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As 2012 draws nearer to a close, we should all keep in mind that the opportunity for maximum estate and tax planning may also be drawing to a close. What are we talking about? Let’s look at the estate and gift tax changes which are scheduled to change at the end of 2012:

1) The $5,000,000 lifetime estate and gift tax exemption amount (actually $5,120,000) in 2012 is scheduled to revert to $1,000,000 in 2013.

2) The highest estate tax rate is 35% in 2012, which is scheduled to revert to 55% in 2013.

There’s no guarantee the estate/gift tax exemption will be $1,000,000 in 2013, or that the highest rate of estate tax will be 55% in 2013. But these are what’s scheduled, and absent an agreement from Congress, this is what we’re getting,

So how we can take advantage of what is scheduled to occur?

Suggestion 1- Make Gifts This Year (2012)

Obviously we’re talking about very wealthy people here. But if you have millions of dollars, you want to take advantage of every dime of that high $5,120,000 2012 exemption before it goes away. How do you do that? Recall that the estate tax exemption and the gift tax exemption basically operate in unison. So what the affluent person can do now is make a gift (let’s say to a relative but it could be to anybody). So the affluent individual makes a gift to his daughter (that’s probably who would inherit much of his estate anyway) in 2012 in the amount of $5,120,000. Now the wealthy individual has lowered his estate by $5,120,000 by giving that amount to the person to whom it was going to go to upon his death anyway. And because he did it in 2012, with a high estate/gift tax threshold, he was able to do it with no tax consequences. Imagine, on the other hand, if he didn’t make the gift in 2012, but instead held on to the money and then passed away in 2013. Upon his death the $5,120,000 still goes to his daughter (under the Will), but under this scenario (with only $1,000,000 in the estate tax exemption in 2013), $4,120,000+ is subject to the estate tax (which is taxed at maximum of 55% in 2013= over $2,000,000 in estate tax). So by not making the gift to daughter in 2012, the wealthy individual’s estate lost over $2,000,000 to the IRS.

Suggestion 2- If you Have Loans Outstanding to Family Members in 2012- Consider Forgiving Them (This Year)

Somewhat in line with Suggestion 1, if you are an affluent individual who has loans outstanding to you children, consider forgiving the loans (and making them gifts to your kids). Again, for the affluent, 2012 is potentially a very good year to make gifts to family members.

Suggestion 3- Put the Gifts For the Family Members into a Trust First

Again, it’s a good year for gifts to individuals who would inherit from you anyway. Why put the gifts in a trust 1st? Well, for starters, if the individual’s daughter has trouble with creditors (or if the individual’s daughter gets divorced and we don’t want the ex-husband getting any of the gift) those gifts (to the family members) are protected (unlike the outright gift). Also, this allows the wealthy individual to pay the tax on the growth (the interest/income component) instead of the daughter.

Other really interesting gift opportunities exist when gifting an interest in an LLC or partnership, where the gifts can actually be well above the $5,120,000 and still exempt (due to the discounting of interests in entities due to lack of marketability and for minority interests).

Last Question- Any Chance 2012 Gifts of $5,000,000+ Will Be Deemed Not Exempt in Later Years?

This is the question of the clawback. $5,120,000 is the exemption amount in 2012, but will the IRS retroactively deem that the $5,000,000 gift of 2012 was not entitled to the full exemption? There is no indication this will occur (although some practitioners do worry about it). For now, we say gift away, at least for the rest of 2012!!!

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So we’re on to Part 2 on this topic. Here, we’re talking about a US citizen who owns a California home (maybe in Palm Springs), but lives in Illinois.

Presumptions Generally

Let’s review the FTB’s presumptions on time spent in California. If you spend more than 9 months (in a calendar year) in California- you are presumed to be a California resident that year (but you can rebut it by going to the checklist). You can find this presumption in Cal Rev. & Tax Code §17016. There is also a lesser presumption (found in regulations as opposed to the Cal Rev and Tax Code) which provides if you are present in California less than 6 months a year, you are presumed to not be a California resident. This “lesser” presumption is found at 18 Cal. Code of Regs. §17014(b). I consdier it a lesser presumption since it comes from the Cal tax regs and not the Code (unlike the 9 month presumption). There is no presumption if you are present in California between 6 months and 9 months. But in all events, you still must go back and review the checklist.

