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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 The taxpayer has not contributed any money to the RRSP nor withdrawn any money from the RRSP since becoming a U.S. resident.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.

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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:

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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.

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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

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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,

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We’re taking a break from speaking about the FBAR amnesty program (we will return to this topic shortly), but were going to continue to parallel (for now) our Canadian Snowbird Blog. So the topic at hand is how do I sell my house (we’re assuming the house has gone up in value), buy a new house, and not pay tax? Let’s assume, for the sake of discussion, that I sell a La Quinta home which has appreciated in value by $500,000 since I bought the house in 1997.

Question #1- Can I 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. Internal Revenue Code Section 1031allows me to exchange, tax free, US real property for other US real property, if several requirements are met.

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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?

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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, this could be citizens from any country outside of the US 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:

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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!!!

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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.

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. 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. The FBAR requirement has been in existence since 2003.