David A. Altro’s Book Available as an eBook

The second edition of the book Owning U.S. Property – the Canadian Way by David A. Altro has been available for just over a year and has experienced great success and received praise by readers.

In order to make the book more available, we have very recently released it as an eBook for the Kindle. The eBook can be purchased online from Amazon.

If you would still like to have a hard-copy of David’s book, you can continue to use our website to place an order online.

Gift Tax Developments

While it is possible to donate property in Canada without any tax consequences, it is quite a different affair for Canadians in the United States. Thus, it is important for Canadians holding assets in the U.S. to be informed about the rules underlying the donation, without which the noble intention of offering a present to someone you love can quickly turn into a poisoned gift.

The basic scheme of the tax on the donation is that a person who disposes of property for free or for less than the fair market value must pay a tax based on the full fair market value of the asset. Gift tax applies in the context of inter vivos disposition since the donation through testamentary disposition will be governed by the estate tax. Read the rest of this entry »

IRS Simplifies Compliance for Americans in Canada

Being an American citizen is, for many around the world, a highly sought after position. Some might call it a gift, though I doubt the United States IRS would classify it that way. In fact, for the IRS, American citizenship is only one half of the bargain. At least, this appears to be the mindset behind how the United States has structured its income tax laws. Unfortunately, American citizens are required to file a U.S. income tax return on all worldwide income and a Foreign Bank and Financial Accounts Reporting (FBAR), regardless of where in the world they reside.

Up until recently, most U.S. citizens residing outside of the United States were unaware of this responsibility. Though this responsibility has always existed, the IRS did not take an aggressive stance on it until 2011. Since then it has issued warnings that citizens found to be out of compliance with their income tax returns and FBAR may be subject to both civil and criminal penalties, plus interest on any taxes due. Read the rest of this entry »

David A. Altro and Matt Altro published in STEP Journal – June 2012

Canadian departure tax: obstacle or opportunity?

By David A. Altro, B.A., LL.L, J.D, D.D.N, Fin. Pl., TEP and Matt Altro, B.Comm., CFP®, F. PL.

Canadians move to the US for a variety of reasons. Proximity to family, lifestyle, sunny weather, employment, health issues and lower income tax rates are some of the more popular reasons. If tax is the main driver for a client to hang up their hockey skates in favour of a golf club, they will probably choose to live in a state with little or no state income tax, such as Florida.

The highest marginal rate for a resident of Quebec is 48.2 per cent (Ontario is 46.4 per cent). The highest marginal rate for a Florida resident is only 35 per cent. The tax savings are more pronounced when you take into account that a Quebec resident reaches the highest marginal rate at just CAD132,000 of income, while a Florida resident reaches the highest marginal rate only at income above USD379,000.

But before recommending a one-way ticket to West Palm Beach, it is important to understand the tax impact of becoming a non-resident of Canada. When a Canadian moves to another country and gives up tax residency in Canada this may give rise to a tax commonly referred to as departure tax. To better understand how this departure tax is calculated, a key concept of the Canadian tax system should be reviewed. Canadian residents are taxed on their worldwide income only while they are considered tax residents of Canada. Unlike the US, which taxes based on citizenship, when Canadians depart Canada they are no longer obliged to pay tax to Canada unless they continue to earn Canadian-source income. Canadians who depart Canada need to complete their final personal tax return (also known as an ‘exit return’) by 30 April of the year following their departure.

Income tax marginal rates for married couples filing jointly

As this is the end of tax in Canada, the Canada Revenue Agency (CRA) expects to settle up with its residents on departure. According to Canadian tax law, Canadian residents who depart and become US residents for tax purposes are deemed to have disposed of assets at fair market value. This event may give rise to a capital gain. A capital gain triggered by departure is commonly referred to as departure tax, so departure tax is not a new tax: it is actually capital gains tax in disguise.

Upon disposition of an asset, if the fair market value is greater than adjusted cost basis there will be a capital gain: 50 per cent of the gain is added to the taxable income for the year and taxed at the seller’s marginal rate. Capital gains tax is triggered at the earlier of sale, death or departure. So paying tax on departure is simply pre-paying a tax that will ultimately be due. The question is, pay now or pay later?