Make Sure to RE-Review the Checklist

We must re-review the checklist of items the FTB looks at from Part 1 of this topic (e.g., location of your spouse/RDP and children; location of your principal residence; where your vehicles are registered; where you maintain your professional licenses, etc.). The FTB may still deem the American from another state (Illinois) a California resident if they have enough checks in the wrong category, even though that person does not spend more than 6 months a year in California.

What Does it Mean For the American From Another State to Be Deemed a Resident of California?

It’s significant. It means that California will tax the individual up to 9.3% of the income they earn anywhere in the world.

What Taxes Must the American Who Is Not Deemed a Resident of California Still Pay to California?

Here were talking about owing tax to California solely on California source income. So what are we talking about here?

Gain From the Sale of California Real Property- A big one. You sell your California vacation house, you owe tax in California. Count on 9.3% of the gain on the property (i.e, buy for $300,000, sell for $500,000, its 9.3% x $200,000= $18,600 in tax to the state of California). You’re still going to owe tax to the IRS on top of this. By the way, upon the sale of your house, the buyer must withhold from you (the out of state seller, or the in state seller for that matter) either: 3.3% of gross sales price ($500,000 x 3.3%= $16,500); or 9.3% of the gain ($18,600), and send it in directly to the FTB. You, as the seller, can choose the withholding amount (you should choose the lower amount).

We’ll talk about the tax on other sources of California income in Part 3 of the series.

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So we’re on to Part 2 on this topic. Here, we’re talking about a Canadian citizen who owns a California home (let’s say in La Quinta for example), and the likelihood that person is deemed in a California resident for tax purposes. Again, in fairness, it’s going to be highly unlikely the FTB (the California Franchise Tax Board…basically the IRS for the State of California) deems a Canadian citizen a California resident in a given year, because most Canadians are here on a B-2 Visa (they may not even be aware of this fact), where they simply show the US officials at the border their passport and they’re permitted entry in the US. Under the standard B-2 tourist Visa, the Canadian citizen is only legally permitted to stay in the US up to 6 months in a calendar year. Unless the Canadian citizen is violating the terms of the B-2 Visa (not a good idea, it could be hard to get into the US the next time), or is in the US on a visa other than a B-2 where the Canadian is permitted to stay in the US more than 6 months (like a work related visa), or the Canadian is a dual Canadian-US citizen or has a US green card (permitting the Canadian citizen to stay the entire year in the US if he or she likes), it’s difficult for the Canadian (in California less than 6 months) to be deemed a California resident. But not impossible. We must re-review the checklist of items the FTB looks at from Part 1 of this topic (e.g., location of your spouse/RDP and children; location of your principal residence; where your vehicles are registered; where you maintain your professional licenses, etc.). The FTB may still deem the Canadian a California resident if they have enough checks in the wrong category, even though the Canadian does not spend more than 6 months a year in California.

Presumption Generally

Let’s review the FTB’s presumption on time spent in California. If you spend more than 9 months (in a calendar year) in California- you are presumed to be a California resident that year (but you can rebut it by going to the checklist).

What does it Mean For a Canadian to Be Deemed a Resident of California?

It’s significant. It means that California will tax the individual up to 9.3% of the income they earn anywhere in the world. And the key part is there will be no credit available in Canada on these taxes (unlike federal taxes imposed by the IRS). In addition, California does not allow a foreign tax credit or foreign earned income exclusion. There is no treaty or credit system between states and countries or states and provinces.

But it’s Unlikely a Canadian Will Be Deemed a California Resident, So What California Taxes are Canadians Much More Likely to Owe?

Instead of owing 9.3% on the income the Canadian earns anywhere, it is far more likely the Canadian will owe tax, as a nonresident of California, solely on their California source income. So what are we talking about here?

Gain From the Sale of California Real Property– A big one. You sell your California vacation house, you owe tax in California. Count on 9.3% of the gain on the property (i.e, buy for $300,000, sell for $500,000, its 9.3% x $200,000= $18,600 in tax to the state of California). You’re still going to owe tax to the IRS on top of this. By the way, upon the sale of your house, the buyer must withhold from you (the Canadian seller) either: 10% of the gross sales price ($50,000 in our example above); or 9.3% of the gain ($18,600), and send it in directly to the FTB. You, as the seller, can choose the withholding amount (you should choose the lower amount). The withholding amount isn’t the final tax you owe, it’s just the state of California’s insurance policy that you won’t shuffle back to Canada without paying the California tax. It’s a security deposit if you will.

