Published on:

Many Canadian snowbirds who purchase Palm Springs area property wish to rent out the property during the time when they can’t use it personally (or maybe rent it out all the time). I think it’s a great idea, primarily because if the snowbird plays his or her cards right, they can receive rental income and possibly owe $0 tax on the income in the United States- a great deal. But if you’re going to let strangers use your property as business guests, in these days of excess lawsuits, you have to protect yourself. Insurance is a must, but insurance will only protect you to a certain point. It is possible a court could award a settlement of a far higher amount than the value of your US house or your insurance. Next, the injured renter wants every penny you have to compensate for the injury. Finally, I am asked from time to time whether a judgment from a California court could ever be enforceable in Canada? The answer is it is possible for a judgment from a California court to be enforceable in Canada. So Canadians, like Americans, need to be careful about how they conduct their US businesses, just like they need to careful about how they conduct their Canadian businesses.

So Let’s Review Our Various Ownership Forms From a Liability Protection Perspective

Ownership as an Individual, as Joint Tenants or Tenants in Common– If you are going to rent out your property to strangers regularly, none of these basic forms of homeownership is likely a wise idea. In each case, the owner can be sued in his or her personal capacity (it’s either one or multiple individuals who own the property), and that means (in a worst case scenario) you could lose all your personal assets.

Ownership as a Partnership– Ownership via a regular partnership is no different from a liability protection perspective as ownership as an individual or joint tenant,etc. The court’s view it as multiple individuals who own a property.

Ownership as a Limited Partnership– Ok, now we’re getting somewhere. Limited partnerships offer limited liability to each partner other than the general partner (and there must be a general partner). Limited liability means in a worst case scenario the limited partner can lose his or her interest in the limited partnership (ie. the value of his or her portion of the house), but that’s it. NO PERSONAL LIABLITY. On the other hand, there has to be a general partner. Being the general partner doesn’t help you at all from a liability protection perspective, so what we see quite a bit is the partnership naming a corporation (which itself has limited liability) to serve as the 1% general partner, while the individuals serve as the 99% owning limited partners. Now nobody’s losing any personal assets in a lawsuit. A couple things to note on limited partnerships: (1) the limited partnership will have to file with the State of California and pay a minimum fee (it’s actually called a tax) of $800 per year to the state. That’s price of limited liability. And (2) if your limited partnership is a Canadian limited partnership, it must register to do business in the state of California and pay a minimum fee of $800 per year- again, that’s the price of limited liability.

US Limited Liability Corporation (LLC)– I would love to recommend to all Canadians to own their California house via a LLC if they planned to rent it out. It offers the fantastic mix of allowing the owners to be taxed as a partners of a partnership and not a corporation (being taxed as a partnership is generally far preferable than being taxed as a corporation), and still offers the liability protection for a regular corporation. Alas, I can’t recommend it, because (at least presently) Canada does not recognize LLC’s as taxed as partnerships. So a Canadian using a LLC risks a double tax on the same income (once in the US as a partnership and once in Canada as a corporation), or at least a timing mismatch in the tax credits. Until Canada recognizes LLC’s as partnerships for tax purposes, Canadians should stay away from the LLC.

US S Corporation (small corporation with special tax rules)– Canadians can’t use these, as the US S corp. rules do not allow for foreign shareholders.

Regular (“C”) Corporation– Canadians can use an American or Canadian corporation to own their US house, again provided they pay the state of California a minimum of $800 a year for liability protection. And they work great for liability protection. But the tax implications of a corporation are probably the least favorable of all choices (to be discussed at a later post).

Trusts– I love trusts for avoiding probate, but most trusts don’t have special liability protection. There are special trusts which do serve this purpose, but the rules about these trusts are restrictive.

Conclusion

As of now, for Canadian owners whose primary concern is liability protection from the rental of their Palm Springs area home, I favor limited partnerships. They give the best mix of liability protection with good tax benefits (to be discussed at a later post). When Canada recognizes the US LLC as taxed as a partnership, the LLC would likely become the favored way for Canadians to own US real property for liability protection purposes.