On understanding departure tax, it is clear why it is critical to analyse assets before the client leaves Canada. As with most tax law there are some exceptions to the rule. Some assets do not give rise to tax upon departure at all. For example, all Canadian real estate is exempt from departure tax, as are registered retirement savings plans (RRSPs) and registered retirement income funds. Examples of assets that are subject to departure tax are all stocks and bonds held outside registered accounts, and shares of private corporations.

Does this mean that a wealthy Canadian will owe millions of dollars to the CRA when giving up Canadian tax residency? Typically, the answer is no. With proper planning, the worst-case scenario is simply a deferment of tax. The CRA will allow departing Canadians to defer the tax by posting security equal to the taxes due. Considering that the CRA does not charge interest on the tax, Canadians who depart and choose to defer the tax are no different to those who are still in Canada. In either situation, no tax is due until sale or death.

While a deferment is typically better than paying tax now, numerous strategies can be used when planning a cross-border move to minimise or eliminate the eventual departure/capital gains tax due.

When is capital gains tax paid in canada?

Business ownership
One of the most complicated areas for Canadians to address when moving to the US is what to do with their companies. Can they maintain an interest in their Canadian company as a US resident? If so, does the company need to be restructured to ensure income and dividends can flow to them, as the US-resident shareholder, in a tax-efficient manner?

Another option is to consider selling the shares of stock before becoming a US resident. If the company qualifies as a Canadian-controlled private corporation (CCPC), under Canadian tax law the owner may be eligible to use a CAD750,000 lifetime capital gains exemption. This means that if the company’s adjusted cost basis is CAD500,000 and it is sold for CAD2,000,000 there would be a gain of CAD1,500,000. If the exemption is applicable, the first CAD750,000 of gain would not be taxed. If the owner’s spouse is a shareholder as well, this exemption doubles to CAD1,500,000 of tax-free capital gains.

Using the example above, if both spouses use their exemption, there would be zero tax on the company’s sale. If the company does not qualify as a CCPC or there is a significant amount of tax remaining, consider making use of the Canada-US Tax Treaty and restructuring the company on a cross-border basis to minimise or eliminate tax.

RRSPs are excellent tax-advantaged investments in Canada. The investor gets a tax deduction when they make a contribution, then the proceeds grow while tax is deferred. Funds are taxed at ordinary income tax rates when withdrawn but, unlike US retirement accounts such as 401K and IRAs (individual retirement accounts), there is no 10 per cent penalty for withdrawing the RRSP before the age of 59 and a half. For many Canadian residents with a substantial income-producing portfolio or pension income, this means they will pay almost 50 per cent tax to the CRA on their RRSPs, as Canadian residents.

All Canadians who move to the US ask what they should do with their RRSP. As noted, RRSPs are exempt from departure tax, but without proper planning the Inland Revenue Service (IRS) will tax RRSPs on interest and capital gains income as it would any other investment account, rather than recognise their tax-deferred status. Before calling their investment advisor to liquidate the RRSP, they can turn to the Canada-US Tax Treaty for relief. The solution is to make a treaty election and file form 8891 along with the US return each year. If this is done correctly, the IRS will grant the same tax treatment as the CRA, which is to allow tax on the accrued income to be deferred.

Collapsed funds

While the RRSP can be kept intact on a move to the US, many Canadians choose to collapse their RRSP once they are stateside. This is because non-residents of Canada enjoy a special advantage created by the Canada-US Tax Treaty: they can withdraw their RRSP at a tax rate of just 25 per cent. With proper planning, the tax rate may be lowered to 15 per cent on withdrawal. This is a far cry from the 40–48 per cent most high-net-worth Canadians may pay when they collapse their RRSPs in retirement if they stay Canadian residents.

The potential savings are further increased because the tax paid to Canada (25 per cent or 15 per cent) can be used as foreign tax credits to offset tax owed to the IRS on specific types of income earned in the future. This is a good strategy if a client plans to retire in the US and wants to make the most of their RRSP. Another benefit to collapsing the RRSP is that it eliminates the additional currency risk of leaving the RRSP in Canada while having a lifestyle primarily in the US. And, if the client ever moves back to Canada, they are not stuck with an RRSP where the CRA gets half.

While there are many tax opportunities in moving to the US, there are also many pitfalls to leaving Canada. The US may be a tax haven for Canadians who own a big RRSP and substantial income in retirement, but most Canadians are not able to take advantage of this because they do not have a viable immigration plan or they cannot get private medical insurance. The best defence against these hazards is a cross-border professional who can design a holistic cross-border plan that addresses tax, estate, financial, retirement, accounting, insurance, investment and healthcare issues.