We’ll talk about the tax on other sources of California income earned by the Canadian, like wages earned in California, business income earned in California, and California interest and dividends, in Part 3 of the series.

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It’s going to be harder for most Canadian snowbirds visiting California to be deemed California residents than it is Americans from other states to be deemed California residents, but it’s not impossible. The biggest reason for this is most Canadian snowbirds are in California (and the US) on a B-2 tourist visa, which means the Canadian snowbird (unlike other Americans) cannot be in California longer than 6 months in a calendar year (without violating their visa). Also, as the Canadian snowbird reviews the checklist below, it appears less likely (although not impossible) somebody who lives permanently in Canada could have too many negative checks on the checklist. On the other hand, the test for California residency is in some ways more dangerous to the Canadian snowbird than the test for US residency. Why? Because if the Canadian snowbird fails the test for US residency in a given year (we’ve discussed the test in prior blog entries), they could still fall back on the US-Canada Tax Treaty, which contains tie-breaker provisions between the two countries- which would probably lead to the determination that the Canadian who failed the US residency test (i.e., was in the US too much in a given year) was still a resident of Canada (and not the US) in a given year. California has no treaty with Canada (no US state does). So there isn’t any treaty to save the day for the Canadian who is deemed by the State of California to be a California resident in a given year.

The rest of the analysis for the Canadian snowbird is the same as it is for Americans from other states visiting California…

General Rules on California State Taxes

Let’s start with some general principles of California state taxation:

Residents of California- are taxed on ALL income, including income from sources outside California. A California resident is any individual who meets any of the following:
• Present in California for other than a temporary or transitory purpose.
• Domiciled in California, but outside California for a temporary or transitory purpose.

Domicile means the place where you voluntarily establish yourself and family, not merely for a special or limited purpose, but with a present intention of making it your true, fixed, permanent home and principal establishment. It is the place where, whenever you are absent, you intend to return.

Nonresidents of California- are taxed only on income from California sources. A nonresident is any individual who is not a resident.

Part-year residents of California- are taxed on all income received while a resident and only on income from California sources while a nonresident. A part-year resident is any individual who is a California resident for part of the year and a nonresident for part of the year.

California Has a High State Income Tax

Individuals from other states and other countries will want to avoid being deemed a California State Tax Resident. Why? Because California state taxes are not low. For 2102, the highest rate of tax (for individuals earning over $98,000 approximately) is 9.3%. That’s in addition to the federal income taxes (with a high rate of 35%). So this is a high state income tax, no question.

How Does the FTB (the California Franchise Tax Board) Determine Whether an Individual is a California Tax Resident?

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.

Factors to consider are as follows:
• 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.

So a determination of residency, at first instance, is a balancing test. Again, not all factors are created equally. A job or real estate ownership indicates a closer tie than merely enjoying a country club membership.

There’s a lot more to discuss regarding California income tax, including how nonresidents are subject to tax on their California source income, in our next post….

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We next start a detailed series on the consequences of, and how to avoid, being deemed a California state resident for state income tax purposes. We will track this discussion on our Canadian Snowbird blog.

General Rules on California State Taxes

Let’s start with some general principles of California state taxation:

Residents of California– are taxed on ALL income, including income from sources outside California. A California resident is any individual who meets any of the following:
• Present in California for other than a temporary or transitory purpose.
• Domiciled in California, but outside California for a temporary or transitory purpose.

Domicile means the place where you voluntarily establish yourself and family, not merely for a special or limited purpose, but with a present intention of making it your true, fixed, permanent home and principal establishment. It is the place where, whenever you are absent, you intend to return.

Nonresidents of California– are taxed only on income from California sources. A nonresident is any individual who is not a resident.

Part-year residents of California– are taxed on all income received while a resident and only on income from California sources while a nonresident. A part-year resident is any individual who is a California resident for part of the year and a nonresident for part of the year.

