Palm Springs Tax and Trust Lawyers

So we're still on a parallel track with our main blog (these will separate again after we complete the FBAR amnesty discussion). We're talking about when a Canadian snowbird can sell an appreciated property (like a property in Indian Wells that has increased in value) and close to simultaneously buy a new property (our Canadian purchases a Palm Desert property), and not pay any tax on the first sale. This is done under IRC Section 1031. What Canadians should take away from this discussion (and the 2 previous blog entries) is its very unlikely Canadians can use 1031 and get the tax free treatment on the sale of the first property. Why so unlikely? Because Canada does not have a tax provision like 1031. So while the Canadian might be able to exchange a US property he or she is using as a rental property (remember, a vacation house won't work probably unless the Canadian snowbird uses it no more than 14 days a year) for another US rental property (must be US, can't be exchanged for a property in another country), and qualify for 1031 on their US tax return, Canada will still tax them immediately upon the sale of the first property. What good are nonrecognition provisions in one country if they are not observed in the other country (and the treaty doesn't mandate Canada honor US Section 1031)? The answer is: no good at all. Canadians buying property in the US must worry about both how the US and Canada taxes the transaction. Canadians, until your government adopts 1031 (or a provision like it), you cannot utilize the favorable treatment of the IRC Section 1031, even for property exchanges in the US.

The remainder of this entry is copied from our general blog on 1031 examples.

Let's do some basic (and not so basic) 1031 examples. Again, before we start, remember that in addition to a rising real estate market (no sure thing the last few years, although in the Palm Springs area we might finally be turning the corner), in order to qualify for 1031 you need property either: held for (a) investment or (b) productive use in a trade or business.
Also remember vacation homes are unlikely to qualify as either: held for (a) investment or (b) productive use in a trade or business, unless the owner or the owner's family uses the vacation house not more than 14 days a year. A property used as rental property will qualify for Section 1031 because the IRS deems rental properties as held for productive use in a trade or business.

Basic 1031 Examples

Here's a basic example (1): Tom purchases a Palm Desert house in 2001 for $500k. Tom sells it in 2006 for $1,000,000. Shortly thereafter in 2006, Tom purchases an Indian Wells home for $1,000.000. In 2012, Tom sells the Indian Wells home for $1,250,000. Assuming the Section 1031 requirements met, Tom's taxable income in 2006 is $0, and Tom's taxable income in 2012 is $750,000.

When the taxpayer receives cash in the transaction, the taxpayer must recognize gain (at least to the extent of the cash received).

Basic example (2): Tom exchanges real estate held for investment (i.e., the general rule is he or his family uses it not more than 2 weeks a year), which he purchased in 2000 for $500,000 which now (in 2012) has a fair market value of $800,000, for other real estate (to be held for productive use in a trade or business) worth $600,000, and $200,000 in cash. The gain from the transaction is $300,000 (Tom bought a property for $500,000 and is now exchanging it for a new property worth $600,000 plus $200,000 in cash), but the $300,000 gain is only recognized to the extent of the cash received: $200,000. Tom must recognize $200,000 in 2012 when he engages in the exchange.

And let's do one more example (with a little more complexity, including two assets transferred (only one of which qualifies under 1031)), plus the question of what is the basis in the new property:

Basic example (3): In 2007, Tom transfers real estate he used exclusively as a rental property which he purchased in 2002 for $1,000,000 in exchange for other real estate (to be held as rental property) which has a fair market value of $900,000, an automobile which has a fair market value of $200,000, and $150,000 in cash. Tom realizes a gain of $250,000 (bought property in 2002 for $1,000,000 and sold it in 2007 for property plus a car plus cash all worth $1,250,000). Tom must recognize (ie pay tax on) the entire $250,000 gain because he received items other than another real property (the car plus the cash) worth a total of $350,000. The basis of the new rental property received in exchange is the basis of the transferred real estate ($1,000,000) decreased by the amount of money received ($150,000) and increased in the amount of gain that was recognized ($250,000), which results in a basis for the property received of $1,100,000. This basis of $1,100,000 is allocated between the automobile and the real estate received by Tom. The basis of the automobile must remain its fair market value at the date of the exchange- $200,000, with the basis of the real estate received being the remainder: $900,000. So at the end of the transaction, the basis in new property is only $900,000 ($100,000 less than the basis in the old property).

Before we show mathematical examples of how a 1031 exchange works, let's look a little more at when a Canadian snowbird may exchange their Palm Springs home (which we are assuming has appreciated in value) for a new Rancho Mirage home, and not pay any US tax. Recall the problem is that home must be "used in trade or business" or "held for investment" in order to be eligible for 1031 tax free exchange treatment. The IRS does not generally view the typical vacation house as either used in trade or business or held for investment. However, the IRS did issue a safe harbor in Revenue Procedure 2008-16, which states that vacation properties may qualify for a 1031 if:
(a) The dwelling unit is owned by the taxpayer for at least 24 months immediately before the exchange; and
(b) Within the qualifying use period, in each of the two 12-month periods immediately preceding the exchange,
(i) The taxpayer rents the dwelling unit to another person or persons at a fair rental for 14 days or more, and
(ii) The period of the taxpayer's personal use of the dwelling unit does not exceed the greater of 14 days or 10 percent of the number of days during the 12-month period that the dwelling unit is rented at a fair rental.
In addition, the replacement property must meet the same requirements for the two years after the exchange (i.e., must be rented out and not used too much for personal use).