Published on:

So a few months ago on this blog we informed you that the IRS offered a new FBAR amnesty program (now the 3rd program it’s offered), but that it only had released the broad stokes of the program (see our entry from February 16, 2012, for our last discussion of this topic). Since then, the IRS has established new procedures for dual citizens who have foreign bank accounts but who have paying the appropriate tax on the amounts in the those accounts in the foreign country at issue. Taxpayers with this situation can resolve it rather easily without having to go through a formal amnesty program (see our post from July 5, 2012, discussing this new option). However, that program won’t be available for everyone, and for the rest there is now the 2012 Overseas Voluntary Disclosure Program (the “OVDP”). On June 26, 2012, the IRS issued a set of Frequently Asked Questions and Answers (this is new guidance to assist taxpayers under the 2012 OVDP).

Background

Again, recall 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. The term financial account 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, by June 30 of the year after the US citizen or resident had a non-US account.

So What Are Broad Strokes of the 2012 OVDP?

Largely, we’ve already discussed basics of the 2012 OVDP in our prior posts, since the amnesty program remains very similar to the 2011 amnesty program. Taxpayers going through program will have to make a very important decision.

Option One- No Questions Asked. The taxpayer chooses pay a one-time penalty of 27.5% of the highest aggregate overseas account(s) balance in the highest year. So if the aggregate overseas account balance in the highest year (of all the years 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 taxpayer 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). That stings, no question.

Option Two- Roll the Dice for a Lesser Penalty. The taxpayer asks 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 this is a gamble with big stakes. If the IRS agrees that the taxpayer is entitled to a lesser penalty based on the facts of the case, then great. But if the IRS doesn’t agree, the taxpayer can lose big. In fact, if upon review the IRS believes that the taxpayer’s failure to file a FBAR was “willful”, they can take EVERYTHING in the foreign accounts (maybe more). The taxpayer cannot elect option two and roll the dice if the facts of his case have even the whiff of a willful failure not to file FBARs. So what factors suggest to the IRS a taxpayer willfully failed to file a FBAR???

How Do I Know if the IRS will Consider My Failure to File FBARS a Willful Failure, so That I Better Take the 27.5% No Questions Asked Penalty?

So this is really where the rubber meets the road on the 2012 OVDP FBAR amnesty. I need to know whether my case is too risky to ask for the opt-out, and just accept the 27.5% one-time penalty. I must accept the 27.5% penalty if there is a decent chance the IRS will deem my failure to file FBARs as willful. What is a willful failure to file? While there are no concrete answers to this, here are some factors (which come both from the 2012 OVDP Q&A guidance and from our own discussions with the IRS):

1) If the taxpayer has large, unreported taxable gains attributable to the overseas account(s), this is a negative factor (e.g., you got a Swiss account which you haven’t filed a FBAR for and you trade stocks in the account and had some major gains and a lot of tax due in the US from these gains…you should probably take the 27.5% amnesty deal…see Q&A 51.2 of the new ODVP guidance).

2) You failed to check the box on Part III of the Schedule B of the Form 1040 that states you had foreign bank accounts. It’s one thing not to file FBAR’s annually, but it’s another thing to fail to state on your personal income tax return that you had any foreign bank accounts. That is not a good factor for someone looking for the opt-out deal.

3) You failed to pay the appropriate tax in the foreign country at issue. It looks better if while failing to file FBARs and paying tax in the US, you were at least tax compliant in the foreign country at issue. Note that if you paid the correct tax overseas, it’s quite possible (due to the tax credit system) that you have $0 US tax owed. If you paid the correct tax to the foreign country at issue, that’s a very positive factor.

Make a Calm, Objective Decision on Whether to “Opt-Out”

In our experience, there is natural inclination for clients not to want to accept the 27.5% (of the highest aggregate foreign account balance(s) in the highest year) penalty. This is understandable. But again, you need to calmly and objectively assess your case before you make the critical decision of whether to opt-out of the no questions asked 27.5% penalty. The stakes are huge (you could lose the entire value of these accounts if you’re wrong). If you haven’t declared your overseas bank accounts yet, and you are increasingly worried about the IRS and the Department of Justice discovering them, we strongly recommend you give us or a competent tax attorney a call to review your case.