© Copyright (c) Society of Trust and Estate Practitioners. Article first published in STEP Journal Volume20/Issue5.

Pop Culture and the Trust by Bonnie L. Altro

While reading a recent edition of O Magazine, I came across Suze Orman’s monthly column. For those who don’t know, Ms. Orman is a financial expert and has written many books on financial prosperity. She was a frequent guest on The Oprah Winfrey Show and now has her own show on Oprah’s network. The column addressed how to be smart about your assets by protecting your estate from unnecessary costs and delays when you pass away. And what was her suggestion to achieve this peace of mind? A trust.

For most Canadians, owning property in a trust is a new concept. They have never thought of holding property this way, and when they hear about all of the benefits, they have a number of reactions. Some love the idea and start to question why their Canadian estates aren’t organized in the way we suggest that their U.S. estate be arranged. Some are less enamored by the concept of a trust and worry that the trust will cause complications in connection with the purchase or may scare off the seller. I assure them that this won’t be the case. I explain that using a trust to hold U.S. assets is not something we recommend to solely to Canadians, but that this is the recommended approach for Americans as well. And to back me up on this, like I do with so many things, I quote Oprah. Ok, maybe in this case, it is not Oprah directly, but Oprah’s trusted advisor, Suze Orman.

I find Ms. Orman’s article compelling because it addresses a key myth when it comes to the way trusts are viewed in pop culture: that they are useful only for the wealthy, as vehicles for holding and controlling family money. This assumption can largely be blamed on the term “trust fund” and its use in TV shows and movies depicting a world of excess. That term has penetrated our collective vernacular and has made trusts synonymous with privilege.

The truth is that trusts can be more important for those of us who are not wealthy, as the costs of settling an estate without a trust in place are more painful when paid by those who have less to spare. Just to give you an idea of what I mean, probate costs in the U.S. can run between 3 and 5 percent of the value of the U.S. property depending on the state. Further, should a property owner not pass away, but become incapacitated instead, the cost of a guardianship procedure or a conservatorship to deal with the issue can cost about $10,000. You can see how the beneficiaries of those leaving less disposable funds in their estate will be even harder pressed to deal with the financial strain that such events can cause. Trusts are often the solution as they simply lessen cost and hassle on death or incapacity.

Usually clients feel comforted to know that trusts are highly recommended for both Canadians (a Cross Border Trust) and Americans (a Revocable Living Trust) as smart ways to hold U.S. real estate by experts that we trust such as Ms. Orman. I mean, a blessing from one of Oprah’s messengers! What could be better?

For more information, see one of Suze Orman’s articles on revocable living trusts here.

Bonnie L. Altro is a partner at Altro & Associates, LLP. Her practice focuses on real estate closings, U.S. probate and cross border tax and estate planning.

How Should Canadian Snowbirds Take Title to Arizona Real Estate? It Depends!

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.

The Issues

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.

David A. Altro featured in the Montreal Gazette Monday, February 20, 2012

Tax Strategy: Marriage affects tax exemption on principal home

David A. Altro is a frequent contributor to Paul Delean’s business column in the Montreal Gazette. Click here to view the article online or scroll down to read David’s answers to the second and third questions.

The Gazette
Monday, February 20, 2012

The impact of marriage on the principal-residence exemption and tax obligations in the U.S. for Canadian citizens were among the topics raised in the latest batch of reader letters. Here’s what they wanted to know.

Q: “If two people who own their own homes get married, how does the principal-residence exemption apply?”

A: A couple can designate only one property as principal residence, so marriage has the effect of eliminating the exemption for one of the two properties. If you keep both and real estate continues appreciating, the increase in market value of one property from the time of the marriage has tax implications. If you sell one property before the marriage, that’s not an issue since each partner is entitled to claim the principal-residence exemption for the years they were on their own.

Q: “I have a daughter who is a Canadian citizen but has permanent residency in the U.S. and is married to a U.S. citizen. She’s currently at home raising a daughter, but when she gets employment will she have to pay U.S. taxes and report her income in Canada as well?”

A: No. Cross-border tax expert David Altro says that if she isn’t a resident of Canada, she won’t pay tax to Canada unless she has certain types of Canadian-sourced income.

