approved by the County Probate Court in order to pass it along to the intended heirs. Even the simplest estates require at least 5 months to probate in Arizona, because the personal representative must wait for four months for any creditors to make claims against the estate; more often Arizona probate takes closer to a year when you factor in delays in the court system. Furthermore, unlike some other States, the costs associated with Arizona’s probate system are not tied to the value the estate. Therefore, when lawyers are retained to assist with the probate procedure, the client will often be paying on an hourly rate in addition to court fees and other disbursements.
US Estate Tax
A big surprise for many Canadian owners of US properties is that they may be liable for US estate tax upon their death. The rules for determining US estate tax liability for Canadians who die owning US real estate contain two tests: if the value of the US asset is less than $60,000, then no tax is payable; if the value of the US asset is more than $60,000, but the total net worth of the decedent is less than the ‘exemption amount’, then still no tax is payable. The current exemption amount is $5million, but is set to decrease to $1million on January 1, 2013. If the values of the US assets and worldwide estate are higher than these amounts, then there will likely be some tax to pay on death. Calculating US estate tax liability for nonresident Canadians involves consideration of formulas in both the Code and the Canada-US Tax Treaty (the “Treaty”), a detailed discussion of which is beyond the scope of this article.
A Variety of Solutions
Everyone’s situation is different, and the most appropriate strategies in any particular case are equally diverse. Some factors that are important in determining the best solutions include: the value of the Arizona property, the total net worth of the client, the clients’ family structure, the residency and citizenship of the clients and their intended heirs, and many more.
To illustrate the issues and options available, we will look at a hypothetical couple, Michael and Mary, whose facts we will change in a series of examples. Throughout the discussion, we assume that Michael and Mary are Canadian citizens and residents who plan to buy a property in Phoenix Arizona.
Example 1: the modest estate
In this example, Michael and Mary are looking at buying a house for $100,000, and have a total net worth in Canada of $4million, including their home, investments, RRSPs, and life insurance.
In such a situation, Michael and Mary may have little to be concerned about. The Arizona probate rules provide a fast-track process where the value of real estate is less than $75,000. A similar small estate probate exemption is available for personal property valued at less than $50,000. (A.R.S. §14-3971) If estate values are below these amounts, the executor only needs to wait six months and file an affidavit in the prescribed form at the courthouse, a copy of which can then be recorded at the land recorders office to transfer the property.
If they take title as tenants in common, then upon either of their deaths the value of their share of the Arizona house would be eligible for the small estate exemption from probate (assuming that the house has not appreciated in value by the date of death). Likewise, the value would be lower than the $60,000 initial US estate tax threshold, so this also does not present a problem. To manage the incapacity problem, Mary and Michael could execute durable powers of attorney and living wills to allow one spouse to act in the place of another in the event of incapacity.
Note that if Michael and Mary were to take title as joint tenants with a right of survivorship, the property would pass to the surviving spouse automatically on first to die. However, they would be required to prove to the IRS that the decedent had not paid for the entire property, or section 2040(a) of the Code would make the entire value includable in his or her taxable estate, which may give rise to estate tax liability. This fact illustrates the importance of getting good tax advice when purchasing US real estate to ensure that this presumption can be rebutted.
Proper estate planning would also be important in this example, because if Mary survives Michael and inherits his share of the Phoenix property, then upon her subsequent death she would be ineligible for the small estate exemption to probate and US estate tax.
Example 2: the bigger vacation house
Let’s now assume that Michael and Mary decide to purchase a house for $200,000, with the other facts staying the same.
In this scenario, their respective shares in the property would not qualify for the small estate exemption from probate. One option they could consider would be to execute a Beneficiary Deed. Arizona is one of twelve US states that offers this option, which allows a property owner to record a deed of transfer during his or her life that only becomes effective upon death. A validly executed Beneficiary Deed avoids the probate process, but does not address issues of incapacity or US estate tax liability.
Under these facts, the incapacity issue could be resolved with the power of attorney and living will mentioned above. However, the taxable estate of the first to die would be $100,000, potentially giving rise to approximately $6,500 in US estate tax. This could be eliminated if the survivor inherits the deceased spouse’s share, due to a marital deduction available to Canadians under the Treaty. However, that surviving spouse would then own the entire combined estate, and would be liable for approximately $37,500 in US estate tax on his or her subsequent death.
A better option for this scenario could be for Michael and Mary to purchase the property in twin Cross Border Trusts (CBTs). This structure consists of revocable living trusts for each of Michael and Mary, which would own the Phoenix home as tenants in common. To be effective for Canadian Snowbirds, CBTs must have special clauses to ensure tax compliance in both Canada and the US. The trust instrument also specifies who would be the decision maker in the event of incapacity, so that issue is covered. Because trusts never die, probate would be avoided. Upon the death of one spouse, his or her interest would be passed to the survivor in a form of trust that would defer any US estate tax owing on the estate of the first decedent, be shielded from US estate tax on second to die, and protected from creditors. In this way, the CBTs serve the function of the last will and testament, power of attorney and living will in one trust package.
