US Tax Reform Considerations for Canadians Owning US Situs Property
Towards the end of 2017, US President Donald Trump signed off on the biggest overhaul of the US tax code in years. The final legislation, known as the “Tax Cuts & Jobs Act” includes several adverse provisions affecting American expatriates living in Canada. On the other hand, changes affecting the average Canadian owning US real property are largely neutral or beneficial. This article addresses some of the provisions affecting Canadians.
The Tax Treaty Exemption
Effective as of January 1 2018, the US estate tax exemption increased from $5.49 million to $10 million. For Canadians who own US property (i.e., US-situs assets), this is welcome news. Yes, the US estate tax can apply to Canadians as it applies to the value of US-situs assets such as real estate and even US-issued equities. For most Canadian decedents, US estate tax should apply only if the current value of their worldwide assets, as of the date of death, exceeds $10 million.
This result is achieved through operation of the Canada-US Tax Treaty (“Treaty”). Article XXIX-B of the Treaty provides a US estate tax exemption in the form of a “prorated unified credit” equal to the exemption amount times the applicable estate tax rate. This credit amount is prorated by the ratio of US assets owned over worldwide assets owned to arrive at the excluded amount.
Unbeknownst to many, the Treaty exemption only applies if an estate tax return is correctly filed on behalf of the deceased and makes reference to Article XXIX-B of the Treaty. Generally, an estate tax return is required if the deceased owned US situs assets valued over $60,000, the filing threshold for which an estate tax return is required. The estate return is due nine months from the date of death. Failure to file an estate tax return can have draconian results. IRS can reduce the basis in estate property inherited to zero, adjusted only after a return is filed. Absent a return, suppose a Canadian inherits property that is sold shortly thereafter for $1 million. The inheritor would have a taxable gain of $1 million unless the estate filed an estate tax return. This rule also effectively bars depreciation deductions on income-producing properties.
Interest Expense Deductions
Tax reform also establishes a limitation on net business interest expense deductions. For a Canadian business that carries a lot of debt, the new limitation prohibits a deduction for interest expense in excess of 30% of the business’ US adjusted taxable income. The limitation does not apply to a business with annual gross receipts of $25 million or less, computed over an average of three years.
Alternative Depreciation System
Real estate investors can elect out of the interest expense limitation but doing so comes with other consequences. Making the election requires the use of the alternative depreciation system (ADS) to depreciate real property. Relative to other depreciation methods, ADS depreciates the cost of assets over a longer period of time, resulting in smaller annual deductions. The overall impact of making the election would enable the entity to claim more interest expense but less tax depreciation per year. (Additional tax reform revisions to ADS decreased the recovery period for residential rental property from 40 to 30 years).
All in all, changes pertaining to the interest expense limitation and to the ADS recovery period may provide some Canadians with tax relief, however it is likely to have little to no effect on the average Canadian owning a US winter residence.
Canadian residents seeking to acquire US property should consider various ownership options and the estate tax implications related to each. Estate tax can be lawfully managed. Of course, the considerations differ for Americans resident in Canada given US taxation is based on citizenship rather than residency. In any event, competent cross border tax advice is critical to avoid unexpected tax outcomes.