Q: “About seven years ago, I inherited a home in San Diego where I spend my winters. Am I affected by changes in the maximum tax rate on U.S. property to 55 per cent from 35 per cent?”

A: The tax you are referring to is U.S. estate tax, which applies to your U.S. property upon death. “Under current U.S. law, if you are Canadian, there will be no tax if the property market value is under $60,000 on death,” Altro said. “If above, there will still be no tax if your worldwide estate is under the exemption of $5 million. But on Jan. 1, 2013, the exemption drops to $1 million and the tax rate on U.S. property increases to a maximum of 55 per cent from 35 per cent.” Altro said it could be advantageous owning the property in a cross-border irrevocable trust to avoid taxes and probate costs.

Q: “I have an adult son with Tourette’s and severe OCD (obsessive-compulsive disorder) for whom it was recommended, by a specialized team, to hire a behaviour therapist to work with him at hospital and at home. He is under public curatorship and receives welfare. Since I paid all expenses, can I claim a deduction on my tax return?”

A: The first step should be asking the Canada Revenue Agency for a ruling. Because of the public curatorship, he may or may not meet the definition of dependant. If he does, costs would be deductible (allowable medical expenses for other dependants). There might also be eligibility for the disability tax credit.

The Gazette welcomes reader questions on tax and investment matters. If you have a query you’d like addressed in this column, send it to Paul Delean, Montreal Gazette Business Section, Suite 200, 1010 Ste. Catherine St. W., Montreal, Que., H3B 5L1, or by email to pdelean@montrealgazette.com

© Copyright (c) The Montreal Gazette

David A. Altro Published in STEP Journal – February 2012

Frozen Over
By David A. Altro and Ben Jeske

Estate freezes have been in Canada since the introduction of federal capital gains taxation 40 years ago. Along with the capital gains tax (CGT) on properties sold by taxpayers, the so-called death tax was also brought in. Essentially, when a taxpayer dies, they are deemed to have sold all their assets at fair market value, and will be assessed for CGT on all accrued gains. The estate freeze, in essence, is an attempt to cap the value of the assets owned by a taxpayer that would be subject to the death tax. Therefore, the estate freeze generally involves the conversion or exchange of assets susceptible to capital appreciation for assets that retain a fixed monetary value.

Capping CGT

In the context of a closely held private corporation, the estate freeze consists of the well-known mechanism of the taxpayer exchanging common shares (susceptible to capital appreciation) for fixed-value preferred shares. Immediately thereafter, the taxpayers’ children, or a trust established for their benefit, subscribes for new common shares. Following the completion of the estate freeze, all the corporation’s assets continue to generate income and/or growth for the family – at the level of the shareholders the shares to which such future growth is attributed are the common shares, which are now no longer part of the taxpayer’s property, but are safely in the hands of the next generation. Thus, unless the shares of the corporation are sold to a third party, accrued gains on these shares will not be subject to CGT until the death of the taxpayer’s children. The taxable capital gain being realised on the taxpayer’s death is now capped at today’s current value of the taxpayer’s shares.

Market value

Any one of a number of provisions in the Income Tax Act placed at taxpayers’ disposal allow such share exchanges to take place on a fully tax-deferred basis, but for such common-to-preferred share exchange to be tax-deferred, the taxpayer must ensure the frozen preferred shares they receive have fair market value equal to the value of the exchanged common shares. The safest and surest way of ensuring the frozen preferred shares have the correct value is to:
- obtain an independent valuation of the corporation
- provide an adjustment clause whereby the value of the frozen preferred shares will be adjusted if the tax authorities disagree with the taxpayer on the value of the common shares prior to the freeze; and
- provide that the frozen preferred shares are redeemable at the option of the shareholder.

Where shareholder effectively has a ‘put’ option on the shares, the shares are referred to as being retractable. Canada Revenue Agency is of the view that preferred shares lacking a retraction feature are not worth their stated value.