But keep in mind, Rev. Proc. 2008-16 is just a safe harbor, you don't have to fit within its confines to get 1031 tax free exchange treatment, right? Well, it is possible for a vacation home to qualify for 1031 exchange even if the owner uses the house more than 14 days a year (for example). But it is the IRS' position that if only the owner (and/or his or her relatives) uses the property (and never rents it out to unrelated individuals), 1031 tax free exchange treatment is not available. And while the IRS' position is not necessarily the bottom line, taxpayers (including Canadian snowbirds) must be prepared for the IRS to challenge any occasion where the taxpayer claiming 1031 tax free treatment does not fit within the confines of Rev. Proc. 2008-16.

So when can the Canadian snowbird unequivocally own an appreciated US property and exchange it for another US property and not pay taxes under 1031? Clearly if the Canadian snowbird bought a Palm Springs house, and does not use it personally and strictly rents it out to (unrelated) individuals, then 1031 treatment is available. That is a good example of where the property is clearly used as a trade or business. What about the other permissible use under 1031: holding for investment? There is no clear test for this. The taxpayer must be prepared to show the primary motive in owning the vacation home is profit, and not personal use. The taxpayer who uses the property a lot personally (even though they may have a big desire for profit) will lose the primary motive is profit argument. A dual goal of personal use and profit will not qualify under 1031. Also, abandoning the house for personal use and then trying to sell it shortly thereafter (and claiming it is now held primarily for investment) is likely not sufficient under 1031 (although holding the property for a while after abandoning it for personal use may work...see Moore v CIR (2007)). In short, the Canadian snowbird must prepared to argue the overwhelming primary motive in buying and holding the Palm Springs home is profit, not personal use. This is very difficult to do (unless the Canadian snowbird or his or her relatives really don't use the property at all). If at all possible, fit within the safe harbor of Rev. Proc. 2008-16.

Next entry, we'll get to the computations....

We've been on a little bit of a break for the busy "season" of February, March and into April. Let's also take a break from talking about the FBAR amnesty program (we will return to this topic shortly).

A question we frequently get comes from a Canadian snowbird who owns (for example) a house in La Quinta. The Canadian then wants to sell the La Quinta property, and purchase a Palm Desert property to take its place. Let's assume, for the sake of discussion, that the La Quinta home the Canadian snowbird is selling has appreciated in value by $500,000 since the snowbird bought the house in 1997 (we will think optimistically).

Question #1- Can our Canadian citizen sell the house in La Quinta (for $500k more than he bought it for) and buy the Palm Desert replacement property without paying any US tax?

The general answer is yes. The nonrecognition provisions of Internal Revenue Code Section 1031 apply to the disposition of a United States real property only if the United States real property is exchanged for other United States real property. But real property located in the United States and foreign real property are not property of like-kind, and therefore do not qualify for Section 1031. So our Canadian snowbird cannot sell the La Quinta house and purchase a Vancouver house and receive Section 1031 nonrecognition treatment.

Question #2- What are the general requirements for a Section 1031 exchange?

In order for a taxpayer (whether American, Canadian, or from any other country) to exchange their property in the US for another property in the US, and not pay tax:

A) The Property must be exchanged for "like-kind" property. "Like-kind" simply means that real property must be exchanged for real property. But Section 1031 also mandates both the relinquished property and the replacement property must be held for productive use in a trade or business or for investment. Thus, the taxpayer cannot exchange into or out of the taxpayer's own personal residence. Vacation homes may qualify if they are rented out by the taxpayer to unrelated persons, or held primarily for investment rather than personal use. The Canadian snowbird needs to watch this requirement carefully. For example, in the 2007 case of Moore v. CIR, the Tax Court held that an exchange of vacation homes did not qualify for nonrecognition under § 1031(a)(1) because neither home was held for investment: "the mere hope or expectation that property may be sold at a gain cannot establish an investment intent if the taxpayer uses the property as a residence." Subsequent to the Moore case, the IRS issued Rev. Proc. 2008-16, which provides vacation properties may qualify for a 1031 if:

(a) The dwelling unit is owned by the taxpayer for at least 24 months immediately before the exchange; and
(b) Within the qualifying use period, in each of the two 12-month periods immediately preceding the exchange,
(i) The taxpayer rents the dwelling unit to another person or persons at a fair rental for 14 days or more, and
(ii) The period of the taxpayer's personal use of the dwelling unit does not exceed the greater of 14 days or 10 percent of the number of days during the 12-month period that the dwelling unit is rented at a fair rental.
In addition, the replacement property must meet the same requirements for the two years after the exchange (i.e., must be rented out and not used too much for personal use). So Canadian snowbirds with a vacation home for(primarily) personal use will have a difficult time taking advantage of Section1031 tax free exchange treatment.

B) It's not as simple as selling your property one day (let's assume for a gain), and buying a replacement property down the road, and not paying tax on the gain. First, the replacement property must be identified not later than 45 days after the sale of the first property. What does it mean to indentify a property? You identify a property in writing, giving the writing to an independent party (a qualified intermediary). Second, the replacement property must be received not later than 180 days after the sale.

We'll pick it up here in our next post, reviewing some examples of how the tax treatment works....