California Has a High State Income Tax

Individuals from other states and other countries will want to avoid being deemed a California State Tax Resident. Why? Because California state taxes are not low. For 2102, the highest rate of tax (for individuals earning over $98,000 approximately) is 9.3%. That’s in addition to the federal income taxes (with a high rate of 35%). So this is a high state income tax, no question.

How Does the FTB (the California Franchise Tax Board) Determine Whether an Individual is a California Tax Resident?

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.

Factors to consider are as follows:
• 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.

So a determination of residency, at first instance, is a balancing test. Again, not all factors are created equally. A job or real estate ownership indicates a closer tie than merely enjoying a country club membership.

There’s a lot more to discuss regarding California income tax, including how nonresidents are subject to tax on their California source income, in our next post….

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As a California property owner, you have the right to appeal the amount of your property taxes. You can use an attorney to represent you in your appeal, or you can do it yourself. Property taxes are assessed (and appealed) on a county-wide basis in California, so for those of us in Riverside, Banning/Beaumont and the Coachella Valley (Palm Springs, Rancho Mirage, Palm Desert, Indian Wells, etc.), our appeals are handled in Riverside County.

Am I really Challenging The Amount of My Taxes?

Actually no, what you are really challenging is the Riverside County Assessor’s enrolled value of your property.

Appeals Generally

First of all, there is a chance (maybe unlikely) you can change your assessed value without even appealing. You can try contacting your Assessor and make the case informally. Absent a glaring mistake or omission by the Assessor, that’s probably not going to work. So you can file an appeal with your local appeals board (for us in the Palm Springs area, this means the Appeals Board of Riverside County). Again, an attorney is not required, but property tax appeals frequently include legal issues, and attorneys are used to the appeals process (they do many of these), so it’s not the worst idea. And by the way, the appeals process (with the Riverside Board) is going to take a while, in fact you can count on months (maybe 6 to 8 months until your hearing).

What Kind of Appeal Do You Want to File?

Decline in Value Appeal– Very common. You believe your property is no longer worth as much as the assessed value. If you are filing a decline in value appeal, you must file your appeal as follows:

If you received your assessment in the mail by August 1- you must file your appeal between July 2 and September 15.

If you did not receive your assessment in the mail by August 1 (you received it later)- you must file your appeal between July 2 and November 30.

Base Year Value Appeals– A little different than a decline in value appeal. Here, what you’re auguring is that there should be a change in your property’s “base year value”, because (for example) a change in ownership of the property occurred, or perhaps there has been a change to the structure of the property (you added a garage). The concept of a base year value, of course, stems from California’s Proposition 13. Under Proposition 13, once a base year value has been established (for example, when you buy a previously owned house, the property has now undergone a change in ownership, and a new base year value is established), the property value (for tax purposes) can only go up a small percentage each year. We’ll speak more of Prop. 13 in detail in later blog posts.

Calamity Reassessment Appeal– A natural disaster has affected the value of your property (so a reassessment is required).

What Kind of Evidence Can You Present?

Obviously, most people will want to show evidence that their property is not worth what the assessor believes. The best evidence will be sales of houses which are comparable to yours (e.g., in your area, of like size, etc.). While the Appeals Board will consider this evidence, the only “comps” which generally count for their purposes are the sales that occurred between January 1 and March 30 of the year in question (sales prior to Jan 1 can be considered as well, but must be adjusted for elapsed time). You may wish to consider getting a formal appraisal (although evidence of three comparable sales of home sales in your area (within one mile radius of your home), of (generally) the same size and condition, will generally suffice.

For more information on the Riverside County Property Tax Assessment Appeals Process, give us a call.

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We’ve written before about Canadians being subject to the US estate tax. We know that a Canadian (or any non-US domiciled (also not a US citizen) individual) can be subject to the US estate tax on the value of some of their US property when they die. What property are we talking about? Mainly the value of their US house(s)/ real estate, and furnishings in the house(s), and (and this is important)- the value of their US securities (stock of US companies). US securities count no matter where the Canadian holds the stocks, but there is an exception for the US securities held by a Canadian mutual fund (but note, there is no exception for securities held by the RRSP of a Canadian…the value of US securities held in those count).

How Much May a Canadian Exempt From the US Estate Tax?

