Subject: Cross Border Estate Planning
Date: 2011
Rather than write another boring article about structures to use to own your Florida, Arizona, or California condo or home to add to the thousands out there, I thought I would share with you some mistakes I am seeing as a cross border tax enthusiast regarding the ownership of U.S. vacation properties, which I might add are occurring at a far too alarming rate. The lesson of this article, to tell it to you up front, does not lie in memorizing these errors below so you won’t make them, or re-reading the myriad of articles on Florida structures, but instead, on recognizing prevention is the best cure. Canadians considering acquiring vacation property for their personal use (opposed to rental real estate-which triggers many more tax issues) need to follow a very basic and simple approach- retain both U.S. and Canadian tax counsel expert in international taxation to work together as a team to prepare a suitable solution for their needs.The illustrations below are in no particular order and you may assume all of the players are Canadian citizens and residents.
The first few illustrations attempt to provide you with a picture of some of the grizzly consequences that can befall property owners and their advisors who lack familiarity with the complex often thorny subtleties of the U.S. gift tax rules, which are quite different from Section 69 under the Income Tax Act (Canada).
Example 1. Mr. V was diagnosed with cancer and after receiving advice from his tax advisor, decided to transfer the ownership of his condo in Florida with a fair market value (FMV) of $300,000 to his son, Y, who was 20 years younger, to avoid any US estate tax. Mr. V triggered a massive U.S. gift tax on the transfer of his property to his son. Because of the steep devaluations in real estate, had the transfer been structured as a sale the long term capital gains rate of 15 percent would have resulted in a very modest U.S tax.
Example 2. Mr. and Mrs. W, were the proud owners of a luxurious condominium in Boca Raton Florida. With the advice of their tax advisor, they transferred the property to a Canadian trust on the assumption that under Canadian gift tax rules, there had been no appreciation in the property, and hence there would be no Canadian (and U.S. Federal tax) on the transfer—or so they thought. Yep, you guessed it, they triggered a brutal gift tax on the FMV of their new $1 million condo (Ouch!!). A properly structured trust, from the time of purchase (or a sale to a subsequently established trust) would have avoided the unfortunate outcome.
Example 3. Mrs. X owned a ski chalet in Colorado and wished to transfer title to her two children by way of a sale to avoid U.S. estate tax on her death. She took back a mortgage from the boys which was not made with arms length terms. She unwittingly made a taxable gift of the underlying real estate to her sons where the value of the property exceeded the value of the note. Non-arm’s length loans between related parties whether directly or indirectly through the use of a trust may cause serious U.S. transfer tax problems.
The next couple of signs on the road to watch out for concern transfers (not pursuant to bona fide sales for an adequate and full consideration) in which a person retains an interest or power under Code Section 2036 (transfers with retained life estates), Code Section 2037 (transfers with retained reversionary interest), and Code Section 2038 (transfers with retained powers to alter, amend, revoke or terminate). These sections of the code comprise deep bodies of law with cases running back almost a century, and no attempt is made here to explain these rules, but rather to alert you to their importance in preserving wealth under the U.S. transfer tax regime.
In Commissioner v. Estate of Church, 335 U.S. 632 (1949), the decedent transferred property to an irrevocable trust but the trust instrument required that the trustees pay the income to him for life. In the course of the opinion holding the transferred property includable in the decedent's estate, the Court stated—
“an estate tax cannot be avoided by any trust transfer except by a bona fide transfer in which the settlor, absolutely, unequivocally, irrevocably, and without possible reservations, parts with all of his title and all of his possession and all of his enjoyment of the transferred property.”
In making an irrevocable transfer of property to a trust, the aim is to avoid inclusion of the value of the property in the estate of the transferor or trust beneficiaries where possible. However, great care must be taken in establishing the trust and its drafting, and in the trusts operation to achieve this objective. Often clauses which may appear to be innocuous generally, or have no adverse Canadian tax consequences, may nonetheless provide the taxpayer with “strings” to the trust property enabling the IRS to tie those assets to his estate.
Below is a list of potential problems to watch out for in using an irrevocable trust which may individually or in combination potentially trigger inclusion of the trust property in the estate of the grantor/settler (or transferor), or other transfer tax consequences:
- Unrestricted right of grantor/settler (or transferor) to remove and appoint a trustee;
- Right of grantor/settler (or transferor) to determine the terms of sale of the property, including any veto rights;
- Non-arm’s length loans to a trust by the grantor/settler (or transferor);
- The absence of a landlord tenant relationship between the trust and a non-beneficiary who is living in the home, including the settler/grantor’s spouse after the death of the spouse beneficiary;
- Payment by the grantor/settler (or transferor) of expenses of the home, such as condo fees, taxes, maintenance, etc.
- Exercise of any stock voting powers by the grantor/settler (or transferor), or of any power of appointment with respect to the trust;
- Selection of a beneficiary as trustee under certain circumstances.
The above list is merely illustrative given the very complex subject area.
There are two additional misconceptions worth mentioning that I am frequently seeing out there in cross border tax land. The first is that if your global estate is under $5 million, no U.S. estate tax will apply. The problems with this estate planning technique are first, that the lifetime exemption of $5 million will expire in 2012, and hence, as we don’t know the rate thereafter this is not a safe bet (please see my article -New U.S. Estate and Transfer Tax Rules, Volume 4 Issue 1, It’s Personal, March 2011). Second, reliance on the pro-rated estate tax exemption afforded to qualifying residents under the Canada-U.S. Tax Treaty (Article 29B – Taxes at Death) really assumes that the family in their hour of grief will be advised on U.S. international tax matters in a timely fashion, both substantively and on related compliance, to harness any applicable relief available at that time, and will act accordingly. A roll of the dice, and it will certainly not be for free on the professional side, so, better off with a trust, or another solution if the circumstances warrant it.
Prospective home buyers then should work with their U.S. and Canadian tax advisors to initiate a dialogue so that they can become educated about the relevant Canadian, U.S., and state tax, legal, financial, and personal issues they are facing, so that they can make an informed and wise choice. Current vacation property owners with a structure may wish to have that looked at to see if there are any concerns. Those U.S. property owners without any estate tax planning may wish to examine their options now, and take advantage of the lower property values which may potentially reduce the cost of setting up a structure.
Copyright © David S. Kerzner