We're speaking about US citizens or residents (and US tax residents can be citizens of any country who happen to stay in the US too long in a given year, with special attention paid to in this blog Canadian citizens who may visit Palm Springs, or Rancho Mirage or Palm Desert long enough for a given year that they are deemed a US tax resident; we are also speaking of citizens of foreign countries who are US green card holders). US citizens and residents must declare to the Department of Treasury their foreign bank accounts (provided they have over $10,000 in aggregate foreign bank accounts/ assets...not a high bar). They must file these information returns (called "FBARs") by June 30 of each year. Many US citizens and tax residents (particularly those who are current or former citizens of another country) are unaware of the FBAR requirement, which was enacted in 2003. That is why the IRS amnesty programs can be so valuable. In 2012, the IRS is again offering a FBAR amnesty program. This is the third such amnesty program. There is no guarantee there will be a fourth.

Structure of the IRS Amnesty Program
Although the IRS has yet to provide (much) specific guidance on the 2012 amnesty program, it will almost certainly follow the framework provided in the 2011 program. So it makes sense to review generally the 2011 program (the "OVDI Program"). Taxpayers who made voluntary disclosures under the 2011 OVDI Program could expect the following penalties/payments:

Path One- the No Questions Asked Path requires the taxpayer to pay 27.5% (for the 2012 program...under the 2011 OVDI Program it was only 25%) of the highest aggregate overseas account balance in the highest year. So if the aggregate overseas account balance in the highest year (when the individual did not file a FBAR) was $2,000,000 (and by the way, when we say highest aggregate overseas account balance we are including the value of overseas assets- such as a house- plus the value of overseas accounts), the individual is volunteering to pay a penalty to the IRS of $550,000 (27.5% x $2,000,000), plus the unpaid income tax (if any), plus penalties for failure to file or pay income tax (if any). So, under Path One, the easy/no risk path, the individual with undeclared overseas accounts (and assets) of $2,000,000 must pay a penalty of $550,000 at an absolute minimum...THIS IS A STIFF AMNESTY PENATLY!!!

Path Two- Opt Out of the 27.5% No Questions Asked Penalty, and Ask the IRS for a Lesser Penalty Path Ahh, this sounds better. Let's ask for a lower penalty than the 27.5% general amnesty penalty (which required a payment of at least $550,000 for a $2,000,000 overseas aggregate account balance above). But here's the catch: you can ask the IRS for a lesser penalty, and they might agree (and the individual might end up owing almost nothing to the IRS)...on the other hand, under Path Two, if the IRS doesn't agree, they can take every penny of your overseas aggregate account balances!!! Quite a gamble under Path Two.

More on the Path Two, and the decision making process which an individual must undertake when deciding between Path One and Two (or not taking part in the amnesty program at all)...in Part III of this series coming up.

In January, the Internal Revenue Service reopened the offshore voluntary disclosure program to help people hiding offshore accounts get current with their taxes. Although details of the 2012 program were not immediately available, the parameters will likely be very similar to the 2011 Offshore Voluntary Disclosure Initiative ("OVDI"). While 2011 OVDI Program seemed straight-forward, it turned out it was anything but straight-forward.

Canadian Snowbirds Who Are US Citizens or Tax Residents Must File a FBAR Annually

US tax citizens or residents (i.e., Canadians who are in the US a little too much in a given year) must file a "FBAR" (a "Report of Foreign Bank and Financial Accounts") annually, provided the US citizen or tax resident has over $10,000 in financial account(s) which are not located in the United States. The term financial account is broadly defined and includes any bank, securities derivatives, or other financial instrument accounts. It also includes any savings, demand, checking, deposit, or other account maintained with a financial institution in addition to certain annuity and life insurance contracts, commodities and precious metals and safe deposit accounts. Canadian snowbirds will likely have no shortage of these back in Canada. The FBAR is filed on a US Treasury Form TD F 90-22.1. The FBAR is filed with the US Department of Treasury by June 30 of the year after the US citizen or resident had a non-US account. The FBAR requirement has been in existence since 2003.

2012 Program Will Likely Be Similar to the 2011 Program

Although the IRS has yet to provide details, it's a fairly safe assumption that the 2012 will look very similar to the 2011 OVDI Program. So, for taxpayers who went through the 2011 OVDI Program, what were the penalties?

Non-Willful Failure to File a FBAR

The general penalty for a "non-willful" failure to file a FBAR for a given year is $10,000 per year.

Willful Failure to File a FBAR
A willful failure to file a FBAR is far more significant. In the case of a willful failure to file a FBAR, the penalty can be as high as 50% of the aggregate balance of the overseas account(s) per year. This is steep. Let's look at this example published last year by the IRS in their 2011 Offshore Voluntary Disclosure Initiative Frequently Asked Questions and Answers (Q&A 8):

We start with an account balance in 2002 or $1,000,000

Year Interest Income Account Balance
2003 $50,000 $1,050,000
2004 $50,000 $1,100,000
2005 $50,000 $1,150,000
2006 $50,000 $1,200,000
2007 $50,000 $1,250,000
2008 $50,000 $1,300,000
2009 $50,000 $1,350,000
2010 $50,000 $1,400,000

If the taxpayers didn't come forward, when the IRS discovered their offshore activities, and the IRS deemed the failure to file "willful", they would face up to $4,543,000 in tax, accuracy-related penalty, and FBAR penalty. The taxpayers would also be liable for interest and possibly additional penalties, and an examination could lead to criminal prosecution.