Example 3: the risk averse buyers
Let’s extend the facts in Example 2 such that Michael and Mary are concerned about potential liability from lawsuits in the US. Perhaps they intend to rent the house out for part of the year, or have guests stay there often. If someone were to slip and injure themselves, then they, as property owners, could be sued. With property in their personal names or in CBTs, creditors can reach beyond the Arizona real estate to enforce judgments against other personal assets.
In this scenario, a possible strategy would be for Michael and Mary to hold the Arizona house in a form of limited partnership (“LP”). A partnership is a business entity where at least two parties are working together with a view to profit. An LP is a special form of partnership consisting of at least one general partner, who has managerial control, and at least one limited partner, who has an equity stake, but cannot participate in the management of the entity.
LPs provide good tax advantages in that net revenue flows through to the individual partner to report as personal income. For Canadian Snowbirds this ensures that foreign tax credits are available under the Treaty to prevent double taxation on rental income or capital gains upon sale. Limited partners are also shielded from potential liability as property owners, risking only their stake in the partnership not their other personal assets. The general partner, however, has unlimited liability in respect of creditors of the partnership, so we often recommend setting up a corporation to serve as the general partner.
If an LP in Arizona makes an election under A.R.S. §29-367, it may be convertible into a Limited Liability Partnership (LLP), and even the general partner can limit its liability to the equity stake in the enterprise. This would alleviate the need to establish a corporate general partner. Note that conversion to an LLP gives rise to annual filing requirements with the Arizona government, and potential penalties for failure to file.
Incapacity of a partner does not present difficulty from an entity perspective, as Arizona law allows a partner’s legal representative to step in to exercise the rights of an incapacitated partner (A.R.S. §29-343).
However, LP structures do not address issues of probate or US estate tax. In Arizona, an interest in a partnership is personal property (A.R.S. §29-339). This means that if Michael or Mary die owning a partnership interest valued at more than the $50,000 small estate exempt ion, it would be considered a probate asset. No Beneficiary Deed is available to pass personal property upon death. That partnership interest would similarly be includable in the taxable estate of the deceased, potentially giving rise to US estate tax liability.
More fundamentally, however, for personal use properties that are not rented out for income, it is questionable whether the Canadian government would recognize a valid partnership, since the motivation to earn a profit is arguably lacking (see Backman v. Canada, 2001 SCC 10).
Example 4: The large estate
For this example, assume that Michael and Mary are looking to purchase a $500,000 home in Phoenix, and have a combined net worth of $10million. This scenario presents more challenges, especially in terms of US estate tax liability.
Assuming the purchase was structured to avoid the s.2040(a) presumption of full ownership in a joint tenant, the US estate tax liability on the first spouse to die would be approximately $36,000 if the surviving spouse inherits the property outright. On the second spouse to die, US estate tax would be an additional $138,000.
It is important to note that none of the ownership structures discussed so far are effective in avoiding US estate tax liability. The CBT structure retains sufficient control over trust property to make it included in the estate of the owner of the trust. A properly structured CBT can defer estate tax on the first spouse to die, and split the value of the taxable portion to achieve a lower rate of tax, but US estate tax is not eliminated. Likewise an interest in a LP that holds US real estate is taxable upon the death of a limited partner.
Therefore, if Michael and Mary hope to avoid US estate tax, they must not own the property in a structure that the IRS will look through. One such structure is the Cross Border Irrevocable Trust (“CBIT”), which addresses all the issues discussed above: incapacity, probate and US estate tax. Similar to the CBT, the CBIT must contain language to ensure compliance with the tax regimes on both sides of the border. When properly drafted, however, this can be a very effective structure for Canadians to own US real estate.
For all its benefits, the CBIT is not perfect in every scenario. In order to avoid US estate tax, Michael and Mary must not own the property, which necessarily results in an element of lost control over the asset. Selection of the trustee is always a delicate issue when dealing with the divergent issues of control and tax compliance. Michael and Mary would need to seek advice from a cross border expert to determine whether the CBIT is appropriate for their family situation and future plans and, if so, how it should be structured.
Good advice is Key
The take home lesson from these examples is that Snowbirds who want to enter the US real estate market are well advised to take the time to seek advice from a qualified professional before plunging in. In this case, a solid understanding of how the Canadian and US laws interact to affect rights is the key to the quality of advice sought or received.
There is no universal solution for Canadians purchasing US real estate, and each option has its advantages and disadvantages. The professional must also take the time to gain an appreciation of the particular circumstances of the client in order to provide the most appropriate advice and structures to fit their goals and objectives. With the right advice, however, Canadians can take advantage of the opportunities in places like Arizona.
This article is intended for information only, and should not be relied upon as a legal opinion. Anyone considering making a purchase of US real estate should contact a qualified cross border professional.