Recall that this year US citizens/or residents can exempt $5M from their US estate tax computation (that’s a good deal for Americans, but on other hand they are subject to the US estate tax on the value of their assets held anywhere in the world, not just their US assets). But next year, as presently scheduled, US citizens may only exempt the first $1M from the estate tax (yikes).

As a general rule, non-US citizen/residents may only exempt $60,000 from the estate tax. So a Canadian who dies with a $250,000 house in the US is potentially subject to an estate tax based (generally) on the value of $190,000 in assets ($250,000 – $60,000). That could lead to the Canadian owing maybe $50,000 or so in the US estate tax. The estate of the deceased Canadian won’t like that. That’s why the executor must invoke the protection of the US-Canada Tax Treaty.

Remember, the US/Canada Tax Treaty Offers Relief, But the Executor Must Invoke the Treaty Relief…It’s Not Given Automatically

Recall that the US-Canada Tax Treaty offers relief so that the estate of the deceased Canadian may not have to pay any US estate tax. Recall that the estate of a deceased Canadian may invoke Article XXIX(B)(2)(a) of the Treaty, which says the deceased Canadian may exclude an amount from the US estate tax based on the following formula: $5M (the US exclusion amount, at least for the rest of 2012) x (the value of Canadian decedent’s US assets ($250,000 in this example) / the value of the Canadian decedent’s worldwide assets (let’s say $1M for this example)). So, its $5M x ($250,000/ $1M)= $1.25M the Canadian may exempt. So this amount the Canadian may exempt (1.25M in US assets) is well above the $250,000 in US assets the Canadian decedent died with, so there easily will be no US tax owed here, AS LONG AS THE EXECUTOR INVOKES THE TREATY!!!

How To Invoke the Treaty

The executor must oversee the completion of the IRS Form 706-NA. This is the US estate tax form which must be filled out for executors of non-US citizen residents who die with US assets. But, and here’s the key part, the executor must also ensure that attached to the back of the From 706-NA is an IRS Form 8833. This is the IRS form which must be completed to take a treaty position (any treaty position, so it’s a good form to get to know). Filing out the IRS Form 706-NA without the Form 8833 could lead (needlessly) to the estate of the Canadian paying $50,000 in US estate tax, when they didn’t need to pay a dime. But the executor must actively invoke the treaty by having the Form 8833 completed and attached to the back of the 706-NA!!! The treaty protection does not come automatically.

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This is the third (and last) part in this series. We see a lot of Canadians here in the Palm Springs/ Palm Desert area/ Coachella Valley area who are interested in not just vacationing here, but in purchasing property which they will then rent out. This series has been about the best way to own California property which will be rented out, with the goal of minimizing any damage from a tenant who likes to sue landlords. While this series has been directed towards Canadians purchasing local property, everything we’ve written in this series (with the exception of the discussion about LLCs and why they don’t currently work for Canadians) applies to people from any country, and for that matter much of it applies to Americans wanting to purchase and rent out California property as well.

We’ve concluded that the limited partnership is likely the best structure (for now) for the Canadian looking to purchase and then rent out Palm Springs/ Palm Desert area/ Coachella Valley property. Let’s look at a few more questions and answers on this topic.

Why Don’t I Just Use a Corporation to Buy the Property, But Instead of My Corporation Selling the Property with the High Tax Rate, I’ll Sell My Corporation’ Stock (with the Property in it) at the Low Tax Rate?

This is an interesting way to get around the problem of the high corporate tax rate (35% rate), (and then the tax on the dividend back to the shareholder (if it’s a US corporation with Canadian shareholders, the dividend is subject to withholding to boot- maximum rate of 15%)). Why not just sell the stock of the corporation instead of the property in the corporation (we will steer clear of the US real property holding company issues for this discussion)? Corporate stock sold by an individual shareholder will likely be taxed at the good individual capital gains rate of 15%. So maybe I can have the great individual great tax rate (15% rate) and have my limited liability in a neat corporate structure too? The biggest problem I see with this concept is marketability. It may not be so easy to find a buyer of your corporation, when all the buyer really wants to buy is the real estate in the corporation (particularly, by the way, if it’s a Canadian corporation which holds the property….is an American really going to want to buy a Canadian corporation?). The buyer wants real estate, not a corporation with real estate in it.

Are There Negative Tax Elements to the Limited Partnership Structure?