The civil liabilities outside the 2011 Offshore Voluntary Disclosure Initiative potentially include:

FBAR penalties totaling up to $4,375,000 for willful failures to file complete and correct FBARs (2004 - $550,000, 2005 - $575,000, 2006 - $600,000, 2007 - $625,000, 2008 - $650,000, and 2009 - $675,000, and 2010 - $700,000),

So, if the IRS deemed the failure to file a FBAR was willful in this case, the IRS could impose a penalty of $4,543,000, even though the taxpayer's account was only as high as $1,400,000 (i.e., the penalty is 3 times higher than the highest overseas aggregate account value)!!!

We discuss what constitutes a willful failure to file, and what the 2012 amnesty program offers taxpayers, in future posts. But the key take-away for US citizen/residents with foreign bank accounts is: you better participate in the 2012 amnesty program, because the possible penalties for not filing FBARs are huge.

We've discussed previously how, if the Canadian visitor to Palm Springs is not careful, he or she can inadvertently find themselves subject to US taxation on income earned anywhere in the world (worldwide income). In any calendar year in which a foreign citizen stays in the US over 183 days, the person may become subject to tax in the US on their worldwide income (the person may become a US resident for tax purposes at least for that year, but the US-Canada Tax Treaty does offer potential relief for the Canadian citizen being deemed a US tax resident in this scenario). Also recall that if over a three year period the Canadian citizen is in the US so much that he or she fails the "substantial presence" test (and does not file the closer connection Form 8840...big mistake), the individual may also be considered a US tax resident for that year. On the plus side, even if the Canadian is deemed a US tax resident for the year and the US taxes the Canadian citizen on all his or her worldwide income, there's a good chance Canada will credit most (if not all) the US taxes paid. So for the Canadian who stays a little too long in the US there probably won't be much, if any, double tax between the US and Canada (although the individual could easily end up paying the higher rate of tax between the two countries).

What else does being a US tax resident for a given year mean? Many people are surprised to find out it means you must provide the US Department of Treasury information about all your foreign bank accounts. Well, for the Canadian snowbird visiting the Coachella Valley, there's a good chance most if not all his or her bank accounts are in Canada, so this becomes a significant required disclosure.

US Citizens or Tax Residents Must File a FBAR Annually

US tax citizens or residents must file a "FBAR"( a "Report of Foreign Bank and Financial Accounts") annually, provided the US citizen or tax resident has over $10,000 in financial account(s) which are not located in the United States (which will be a certainty for the Canadian snowbird). The term financial account is broadly defined and includes any bank, securities derivatives, or other financial instrument accounts. It also includes any savings, demand, checking, deposit, or other account maintained with a financial institution in addition to certain annuity and life insurance contracts, commodities and precious metals and safe deposit accounts. The FBAR is filed on a US Treasury Form TD F 90-22.1. The FBAR is filed with the US Department of Treasury by June 30 of the year after the US citizen or resident had a non-US account. That means, in any year in which a Canadian snowbird is deemed a US tax resident, he or she must file a Form TD F 90-22.1 by June 30 of the following year.

What are the Penalties for Failure to File a FBAR?

For a "non-willful" failure to file a FBAR, the penalty will not exceed $10,000 per violation. In the case of a non-willful violation, no penalty should be imposed if the failure is due to reasonable cause and the account was properly reported. We will discuss what constitutes a "non-willful" failure to file in future posts. For each willful violation, the maximum penalty that may be imposed is the greater of $100,000 or 50% of the aggregate value of the non-US account(s) at the time of the violation. THAT'S CORRECT, FAILURE TO FILE A FBAR CAN LEAD TO A PENALTY OF 50% OF THE AGGREGATE VALUE OF THE NON-US ACCOUNT(S) AT THE TIME OF THE VIOLATION!!! Not 50% the taxable amount, 50% of the account balance!!

Wow, for a "willful" failure to file a FABR, the US can (try) to take 50% of the Canadian citizen's account balances of non-US accounts for a given year. As you can see, the potential damage is staggering for the Canadian snowbird who spends a little too much time in Palm Springs (or anywhere in the US) in a particular year or years (if the failure to file is deemed "willful", to be discussed...). There is, however, currently an IRS amnesty program for the non-FBAR filer, which we will discuss in the next post.

So let's get into some real detail on the US estate tax, and how the IRS imposes it on Canadians with homes and other assets in Palm Springs (and the entire US). The estate tax is imposed only on the value of US assets (not the value of worldwide assets) of Canadians (provided they are not "domiciled" in the US). This will be most Canadian snowbird visitors to the Coachella Valley. But is it imposed on every dollar's worth of assets a Canadian dies with in the US? No. Canadians (and Americans) are permitted to exclude a certain amount of assets from the estate tax.

How Much Assets May an American Exclude From the Estate Tax?
For 2011 and 2012, American citizens and residents may exclude their first $5M in worldwide assets (notice the distinction again here as Canadian snowbirds will only be subject to the estate tax on their US assets). What this means generally is that an American who dies in 2012 with $2M is total worldwide assets must recognize $0 estate tax. And, as you will see, a Canadian who dies in 2012 with $2M is total worldwide assets (even if they're all in the US) must also recognize $0 estate tax.

How Much May a Canadian Exclude From the Estate Tax?
If an American can exclude $5M in (worldwide) assets from the estate tax, how much can a Canadian exclude in (US) assets? At least for the year 2012, if a Canadian citizen were to die with worldwide assets of less than $5M, that individual is not subject to the US estate tax. This high (generous) threshold will surely go down in future years. But again, at least in 2012, a Canadian snowbird with worldwide assets of less than $5M and is not subject to the US estate tax (even if all the assets are located in the US).

