July 2004

U.S. Vacation Properties - The Changing Environment

Over the last several years, Canadians have been acquiring personal-use U.S. vacation properties in ever increasing numbers. One question that should always be considered upon the acquisition of such a property is how to structure ownership. The question is of more than academic interest. The owner of such a property will be exposed to Canadian capital gains tax in the event the property is sold or gifted to a person other than his or her spouse. Canadian capital gains tax will also arise upon death (with the possibility of some limited spousal deferral) if the property is still owned at that time. As if this in itself is not enough, the owner will also be exposed to U.S. capital gains tax upon sale of the property (although this tax would normally reduce or even eliminate any Canadian capital gains tax payable on the sale). The taxpayer will also be faced with U.S. gift tax in the event the property is gifted during his or her lifetime and U.S. estate tax upon death. Proper planning can avoid double taxation but even the best planning cannot anticipate all the possibilities.

In the early 1980’s, the most common planning technique was to acquire the property in a single-purpose Canadian company. The major problem faced by owners at that time was the fact that death would give rise to capital gains tax in Canada and estate tax in the U.S. with no opportunity to offset one tax against the other. Similar concerns arose for gifts of the real estate during the lifetime of the owner. Use of a Canadian company, at least arguably, would shield the Canadian owner from exposure to U.S. gift or estate tax and would therefore avoid double-taxation. Although both U.S. and Canadian capital gains tax would arise upon a sale of the property, Canadian taxpayers could claim a foreign tax credit for the U.S. capital gains tax and thereby avoid double taxation. U.S. tax advisors were (and perhaps remain) less optimistic than Canadian advisors about the effectiveness of this type of planning. One Canadian concern did arise with the use of a Canadian corporation. Would the company be viewed as conferring a benefit on the shareholders if the shareholders were allowed to use the property rent-free? Fortunately, the Canadian tax authorities agreed as early as 1980 not to assess a benefit as long as certain guidelines were followed.

Subsequent case law provided further assurances that taxable benefits would not arise if the shareholders carefully planned the acquisition and continued to pay attention to detail. Three major developments have taken place over the last decade that suggest this type of planning should be reconsidered (but not necessarily abandoned) for future acquisitions.

The first significant event occurred in 1995 when the treaty between Canada and the U.S. was renegotiated. Canadian individuals could now claim a foreign tax credit for U.S. estate tax arising on death (but still could not claim a credit for gift tax). This reduced, or in some cases even eliminated, the double taxation that previously existed on death where the U.S. property was owned personally. In addition, estate tax exemption limits for Canadians were increased in some cases. This somewhat reduced the need for using Canadian companies as part of the planning.

At the same time, personal capital gains tax rates declined in both countries to the point where these rates are now considerably lower than U.S. corporate rates of tax. The higher of the two personal rates is the Canadian rate of approximately 23%. However, this is still significantly lower than the U.S. corporate rate which can be as high as 40% when state tax rates are taken into account. A real penalty is therefore imposed on corporate ownership of U.S. real estate at the time the real property is sold if the property is sold at a gain.

Lastly, the Canada Revenue Agency announced on June 23, 2004, that it was revoking its policy regarding corporate ownership of personal use property. The administrative policy will continue to be applied to those arrangements currently in place. Does this mean that future corporate acquisitions of U.S. property will necessarily give rise to taxable benefits thereby further reducing the attractiveness of corporate ownership? Not necessarily. Remember that there is Canadian case law on the taxpayer’s side. What we do know is that the decision to discontinue the administrative policy does add some uncertainty and some reason for concern. What we don’t know is whether this change in policy signals a renewed interest on the part of the authorities in reviewing the Canadian tax consequences for shareholders of Canadian corporations owning U.S. personal-use vacation properties.

Does this mean the end of corporate ownership for future purchases of U.S. vacation properties? No, but it does mean that arriving at a decision will be that much more difficult. It also means, because of all the variables and uncertainty involved, that there will be a greater risk of making what proves to be, with the benefit of hindsight, the wrong choice.

George F. Johnson, C.A.
Senior Tax Partner, Crawford, Smith & Swallow, LLP

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