The biggest negative is that a partnership with foreign (Canadian) partners must withhold tax annually on income, regardless whether that income is distributed to the partners (at the highest individual rate…today that’s 35% on the annual income of the partnership). I view this required withholding as more problematic on paper than in realty. What income is the partnership going to have every year? Well, if you’re renting out the property, clearly that will be rents. But as we’ve discussed (and will again), if the partnership is taking deductions on the expenses that go into the property, there should not be much rental income (if any) on an annual basis. And if the partnership sells property for a gain, yes, this withholding tax rule will kick in. But remember, the withholding tax isn’t the real tax, it’s just a security deposit for the IRS. Your accountant will do your taxes in the year after the sale, and the 35% tax will turn into a 15% (i.e, more than half the tax withheld should be returned).

How Many Limited Partnerships Should I Form to Own My California Properties?

So this is a question we get a lot. I’d like to buy several US properties to rent out, how many limited partnerships do I need? Each limited partnership you own is going to cost money. It will cost some to set each one up, and then each limited partnership will require an annual fee to the state (that fee in California is $800 a year, but some states are much less expensive). But you don’t want to skimp here. Remember that in a worst case scenario, if your tenant has a really bad accident and sues the owner of the rental property- limited partnership, you (as the 99% limited partner in the lim. partnership…and again, we think the general partner should probably be a 1% regular (c) corporation) can end up losing every asset in the limited partnership. So the more properties you stuff into one limited partnership, the more than you stand to lose in a worst case scenario. The most careful strategy would be to just put only one property into each limited partnership. Maybe if they’re relatively low value properties you could live with a couple stuffed into a single partnership, but you probably wouldn’t want to go much beyond that, if at all. The safest play: each rental property to go in its own limited partnership.

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In my last post, I summarized that for Canadians looking to purchase California real estate which they could then rent out, but who were worried about potential lawsuits from their tenants (as they should be), utilizing the limited partnership form was probably the best method of ownership currently available. Let’s take a closer look at to why…

Why Can’t I Just Purchase My New California Rental Property as an Individual, as Joint Tenants or Tenants in Common?

Because owning property in an individual capacity provides you no liability protection. If your tenant gets hurt on your property, he or she can sue you personally for all you have in a California court. And keep in mind, it is quite possible that a Canadian court would enforce the judgment of a California court.

I’ve Heard So Much About LLC’s, why Can’t I use a California Limited Liability Company to Purchase My Rental Property?

It’s a shame, because the LLC really would be a terrific structure for Canadians who wanted to purchase California real property which they would then rent out. The LLC offers the great combination of liability protection (which is critical in case of a law suit by your tenant), plus the LLC members may elect to be taxed a partners (and not corporate shareholders). This tax treatment is critical. Corporations pay corporate taxes (at a rate of 35%) on income earned by the corporation, and then when the shareholders receive a distribution (a dividend), the shareholder must pay a dividend tax (i.e., shareholders of a corporation can effectively pay a second tax on the same income). Not good. Partners, however, are taxed just like individuals. The partnership is disregarded, and there is only one tax on the partner. And by the way, on rental income that should be a very low amount of tax, if any, because the partnership can take significant deductions on the rental property.

But the problem is we understand that LLC’s are not currently treated as partnerships for tax purposes in Canada. It’s our understanding from our Canadian colleagues that this may change in the future. For now, the Canadian owners of an LLC electing to be taxed as a partnership (of course you would make this election) will not receive a credit on the US income as a partner (from renting or selling the property) in Canada. Canada would give the Canadian LLC member a dividend credit (presumably) as if the LLC were a corporation, but the Canadian LLC member with rental property in the US doesn’t have a dividend. They were taxed as partners (individuals) in the US. So this means the LLC owner could end up paying tax TWICE on the same income: once in the US (as a partner of a deemed partnership) and once in Canada (as shareholder of a deemed corporation). This is a result that any Canadian investing in US real estate cannot let happen: double tax. Until further notice from the CRA, US LLC’s are off the table for Canadians.

I Already Have a Canadian Corporation, Why Don’t I Just Buy My California Rental Property With That?