Ok fine, but what about the Canadian who dies in 2012 with worldwide assets worth 10M and US assets (a house) worth 1M. How much of the $5M exemption available to Americans can the Canadian citizen use? The US Canada Tax Treaty tells us to use a simple mathematical formula to derive the answer- $5M (for 2012) total possible exemption multiplied by a fraction: the numerator of which is the Canadian citizen's total US assets ($1M) and the denominator of which is the Canadian citizen's total worldwide assets ($10M). In our example the formula is: $5M x ($1M / $10M) or $5M x 1/10= $500,000. So the Canadian citizen with a US home worth $1M who dies in 2012 can exclude $500,000 from the US estate tax, but the other $500,000 is subject to the tax. Taxed at a 35% rate means an actual tax paid to the IRS of approximately $175,000. The 35% is a gradual rate maximizing at 35% (taxed at a lower rate for the lower portions of the taxable estate, so the actual estate tax is likely less than $175,000).

And the Estate Tax is Scheduled to Get Much Worse
Note that in 2013, the exemption amount is scheduled to go back down to $1M, and the highest rate of estate tax is scheduled to return to 45%. So after 2012 the US estate tax will likely impact many more Canadians (and Americans).

In a previous post, we introduced the concept that Canadians with property located in the US are potentially subject to the US estate tax upon their death. This is true even though the Canadian snowbird may never spend enough time in the US to make themselves US residents for tax purposes. In fact, this can be true of the Canadian who spends almost no time in the United States. That's because the US levies its estate tax on a foreign citizen's property located in the US. Ultimately, it's the US location of the property that matters. But note, not all property located in the US is included in the estate tax computation.

What's Included?
Canadians are generally subject to US estate tax on their assets located within the US (US "situs property") upon their death. The following types of property constitutes US situs property for the purposes of the US estate tax:
1) All real estate located in the US (this is generally the big one);
2) Tangible personal property located in the US (these are objects which can be moved touched or felt, such as jewelry, boats and art (which the Canadian citizen might hang in their US home));
3) Shares of stock of a US corporation; and
4) Golf Club Memberships.

What's Not Included?
Not all property located in the US is subject to the estate tax. Property located in the US, but not included in the computation of the US estate tax, includes:
1) Money kept in US bank accounts, either checking or savings, up to certain limits (any funds protected by the FDIC is exempt); and
2) Life insurance issued by a US insurer.

Also, very important, nonrecourse debt (debt where the only security is the house; the borrower is not personally liable) is subtracted from the value of the house in determining the value of the total US estate subject to the estate tax. This gets us to an interesting planning discussion on how to best avoid the estate tax, which we will discuss in a later post.

Americans Who Die in 2011/2012 Are Permitted to Exclude Their First $5M in Assets From the Estate Tax
One of the most hotly contested issues in American politics is how much an individual should be able to exclude from his or her estate for the estate tax computation. In 2011 and 2012, the answer is $5M. That means generally that each individual who dies with $5M or under in 2011 and 2012 will owe no estate tax. Note, before 2011 the exclusion limit was $3.5M. It is possible after 2012 the exclusion amount will drop significantly, perhaps to as little as $1M or even $0 (which would mean, if changed to $1M, people who die in 2013 with assets over $1M would be subject to the estate tax ...i.e., it is quite possible in the future a lot more estate taxes will be going to the IRS).

So How Are Canadian Snowbirds Affected by the US Estate Tax?
As we discussed before, the IRS will count the Canadians included assets (see above) in the US estate tax computation. So the real question is, how much of the $5M exclusion amount (again, this amount could go down significantly in the future) can a Canadian citizen (non-US resident) claim? That answer is governed by the US-Canada Tax Treaty, and is the subject of our next post.

Let's take the case where a Canadian citizen is careful not to spend so much time in the United States so that he or she is not considered a US resident for tax purposes. Therefore this Canadian individual is not paying tax in the US on their worldwide income. This individual will still have to pay tax on their "US source income", and this will include rental income from their property owned in the US. So how will the US tax the Canadian citizen who owns property in the US and rents that property out, but otherwise does not spend too much time in the US so as to be deemed a US resident for tax purposes?
Taxation of Rental Income- General Rule
As a general rule, the Canadian who rents out their US property is subject to a 30% withholding requirement of the gross amount of each rental payment. In other words, the general rule on rental income is that 30% of each rental payment made to a Canadian-citizen landlord should be withheld, and forwarded to the IRS. Technically, it is the renter (likely a US citizen) who has the legal requirement to withholding from the rental payments made to the Canadian citizen-landlord. As a practical matter, the IRS will look to both the renter and the landlord for the withholding amount. To the extent the Canadian citizen hires a US property manager (extremely common for the Canadian snowbird), the property manager will be responsible for withholding on the rental amounts and remitting the tax to the IRS. Since the Canadian citizen must also report this amount on his or her Canadian tax return, a foreign tax credit on the Canadian tax return should be available for the US taxes paid, so this should not result in double taxation.
Electing to Pay Tax on the Rental Income Like A US Citizen
The Canadian renting US property, however, has an alternative to the general withholding rule described above. Instead of the general withholding provision, the Canadian may choose to pretend he or she is a US taxpayer. How does this work? The Canadian files a 1040NR tax return. Why file a 1040NR? Because now, the Canadian taxpayer is taxed like a US taxpayer (at least with respect to the rental income from the US property), and that means the Canadian can take deductions against the income just like a US taxpayer does. What kind of deductions? Well, for example, the Canadian taxpayer may deduct property taxes and mortgage interest from the gross rental income. After taking deductions, the rental income may result in little to no taxable US income. Choosing this route will likely lead to the Canadian paying less US taxes because under this scenario only the rental "profits" are taxed in the US (and not the gross rental amount). The 1040 NR (together with a Schedule E for rental income) should be filed by June 15 of the year after receiving the taxable rental income. For property located in California, the Canadian taxpayer would also file a Form 540NR.