We’ll talk about how long the new FBAR 2012 Amnesty Program is expected to last, and other features of the program, in our next post.

Published on:

So we’re continuing our discussion of why, for the sole purpose of avoiding or minimizing the probate costs of the Canadian snowbird, a trust is likely the best way to own your Palm Springs area home. Remember, probate is the legal process your estate goes through when you die. For the Canadian snowbird who passes away from Vancouver with a vacation house in Indian Wells, there is probably already a probate which must occur back in British Columbia. If at all possible, why make it two? It’s expensive, it can be difficult due to the international component, and can be time consuming (maybe even takes over a year). And by the way, the same analysis holds true for somebody whose permanent residence is in Japan or Germany, or even for somebody whose permanent residence is in Michigan. So if you’re not living permanently in California, you probably would rather avoid a second costly probate (which would occur in California). We will call the second probate in California (the one we’d like to avoid if possible), the “ancillary probate”. Review our last post for an overview of the costs of the California probate process.

Let’s Revisit our Various Forms of Property Ownership, and Review Whether, Upon the Death of a Canadian Snowbird Owner, a California Ancillary Probate is Required.

Property Owned by Individual– If Larry from Vancouver owns, in his name alone, a house in Indian Wells, upon his death a California probate is required to determine who inherits Larry’s Indian Wells house (i.e., so while the rest of Larry’s estate is likely going through the primary probate in process back in BC, the estate has no choice but to also pay for the expensive costs of an ancillary probate in California). As a side note, the California court would likely admit Larry’s Canadian will to determine who to distribute the Indian Wells house to.

Property Owned by a Couple as Tenants in Common– If Larry and his wife Helen, both from Vancouver, owned their Indian Wells house as tenants in common, upon the first to die of either Larry or Helen, the property must go through a California probate to determine who inherits Larry or Helen’s interest in their Indian Wells home (probably the survivor of the two). Talk about needless. Only one of the two owners passed away and we still have to go through an expensive California ancillary probate!

Property Owned by a Couple as Joint Tenants– Joint tenants are considered “co-owners” of the entire property. So as joint tenants, if Larry or Helen dies, then the survivor automatically takes over the entire property without probate required. When the second of the Larry or Helen dies, then a probate will be required to determine who inherits their Indian Wells home.

Property Owned by a Partnership or a Corporation (including an LLC)
Provided all the partners or shareholders of the partnership or corporation, respectively, are domiciled (where they permanently reside) outside of California, upon the death of Larry or Helen, as a partner or shareholder (of the partnership or corporation which owns the Indian Wells house), a California probate should not be required. This should convert the real estate into an intangible asset that will be subject to probate in Larry/ Helen’s home jurisdiction (British Columbia) but not in the jurisdiction where the property is located (California). This, of course, will not eliminate probate altogether, just the ancillary probate in California. So while ownership thorough a partnership or corporation does not likely require a second probate (in California), it likely increases fees required for the primary probate (in this case back in Vancouver). It will also add significantly to the time to transfer the California property to the new owner (it can’t occur until the Canada probate is concluded).

Property Owned by a Revocable Living Trust– Larry and Helen can title their Indian Wells house into the name of their revocable living trust. That way, the house can either be transferred directly to the beneficiaries Larry and Helen have named in their revocable living trust to receive their assets after they die, or sold by the successor Trustee they have named to manage and distribute the trust property after they die. We view this ownership as the best method to avoid California probate costs.

Why is a Revocable Living Trust Likely the Best Method to Avoid Probate Costs?

The basic reason is that the Indian Wells house will not have to go through an expensive California probate when one, or both, of the owners dies. This happens when the house is owned individually, or as tenants in common (upon the first of the couple to pass away), or as joints tenants (upon the second of the couple to die). In addition, while owning the house through a partnership or a corporation will probably not require a second California probate, the value of the partnership interests or corporation shares will likely be added to the value of decedent(s)’ assets in the primary probate (back in Vancouver in our example). Assuming British Columbia probate costs are also based on the value of the assets being probated, then the primary probate becomes that much more expensive. Also, this will add significant delays to the transfer of the Indian Wells property. So a trust is likely the best way to avoid costly probate fees on the value of the Indian Wells house altogether, in addition to being the most efficient way to affect the transfer to those who inherit the Indian Wells house (probably the kids).