First of all, you would get the limited liability you seek with your Canadian corporation only if you register it to do business in California. That will cost a minimum of $800 to the state of California each year (the same as if you were forming a California corporation). If you fail to do that, and your tenant has an accident and sues the owner of the property (the Canadian corporation), the California courts will treat the corporation’s shareholder as individual owners (i.e., the California courts will not respect the liability protection of a foreign corporation which does not register to do business in California). That’s the price of liability protection in California- a minimum of $800 a year.

But standard (C) corporations (whether US or Canadian) owning US rental properties are probably a bad idea anyway. If your corporation buys a rental property in the US today for $150,000, and then the corporation sells it five years later for $350,000 (we’ll think optimistically), the corporation owes a tax to the US of $200,000 (the appreciation) x 35%(today’s corporate tax rate)= $70,000. That’s too much. If you owned the property as a partnership, under same scenario the partners would owe a tax to the US of $200,000 x 15% (today’s individual capital gains rate)=$30,000. That’s less than half-quite a difference.

Finally, note both for purposes of the CRA and the IRS, generally if the corporation’s shareholders don’t pay rent to the corporation to use the property personally in the US (if they ever do), that’s taxable income in both Canada and the US on the “imputed” value of the fair market rent. You don’t own the property, your corporation does. Got to pay rent if you go use the property.

For now, I think limited partnerships are the preferred entity for those renting out the California property. More detail on those soon, in Part 3 of this series.

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IR-2012-65 allows Dual Citizens who Don’t Owe Tax in the US a Pain-Free Way to Become Compliant

First of all, which dual citizens don’t owe tax in the US? As a general matter, a dual citizen who have been living in a foreign country and been paying that country’s tax (as appropriate) probably does not owe much tax in the US (if any). The US taxes its citizen’s income no matter where they earn it anywhere in the world. But the US also works in cooperation with almost every country in the world (except for countries such as Cuba, Iran and Yemen…i.e., countries we have no relations with). If you are an American citizen living in France (you might also be a French citizen), and you have been paying your appropriate French tax for the money you earn in France, odds are you will not owe tax in the US. Why is this so? Most foreign countries have higher tax rates than the US. So as long as the income is of a type which we recognize (such as wages for services, or gains for stock sales, or rental income, or dividends, etc), the US will credit income earned in France by the dual French/US citizen. Thus, after the credit, the US citizen probably owes $0 US tax or very little US tax, on the amounts he earns in France. And the same goes for that US citizens with most every other country.

Now let’s not confuse the issue of whether the dual citizen owes any US tax with the obligation of the dual citizen to: (a) file US tax returns; and (b) file FBARs annually if they have bank accounts outside the US with over $10,000 at any point in the calendar year. Those obligations generally exist whether the person owes US tax or not. But for those people the new guidance is terrific. Those individuals must complet their past-due tax returns (at least 3 years) and delinquent FBARs (at least 6 years), and they’ll probably have no penalty to get compliant provided you don’t owe significant US Tax. A great deal.

Now if you haven’t been paying the appropriate tax in France (or whatever foreign country), and you probably haven’t been paying the appropriate tax in the US if you haven’t been completing your tax returns here, then (provided you have bank accounts in the foreign country over $10,000) you need to go through the 2012 FBAR amnesty program (review our prior posts for a description of the OVDP).

Let’s point out some important factors of the new amnesty program.

More Notes about the 2012 FBAR Amnesty Program

The 2012 FBAR amnesty program is currently underway. There is no deadline for the program. The program could be pulled by the IRS at any time, or the IRS could raise the current amnesty FBAR penalty (27.5% of the highest (aggregate) overseas balance in the highest year with a bank account abroad) at any time. Again, for those going through the amnesty program, you really have strongly consider taking the 27.5% penalty if you did not check the box on the Schedule B of the Form 1040 (asking the taxpayer to check the box if he or she had any foreign bank accounts). For those who don’t go into the amnesty and eventually get caught, the penalties can be enormous. They can wipe you out, no question. Also, in really egregious circumstances, jail is a possibility. And, as we understand it, foreign countries (like Switzerland) are feeling little option but to turn over bank account records to the US government (either presently, or soon).

The IRS clearly draws a distinction between those taxpayers who come in voluntarily, and those who are caught. If you are a US citizen or resident and have overseas bank accounts and you owe tax in the US on those amounts (maybe because you haven’t paid the appropriate tax in the foreign country at issue), you probably should consider the 2012 amnesty program soon.