Many Canadians who own homes in the Coachella Valley (or anywhere in the US) will not be subject to US income tax (other than with respect to their US source income), because they do not spend enough time in the US to be considered a US resident for income tax purposes. We have bloged about this topic in prior posts. But just because a Canadian citizen is not generally subject to US income taxes does not mean that, upon the Canadian citizen's death, their estate will not be subject to US estate tax on their US house and other US property. Let's look at this topic in detail....

When Are Canadians Subject Generally to the US Estate Tax?

As with any non-US citizen/ resident, Canadians are generally subject to US estate tax on their assets located within the US (US "situs property") upon their death. The following types of property constitutes US situs property for the purposes of the US estate tax:

1) All real estate located in the US;
2) Tangible personal property located in the US (these are objects which can be moved touched or felt, such as jewelry, boats and art (which the Canadian citizen might hang in their US home));
3) Shares of stock of a US corporation.

When are Canadians Subject to the US Estate Tax on All Assets they Own Worldwide?

It's one thing to be subject to the US estate tax on your assets located within the US, but under certain scenarios non-US citizens can also be subject to the US estate tax on their worldwide assets! How is this possible? When a foreign citizen is considered "domiciled" in the US, they become subject to the US estate tax on all their worldwide assets. Canadian visitors to the US are unlikely to be considered "domiciled" in the US, as this is a subjective test which requires that the Canadian be in the US with the intent not to return to Canada. Obtaining a US green card, for example, is considered a strong factor in showing an intent not to return to Canada. But the typical Canadian snowbird, down frequently to the US in winter months but with no interest in moving from Canada permanently, will have no concern with having the US estate tax imposed on their worldwide assets (but will, of course, have to prepare for an estate tax on their US situs property).

What Rate of Tax Must Canadians Pay on Their US Estates?

There are many variables to this question. There are several exclusions to discuss, and the US-Canada Treaty plays a significant role. Let's leave the discussion of the numerous variables for future posts, and keep it simple for now. Maximum rates and dollar levels of exclusions (some of which Canadians may be eligible for, to be disscused in future posts) have varied significantly in recently years. In 2011, US citizens my may exclude the first $5 million from their estate tax calculation, and the maximum rate is 35%. So, in simple terms, a US citizen who dies in 2011 with an estate worth $15 million must pay an estate tax of $3,500,000 (15,000,000- $5,000,000 (max exclusion)= 10,000,000; $10,000,000 x 35%= $3,500,000). Note that in 2010, however, the maximum exclusion was only $1,000,000. So the exclusion amounts and maximum rates may change from one year to the next. Again, there are many variables to discuss here, especially as the US estate tax applies to Canadian citizens. We will examine this in more detail in future posts.

Let's stay with the effectively connected to a US trade or business concept discussed in the previous post. As discussed in the previous post, there exists very little guidance as to what it means to be engaged in a US trade or business. If a nonresident alien makes sales within the US, this may be considered a US trade or business. A nonresident alien may be considered to have a US trade or business if the nonresident has employees or agents who regularly travel to the US to make sales visits, or if he employs employees who make presentations in the US, or generally solicit business in the US.

Corporations are more likely to be considered doing business in the US if they have a "permanent establishment" in the United States. The term "permanent establishment" includes:
(a) a place of management;
(b) a branch;
(c) an office;
(d) a factory;
(e) a workshop; and
(f) a mine, an oil or gas well, a quarry or any other place of extraction of natural resources.
A Canadian corporation may also be deemed to have a US permanent establishment if it performs services in the US through an individual present in the US for 183 days or more in any 12-month period for one project or a series of connected projects for US customers.

Canadian individuals who conduct business in connection with a "fixed base" may also be subject to US effectively connected income tax. For example, a Canadian doctor using a US hospital's examining room once a week to examine patients might be considered to be conducting business in connection with a US fixed base.

Tax Implications of Effectively Connected
If the Canadian citizen is engaged in a US trade or business, the individual is taxed by the US on the income which is effectively connected with the US trade or business. The effectively connected US income is taxed in the same manner as business income of a US citizen-resident (i.e., standard ordinary US income rates (currently 35% maximum federal rate for an individual). This is an ongoing test, which means that the conducting of a US trade or business at any time during the year will subject the taxpayer to US taxation. However, the Canadian citizen engaged in a US trade or business can also claim normal deductions which would typically be available to the US taxpayer. More importantly, Canadians doing business in the United States may not be liable for tax in both Canada and the United States, because the US-Canada Tax Treaty will likely remove the double tax via the credit system (to be discussed in a later post).