One final note on Canadians using US revocable trusts- it is our understating that in Canada, when one contributes a property to a US trust, the contributor must pay tax on the gain in the value the house (if any) at the time of contribution. So Canadians may be wary of contributing a significantly appreciated property to a US trust due to the Canadian tax implications. We will talk about this more down the road.

Published on:

On June 26, 2012, the IRS announced a new initiative to help US citizens living in another country (very likely dual citizens) catch up with their unfiled US tax returns and FBARs.

Background

In our law office in Palm Springs, we regularly see clients who may be Americans by birth, but who live in (and are also probably a citizen of) another country (usually Canada). While the dual American/Canadian may enjoy visiting Indian Wells three months a year, she really lives in Vancouver. But since she was born in Seattle, she has a social security number, she is a US citizen, and (whether she wants one or not) she has an obligation to file a US tax return every year (even though maybe she’s never filed one in her life). Plus, since she has bank accounts outside the US in Canada with more than $10,000 in them, she has an annual FBAR filing requirement as well.

Before the Recent Announcement, This Was a Big Problem for the Dual Citizen Living Abroad

Dual citizens living (permanently) in a country other than the US did not know what to do. Was our Seattle-born dual US/Canadian citizen living permanently in Vancouver supposed to file 25 years of back taxes? Wouldn’t that lead to possibly thousands of dollars in back taxes and interest and penalties to the IRS? And as for the delinquent FBARs, isn’t the failure to file penalty for an FBAR $10,000 per each year going as far back as the FBAR program has been in existence (it started in 2003)? Our Vancouver resident might think it would be nice to get straight with the IRS because she doesn’t like the specter of unpaid income tax and past due FBARs hanging over her head, but it’s certainly not worth the $300,000 in back taxes and interest and FBAR penalties she will have to pay for coming clean.

IRS New Procedure Offers Significant Relief For Dual Citizens Living in a Foreign Country Who Have Not Filed US Tax Returns or FBARs in Years

Under the new procedure, taxpayers will be required to file delinquent tax returns for the past three years and file delinquent FBARs for the past six years. All submissions will be reviewed, but for those taxpayers presenting low compliance risk, the review will be expedited and the IRS will not assert penalties or pursue follow-up actions. How do we know if a taxpayer has a “low risk” case where there may be no penalties imposed? Absent unique factors, if the submitted returns show less than $1,500 in tax due in each of the reviewed years, they will be treated as low risk.

So the Dual Citizen Who Hasn’t Done a US Tax Return in 20 Years Can Do the 3 Most Recent Tax Returns, and 6 Most Recent Past Due FBARs, and Maybe Have No Penalties and Now Have a Clean IRS History?

The answer is yes! And it’s easier than you might think. If our Vancouver resident, born in Seattle (and with a vacation home in Indian Wells) has been paying proper taxes in Canada all these years, due to the tax cooperation between the US and Canada (and the tax credit system), she very possibly owes $0 in past due US taxes for the reviewed years (easily below the $1,500 per year threshold). And the same goes if she was born in New York City and now lives in France (or almost any other country). No failure to file income tax return penalty, and no $10,000 per year failure to file FBAR penalty!!! This is great news for the dual citizen living abroad who just wants to clean their US tax record.

See IR-2012-64 for more details, or call our office.

Published on:

We’re going to start a new series on our Canadian blog, aimed specifically at those Canadians purchasing Coachella Valley real estate, and the best way to own their new Palm Springs areas home (i.e., how to take title). The first issue we’re going to discuss is how to best to take title to avoid (or minimize) the expensive cost of California probate. Keep in mind as we discuss the issue of probate, the analysis is the same whether we’re talking about somebody from Canada, or France, or Brazil, or even Washington or Oregon (i.e., people who own a home in California, but who live either in another state in the US or in another country outside the US).