Accrued gain

When the freeze is complete, the taxpayer’s exposure to the death tax is capped. Now you can look at ways of reducing or eliminating the death tax by reducing the value of the frozen preferred shares held by the taxpayer. Often a taxpayer who implements such a freeze still wishes to draw income from the corporation through either salary or dividends. If the corporation is a Canadian-controlled private corporation and earns investment income, a portion of the corporation’s tax payable on such investment income is added to the corporation’s refundable dividend tax on hand (RDTOH). When a corporation with RDTOH pays taxable dividends to its shareholders, it receives a tax refund of one dollar for every three dollars of dividends paid. Finally, if the corporation sells any of its capital property and realises a capital gain, one-half of the gain is added to the corporation’s capital dividend account and is available for tax-free distribution to the corporation’s shareholders by way of dividends.

Golden opportunity

A well-known provision of the Income Tax Act stipulates when a corporation redeems shares of its own capital stock from a shareholder, the amount paid to the shareholder (less the stated capital attributable to the redeemed shares) is treated as a dividend for all purposes of the Act. This provision affords taxpayers who have implemented estate freezes a golden opportunity to reduce the frozen preferred shares’ value, reducing the eventual death tax.

Whenever the taxpayer would otherwise wish to draw dividends from the corporation, either to extract the corporation’s tax-free capital dividend account, to allow the corporation to obtain its RDTOH refund, or simply to provide personal funds to the taxpayer, redeeming some of the frozen preferred shares is recommended. The taxpayer will be treated as having received dividends, but the value of the frozen preferred shares will be diminished and the eventual death tax reduced.

Price adjustment

While redeeming frozen preferred shares is an excellent strategy for reducing the death tax, if not structured properly, it is fraught with difficulty. For the freeze to be tax-deferred, it is always advisable to include a retroactive price adjustment clause in the valuation of the frozen preferred shares. Although the price adjustment clause ensures a fully tax-deferred freeze, it is dangerous to redeem shares whose value could be subject to retroactive adjustment.

To illustrate this danger, take the example of a taxpayer who holds 100 per cent of a corporation valued at CAD 10 million. To freeze this taxpayer’s estate, they convert their common shares of the corporation into 10 million preferred shares, each redeemable for CAD1, subject to the aforementioned adjustment clause. When the taxpayer wishes to receive a CAD 1 million dividend, it is tempting to have the corporation redeem 1 million frozen preferred shares, reducing the taxpayer’s shareholdings to 9 million preferred shares, and reducing the eventual death tax.

But if the tax authorities subsequently intervene, and successfully assert that the pre-freeze value of the corporation was not CAD 10 million but CAD 14 million, to retain the tax-deferred nature of the freeze, the retroactive price adjustment would be invoked and the frozen preferred shares would be retroactively valued at CAD 1.40 per share. Now, although the taxpayer receives only CAD 1 million on the redemption, they are deemed to have retroactively received the new fair market value attributable to the redeemed shares, namely CAD 1.40 per share. The result is tax on an extra CAD 400,000 dividend that the taxpayer didn’t even receive.

Negative tax consequences also flow if the value of the frozen preferred shares is overstated. Suppose that in the earlier example, the tax authorities successfully assert that the pre-freeze value of the corporation was only CAD 7.5 million, not CAD 10 million – and, therefore, pursuant to the adjustment clause, the frozen preferred shares are retroactively valued at CAD 0.75 per share. When you reconsider the redemption of 1 million preferred shares, the taxpayer was entitled to receive only CAD 750,000. But as they received CAD 1 million they run the risk of being taxed as if they appropriated CAD 250,000 of corporation assets.

Thus, the garden-variety estate freeze, involving the exchange of common shares for frozen preferred shares subject to a typical price adjustment clause, is effective in capping a taxpayer’s CGT on death exposure. If you want to do better, if you want to allow the taxpayer to erode their potential death tax exposure, and if you want to do so without tax risk, a properly structured estate freeze will involve issuing at least two separate classes of preferred shares to the taxpayer on the exchange, one class of which would expressly not be subject to the price adjustment clause.

So, while the Income Tax Act offers an interesting planning opportunity to reduce or eliminate exposure to estate CGT, it also contains traps that could translate in high-tax liabilities if affairs are not carefully arranged.

Creditor protection

Now consider another client concern: protection from creditors. As mentioned, one of the requirements to effect a tax-deferred estate freeze is that the frozen preferred shares must be retractable. While this achieves tax objectives, it places the taxpayer at considerable risk should they subsequently face action from personal creditors. While the constituting documents of all private corporations contain provisions restricting the transfer or seizure of shares, the effectiveness of such restrictions to defeat a creditor is far from certain; and if a creditor succeeds in seizing retractable preferred shares, the creditor can demand payment from the corporation.