Don't Forget About California State Tax
Canadian citizens doing business in California also have to consider California tax issues that may arise as a result of their "nexus" to the state of California. As a general matter, states are not bound United States tax treaties, so the California state may tax may not be alleviated by the US-Canada Tax Treaty. We will discuss California state issues in detail in future posts.

Canadian citizens who have not inadvertently become US residents must still pay certain taxes in the US. What sort of taxes are these? First, remember we are assuming the Canadian citizen merely visits the US frequently, but at no point becomes a US resident. There are 2 basic types of categories of income to consider: (A) income effectively connected to a US trade or business; and (B) income not effectively connected to a US trade or business, but stemming from a US source.

Effectively Connected to a US Trade or Business

What does it mean to have income "effectively connected to a US trade or business". If a non-US resident conducts a US trade or business, the effectively connected US income is taxed in the same manner as business income of a US citizen-resident (i.e., standard ordinary US income rates (currently 35% maximum federal rate for an individual, but with normal deductions available as well)). There exists very little guidance as to what it means to be engaged in a trade or business (see IRC Section 864 generally). For example, a non-US resident individual merely collecting interest or dividends from a US payer is likely not engaged in a US trade or business. However, if a foreign taxpayer conducts US business activities through an office located in the United States, that may rise to a US trade or business. When sales of products are consummated in the US, they are generally effectively connected to a US trade or business. Although there is no bright-line test, the threshold for conducting business in the US is low, so typically some business conducted in the US will qualify as effectively connected income.

Noneffectively Connected Income But From a US Source

Non-US resident citizens are also taxed on their noneffectively connected income, provided the income is US source income. There is a big difference in the tax treatment of effectively-connected income (to a US trade or business) versus noneffectively connected income from a US source. Canadians with income effectively connected to a US trade or business are generally treated like US citizens (income at ordinary US rates plus deductions). But for non-effectively connected income, the general rule provided in under IRC Section 871(a) is that the nonresident is subject to a flat 30% tax on US source income (no deductions available here). However, the US-Canada Treaty (as do many US tax treaties) generally reduces the rate on many types of US source income. The various types categories of income addressed in the treaties (subject to the flat tax lowered by the treaties include the following):

1) Interest income

2) Dividend income

3) Rents (watch the distinction here between rents connected to the active management of property (ie, effectively connected to a US trade or business taxed at ordinary US rates) versus the passive receipt of rent, subject to the flat tax and the lower rate provided by the treaty.

4) Pensions and other Retirement Plan Distributions

5) Capital Gains

6) Income from services performed in the US (almost always deemed effectively connected to a US trade or business and taxed at ordinary US rates).

We discuss each of these categories individually, and the US-Canada Tax Treaty treatment of them, in the next post......

California residents are subject to California state income tax on all income regardless where earned. Frequent visitors to California who are not deemed California residents are only subject to California state income tax on their California source income. So the stakes are big when determining whether one is a California resident.

Under California law, a person who stays in the state for other than a temporary or transitory purpose is a legal resident, subject to California taxation. Basically, brief vacations or transactions, such as signing a contract or giving a speech, constitute temporary or transitory purposes that do not confer residency. Every other kind of visit can confer such a status, including coming to California for health reasons, extended stays, retirement or employment that requires a long or indefinite period to accomplish.

How does the Franchise Tax Board determine whether a visit has a temporary or permanent purpose? It applies the "Closest Connection Test." This refers to the state with which a person has the closest connection during the taxable year. For the FTB, this literally means counting all the California contacts a person has and comparing that number with the non-California contacts. Of course, some contacts simply weigh more than others. A job or real estate ownership indicates a closer tie than merely enjoying a round of golf at a country club or a concert at the McCallum. The weightiest factors for residency are:

• Amount of time you spend in California versus amount of time you spend outside California.
• Location of your spouse/RDP and children.
• Location of your principal residence.
• State that issued your driver's license.
• State where your vehicles are registered.
• State in which you maintain your professional licenses.
• State in which you are registered to vote.
• Location of the banks where you maintain accounts.
• The origination point of your financial transactions.
• Location of your medical professionals and other healthcare providers (doctors, dentists etc.), accountants, and attorneys.
Location of your social ties, such as your place of worship, professional associations, or social and country clubs of which you are a member.
• Location of your real property and investments.
• Permanence of your work assignments in California.

This is only a partial list of the factors to consider.

So What is a Frequent California Visitor (aka, a "snow bird") of California to do?

First, know the rules for keeping your status as a part-time resident. Snow birds have a presumption of nonresidence if they follow certain guidelines. The total amount of time you spend in California during the year has to be less than 6 months. You can own a vacation home (but it should probably be smaller or of less value than your main out-of-state residence). You're allowed to have a small local bank account to handle your financial needs related to your stay. Your can have a membership in a local country club. Limit your California contacts to these, and you will probably avoid a lengthy audit, form or no form.

Second, lower your local profile. The State of California doesn't know you're here unless you or the financial institutions you deal with let them know. For instance, any interest generated on your local bank account gets reported to the State of California as a form 1099. You can fly under the State of California's radar by opening a non-interest bearing account. It may cost you a few bucks in interest, but it may avoid an expensive residency audit. Given the ease with which you can access funds across state lines nowadays, it may not even be necessary for you to open a local account.