Let’s First Identify the Common Methods of Real Property Ownership

Owning as an Individual- self explanatory.

Owning as Joint Tenants- Each party of a couple (or more) is a co-owner. When one dies, the property automatically goes to the survivor(s).

Owning as Tenants in Common- Each party of a couple (or more) is an owner of part of the property. When one dies, that portion of the property goes to whomever the deceased tenant in common leaves it to.

Owning via a Partnership- The individuals form a partnership (could be a US partnership or a Canadian partnership), which owns the property.

Owning via a Corporation- The individuals form a corporation (could be a US corporation (including the US LLC) or a Canadian corporation), which owns the property.

Owning via a Trust- The individuals form a trust (could be a US trust (typically a US recovable trust) or a Canadian trust), which owns the property.

What is Probate?

Probate is the legal process (a court proceeding) an estate goes through when one dies. In the US, probate occurs on a state by state basis. So if you are from Canada or Oregon, and you own an Indian Wells house and pass away, as a general matter your estate must go through a California probate. So even all your other assets in the world are in Calgary (where your estate would undoubtedly have its own probate for all your other assets), if you own California real estate your estate will have to go through a California probate. That is, unless you plan ahead to avoid California probate!

What are Normal Probate Fees?

As a general matter, probate fees will be around 2% of the value of the estate being probated (it’s a sliding scale: 3% at the lower levels down to 1% the higher the value of the property). So if we’re only talking about a second house owned in California, we’re talking about one major asset in probate: the house. However, the 2% (avg) are the “ordinary fees”, assuming no major complications. That may be a fair assumption when we’re speaking of someone from another US state, but when we’re speaking of a Canadian or someone from another country outside the US, probate fees may rise significantly well above the ordinary 2% fees. And remember, these are only the attorney’s fees we’re speaking of to this point. There will be separate fees for those going through probate as well (e.g., property appraisal fees, court filing fees, possibly an executor fee). And again, when dealing with property owners who are citizens of foreign countries, the attorney’s fees can jump well above the normal 2%. For Canadians, avoiding (or minimizing) probate with respect to their US real estate should be a high priority.

So What is the Best Form of Ownership to Avoid Costly Probate Fees?

The answer is the US trust (typically the US revocable trust). We’ll discuss why, and compare the US trust to the other forms of common property ownership with respect to probate costs, in our next post.

Published on:

In the last post, we discussed how the State of California will tax RRSP earnings which sit in Canada on an annual basis, even if the Canadian who is now a US resident does not receive a distribution. Not a good result. But don’t forget, the US will also tax the earnings of an RRSP on an annual basis, unless the Canadian living in the US elects otherwise pursuant to Article XXIII(7) of the US-Canada Tax Treaty. How does the Canadian elect that the US should not tax the earnings on an annual basis? He or she files an IRS Form 8891 to defer US tax on income accrued in the RRSP. But what if they forget to file, or only recently recently found out about this obligation?

IRS Private Letter Ruling 201225002 Provides Relief For Past Years For Those Who Recently Discovered the Obligation to File a Form 8891

Just 3 days ago (June 22, 2012), the IRS reviewed a situation where a Canadian (now a US resident) had a RRSP, but had not filed a Form 8891 to defer US federal income tax on the RRSP’s earnings. The taxpayer has not contributed any money to the RRSP nor withdrawn any money from the RRSP since becoming a U.S. resident. The taxpayer was not aware of the need to make an election pursuant to paragraph 7 of Article XVIII of the United States – Canada Income Tax Treaty on Form 8891 in order to defer the US tax on income accrued in the RRSP. Then, the taxpayer read a news article that dealt with IRS rules about Canadian RRSP accounts, did further research on the rules, and sought professional advice. The taxpayer then requested from the IRS an official extension of time (in order to cover prior years) to file the Form 8891, to defer the otherwise required federal income tax on the interest component. The request for an extension of the time is the subject of IRS Private Letter Ruling 201225002.