As all bankruptcy and insolvency lawyers agree, the time to plan creditor protection is when there are no known creditors, so the implementation of a tax-driven estate plan is the ideal time to plan for protection against future unknown creditors.

Although you cannot remove the retraction feature attached to the frozen preferred shares, other structures can be put in place. One possible solution is to interpose a new holding corporation (Newco) between the taxpayer and the original corporation (Oldco). The taxpayer would own Newco, and Newco would now hold the retractable frozen preferred shares. Generally, as long as the common shareholders of Oldco are related to the taxpayer, the retractable frozen preferred shares could be redeemed in the hands of the Newco on a fully tax-free basis in exchange for a demand note. After the demand note is issued, Newco would recapitalise the note’s value in non-retractable preferred shares. Therefore, while the taxpayer would continue to hold all the Newco shares, its only asset would be the hard-to-realise-upon non-retractable preferred shares of the original corporation.

© Copyright (c) Society of Trust and Estate Practitioners. Article first published in STEP Journal Volume20/Issue1.

Modified Carryover Basis Regime – U.S. Estate Tax for Deaths that Occurred in 2010

On Dec. 17, 2010, President Obama signed into law the Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act. Among other provisions, the Tax Relief Act modified and extended the estate tax provisions of 2010 through Dec. 31, 2012 only, resulting in a retroactive reinstatement of the U.S. estate tax for deaths that occurred in 2010.

For beneficiaries of decedents in 2010, U.S. Congress provided two systems of taxing estates and determining basis of their assets: the decedent’s beneficiaries will have the choice of either applying the federal estate tax or making use of the “modified carryover basis regime.”

Executors of those estates are left to determine the better course.

To do so, especially for valuations of gross estates valued over the new $5 million exclusion, they must take many factors and considerations into account. The beneficiaries will need to choose between receiving an unlimited “step up” and use the available $5 million exclusion or elect out of the U.S. estate tax, chose a limited step up in the taxation basis of the inherited property and, instead allow assets to pass tax-free to the beneficiaries under the modified carryover basis regime with its own basis for exclusions but without the step-up to fair market value upon the date of death.

For income tax purposes, the income tax basis of an asset is the price paid for the property plus the value of certain improvements. In the case of stocks and bonds, the basis equals the purchase price whereas for real estate the basis equals the purchase price plus the value of all capital improvements (special assessments levied during the years of ownership) as well as real estate closing costs.

For the tax years prior to and following 2010, beneficiaries of an estate are entitled to receive a “step up” in the basis of the property they inherit meaning regardless of what the decedent paid for the property, the beneficiaries will inherit the property at the fair market value as of the date of death. So if the decedent paid $500,000 for the real estate and did not make any capital improvements and at the date of death the fair market value of the real estate had increased to $750,000, then the beneficiaries would inherit the property with a stepped up income tax basis of $750,000.

“Modified Carryover Basis Regime”

Only for deaths that occurred in 2010 would the decedent’s beneficiaries have the choice to either take a full step up in basis or use the modified carryover basis regime. If the beneficiaries opt to apply the modified carryover basis rules, then it means that the property will pass at the lesser of:

A) the fair market value on the date of death; or

B) the decedent’s original income tax basis in the property plus the value of certain improvements, but not at the full stepped up basis.

For example, if a decedent paid $300,000 for real estate and did not make any capital improvements to it, and the fair market value at the date of death in 2010 increased to $500,000, then the beneficiaries would inherit the property with a carryover income tax basis of $300,000. However, if the fair market of the value of the property decreased to $200,000 upon the decedent’s date of death, then the beneficiaries’ basis in the property would only be $200,000.

That said, the carryover basis is subject to adjustment under the modified carryover basis rules. Where the decedent is neither a resident nor a citizen of the U.S. (Canadian decedent owning US real estate), the modified basis carryover rules limit the amount of the basis increase to $60,000 (as opposed to $1,300,000 for a US resident/citizen).

Examples of Applying the Modified Carryover Basis Regime to a Deceased Person’s Property

Using the example above, a non-spouse beneficiary can only increase the carryover basis by up to $60,000 so that the non-spouse’s beneficiary’s modified carryover basis will be $360,000 instead of $500,000.