Similarly, a lot of part-time residents like to have local brokerage accounts. It seems free time and sunshine go together with playing the market. The problem arises when stock in a local account issues dividends, which get reported to the State of California. You should consult your broker concerning ways to avoid this. Again, because of the ease of trading stock nowadays, the broker may be able to hold the stock for you in an out-of-state affiliate of his office, or you can forget about brokers and trade online (you didn't hear that from me). At the very least, have all brokerage statements sent to your out-of state address. The same is true for bills from all local professional services.

We are continuing with our series on how the US taxes non-US citizens who visit the US regularly. In the Palm Springs area for instance, we frequently see Canadians who maintain a local property for a good chunk of the winter months. For those Canadian citizens who are not lawful US residents, and do not have a green card, they must stay mindful of the amount of days actually spent in the US. An individual who establishes a "substantial presence" in the United States can make him or herself subject to US tax on their worldwide income (i.e., a potential tax on income of a foreign citizen which otherwise has no connection to the United States). An individual has a substantial presence in the US if the individual is present in the US at least 31 days during the current year and at least 183 days for the three-year period ending on the last day of the current year, using a weighted average approach. The mechanics of this test were discussed in Part I of this series. Even if an individual establishes a substantial presence in the US in a given year, that person can still avoid being subject to US tax by declaring a "closer connection" to a tax home in another country. To accomplish this, the foreign citizen individual must file a Form 8840 with the IRS (the "Closer Connection Exception Statement").

Even if the individual meets the substantial presence test, the individual can be treated as a nonresident alien (and not pay US tax on their worldwide income) if the individual:
1) is present in the United States for less than 183 days during the year;
2) maintains a tax home in a foreign country during the year, and
3) has a closer connection during the year to the tax home in the foreign country.

Tax Home The tax home of an individual is first and foremost the location of his regular place of business, employment or post of duty regardless of where the individual maintains his family home. If the individual is not engaged in any business, the visitor's tax home is his regular place of abode.

Closer Connection A frequent visitor to the US will be considered to have a closer connection to another tax home (e.g., Canada) if he maintains more "significant contacts" with the other country and not with the US. Other factors considered in making the closer connection determination include the location of the individual's main residence, where the person's family resides, personal belongings, routine banking activities and organizations to which he belongs.

An individual is not eligible for the closer connection exemption if any of the following apply:

1) The individual was present in the United States 183 days or more in the most recent calendar year.
2) The individual was a lawful permanent resident of the United States (a green card holder).
3) The individual has applied for, or taken other affirmative steps to apply for, a green card; or have an application pending to change your status to that of a lawful permanent resident of the United States.

The Closer Connection exemption is available only to those individuals who file the Form 8840 Closer Connection Exception Statement by June 15 for the previous calendar year. Again, the purpose of the Form 8840 is to demonstrate to the IRS that although an individual spent too much time in the United States so as to pass the "substantial presence" test, he or she should be exempt from US tax on their worldwide income because the person has a closer connection to a country other than the US. Part IV Form 8840 asks a series of questions designed test the closer connection assertion. The form asks questions such as: (a) where is your family located; (b) where is your automobile located and registered; (c) where is your driver's license issues, etc. These questions are likely easily answered favorably for the Canadian citizen who truly is merely a regular visitor to the US, but might have stayed a little too long.

Next, we start a series directed at snowbirds generally, specifically with an eye towards our Palm Springs/ Coachella Valley visitors who hail from Canada.

The United States taxes its citizens and residents on income they earn anywhere in the world ("worldwide income"). Non-US citizen or residents are only taxed in the US on income which is "effectively-connected" to a United States trade or business or on non-effectively-connected business income which is deemed to come from a "US source." Does this mean Canadian citizens who are deemed US residents will pay tax twice on the same income (once in Canada and once in the US)? Not necessarily. Canadian citizens resident in the US will generally receive a credit on their Canadian taxes for taxes paid in the US, but not always (so double tax is possible). If you are a Canadian citizen who is merely a frequently visitor to the area, you must be careful not to inadvertently be deemed a US resident.

Individuals who are not citizens of the US may be considered US residents for tax purposes (and therefore taxed on their worldwide income) if any of the following tests are met:

1) The individual has a green card;

2) The individual becomes a lawful permanent resident of the US; or,

3) The individual has a "substantial presence" in the US.

The substantial presence test is the test of which many frequent visitors to the US must be aware. An individual has a substantial presence in the US if the individual is present in the US at least 31 days during the current year and at least 183 days for the three-year period ending on the last day of the current year using a weighted average approach (the weighted average approach works as follows: the number of days spent in the US in the current year are given full weight; the number of days spent in the US in the last year are multiplied by 1/3; and the number of days spent in the US two years ago are multiplied by 1/6....add up the total for the three years and if it equals or exceeds 183 days, the nonresident alien has a substantial presence in the US. For example, an individual who spent exactly 124 days in the US this year and the previous two years would have a total of 187 days under the substantial presence test:

This Year: 124 x 1= 124

Last Year: 124 x 1/3= 42

2 Yrs Ago: 124 x 1/6= 21

Total= 187 days. Substantial presence test of 183 days exceeded...this person could be deemed a US resident, subject to tax in the US on their worldwide income).

Even if an individual satisfies the substantial presence test in a particular year, the individual can still avoid being considered a US resident if the individual is present in the US on fewer than 183 days in the current year, and the individual has a tax home in a foreign country to which the individual has a closer connection than to the United States (e.g., Canada). But for those who pass the substantial presence text and hope to avoid US taxes by declaring a closer connection to another country, that individual must file an IRS Form 8840.

More on this process to follow in Part II.