The IRS ruled that it has discretion to grant a taxpayer a reasonable extension of time to make a regulatory election, provided the taxpayer provides evidence to establish to the satisfaction of the IRS that the taxpayer acted reasonably and in good faith, and the grant of relief will not prejudice the interests of the Government. The IRS ruled the taxpayer did satisfy the good faith standard, and granted an extension of time until 60 days from the date of the PLR ruling (June 22, 2012) to make an election for all prior tax years. The IRS further noted that once the election is made it cannot be revoked except with the consent of the IRS. For the previous tax years at issue, the taxpayer must file amended US income tax returns to which he attaches a Form 8891 (U.S. Information Return for Beneficiaries of Certain Canadian Registered Retirement Plans ) for the RRSP. For each subsequent tax year through the tax year in which the final distribution is made from RRSP, Taxpayer must attach a Form 8891 for RRSP to his U.S. income tax return.

Bottom line: even if Canadian who is now a US resident didn’t know he or she had to File a 8891 to defer the otherwise required annual federal income tax on the interest component, Private Letter Ruling 201225002 says it’s never too late to do it right.

Published on:

If you’re a Canadian living now in California (so here we’re not really talking about snowbirds, we’re talking about the Canadian who has decided to live in California on regular basis…maybe a green card, or a L-1 visa, or maybe we’re talking about a dual US-Canadian citizen), you may have a RRSP from your time living and working in Canada. You may wonder, how will the US and the State of California tax my RRSP. We’re not talking about when you actually receive a distribution (obviously the US will have a claim to the distribution, and we’ll talk about that another time), we’re talking about the amounts that sit in the plan, and maybe have earnings each year due to plan investments (but, again, these are not earnings the Canadian living in California will actually see until they receive a distribution from the plan, which may not be for years).

How the US Taxes the Earnings of a RRSP?

As a general matter, the US would probably tax the earnings of an RRSP on an annual basis. So as a general matter, a US citizen (or current resident) who lived in Canada for years and has a RRSP would be taxed each year in the US on the earnings of the plan. But here comes the US-Canada Tax Treaty to the rescue. Article XXIII(7) of the Treaty states:

“effective for taxable years beginning on or after January 1, 1996, that a natural person who is a citizen or resident of either the United States or Canada and a beneficiary of a trust, company, organization, or other arrangement that is a resident of the other country that is generally exempt from income taxation in the other country (a “plan”), and is operated exclusively to provide pension, retirement, or employee benefits, may elect to defer taxation in the person’s country of citizenship or residence, under rules established by the competent authority of that country, with respect to any income accrued in the plan but not distributed by the plan, until such time as and to the extent that a distribution is made from the plan or any plan substituted therefor.”

What does this provision of the US-Canada Treaty mean? It means US citizens or residents (ie Canadians living in the US with green cards, or visas or dual citizens) do not have to pay federal US income tax on the amount the RRSP earns each year. To earn this good treatment, however, they must affirmatively elect. The election to defer tax on earnings this year (and in future years) is detailed in Rev. Proc 2002-23, by attaching to their timely filed (including extensions) United States federal income tax return for the current year, a statement that includes the following information:

(i) A statement that the taxpayer is claiming the benefit of Article XVIII(7) of the Treaty under this revenue procedure;
(ii) The name of the trustee of the plan and the plan account number, if any; and
(iii) The balance in the plan at the beginning of the current year.

How Does California Tax the Earnings of a RRSP?

So what about the Canadian now living in California who has a RRSP from a time he or she lived in Canada? States are not required to follow treaties when it comes to state taxation (California did not enter into a treaty with Canada), and when it comes to the earnings of a RRSP, California does not have to follow the US-Canada Treaty. In Information Letter 2003-0040, the FTB (Cal. Franchise Tax Board) specifically states the State of California will tax the earnings of the RRSP each year. The letter states that California views the RRSP like a savings account, and every year California taxes its residents’ earnings in savings accounts. It may not be so easy for them to enforce, but each year Canadians living in California with RRSPs in Canada should be declaring in California the yearly earnings (not the amounts contributed in the plan from prior years- just the current year’s earnings), even though they did not receive a distribution from the plan that year!!!

Published on:

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).

Published on:

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).

Published on:

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….