Thus, if the beneficiary sells the property with a modified carryover basis of $360,000 shortly after the decedent’s death for the fair market value of $500,000, then the beneficiary will owe capital gains tax on the net gain of $140,000, which is the difference between the sales price and the non-spouse beneficiary’s modified carryover basis:

$500,000 – $360,000 fair market value modified carryover basis = $140,000 net gain

Contrast this with the sale of the property by applying a full step up in basis, in which case the basis of the property will be stepped up to the date of death value of $500,000 so that the sale will not generate any capital gains taxes:

$500,000 fair market value – $500,000 stepped up basis = $0 net gain

Using the same example, if the property has an original income tax basis of $300,000 but the date of death fair market value has decreased to $200,000, then the basis inherited by the beneficiaries will be $200,000 because the basis cannot be increased beyond the fair market value at date of death.

In light of the above, estate planners who have clients who died in 2010 will have to work with the deceased client’s estate representative to determine whether to make an election provided under the Tax Relief Act.

If the client’s estate is worth less than $5 million, the estate representative generally will not make the election when filing form 706NA “United States Estate (and Generation-
Skipping Transfer) Tax Return: Estate of nonresident not a citizen of the United States”. Doing so will allow the assets of the estate to receive a step-up in basis; and the estate representative will not have to deal with the obscure modified carryover basis rules.

If the client’s estate is worth more than $5 million, the client’s estate representative may opt for the Modified Carryover Basis regime by preparing and filing no later than January 17, 2012 form 8939: “Allocation of Increase in Basis for Property Acquired From a Decedent: To be filed for decedents dying after December 31, 2009, and before January 1, 2011”.

Factors that may provide the estate planner with hints of the best strategy to deploy include:

  • Fair Market Value of the property (i.e. gain or loss vs. Tax basis);
  • Anticipated future sale of the property;
  • Estate tax vs. Capital Gain tax;
  • Canadian deemed disposition at date of death; and
  • The relative size of the estate.

Canadian executors should always seek advice from qualified Cross Border tax and estate Specialists.

David A. Altro interviewed by the Toronto Sun

U.S. property investment pitfalls easy to overcome

The Toronto Sun
November 10, 2011

A growing number of Canadians are tempted by property bargains in the U.S., but are being put off by bad information about the possible tax pitfalls, according to David Altro, a lawyer and author of a book on the subject.

The baby boomer generation is looking for a warm place to retire and being lured by property at bargain-basement levels, making Canadians the biggest foreign investors in U.S. real estate.

“I wrote this book because there is a lot of mis-information out there for Canadians wanting to buy or move to the U.S.,” Altro said, whose Owning U.S. Property The Canadian Way is now into its second edition.

Much of it revolves around the potential tax bill and bureaucratic headaches for family members trying to sort out the estate upon the death of the property owner.

Altro said a lot of these problems can be avoided completely by setting up an irrevocable cross-border trust. That will help provide protection from creditors for your children and get around expensive U.S. laws on probate.

Similarly, placing your property in a trust is also beneficial if either you or your spouse becomes incapacitated. Under U.S. law, if one person becomes incapacitated the property can effectively be frozen and will require a series of costly headaches to un-freeze.

“A trust can’t become incapacitated,” Altro said.

Many property advisers recommend setting up a corporation to hold and manage U.S. property assets, though Altro said that is not tax effective.

Capital gains on a cross-border trust are taxed at about 15%, compared with a rate of more than 40% for corporations in Florida.

Although there are fees involved with setting up such a trust, Altro says “they are very small” compared with the costs of a potential tax bill or legal help to sort out problems once they have occurred.

There may be another upside for Canadians wanting to buy U.S. property. If they choose to become U.S. residents their income tax bills will drop substantially. Altro said the maximum U.S. income tax is 35% and that kicks in on earnings of more than $375,000. In Canada, the high rate is 46% on income of more than $125,000.

But for many that requires obtaining an elusive Green Card. A bill put forward by two U.S. senators eager to promote further investment in the country’s sagging real estate market may put a visa within reach.

The bipartisan proposal put forward last month would grant a visa to foreigners spending at least $500,000 on residential property.

Residential sales of U.S. properties to foreigners and recent immigrants totalled $82 billion in the 12-month period ended March 31, up from $66 billion the previous year, according to the National Association of Realtors. California accounted for 12% of those sales, second only to Florida.