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U. S. Citizenship Complicates Retirement

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Grainews is looking for farmers with troublesome financial questions. We will protect your privacy. We insist on examining real situations, but we DO NOT use real names or even identify your hometown. You do not have to pay to participate in this article. If you have a financial question, send your name and your question to the editor, Jay Whetter, at 807-468-4006 (phone), 807-468-4588 (fax) or [email protected]Grainews will contact you if we want to follow up.

Thanks Don Forbes of Carberry, Man., for his help with this report. You can contact Don at 204-834-3155 or [email protected]

For the past three decades, a couple we’ll call George, 63, and Susan, 59, have owned and operated a 500-acre irrigated farm in Alberta. They’re ready to retire. The problem is that the farm as it is operating cannot both pay a retirement income to the parents when they retire and still have enough cash flow left for the next generation to expand. So they decided to sell the irrigated land in pieces over a three-year period from 2008 to 2010.

The sale will generate $1 million in total, less mortgage debt and loans that total $400,000. After debts are cleared, the sales will enable the couple to use the $750,000 qualified farm property capital gain exemption to shelter all of their proceeds.

The couple also has off-farm income of $42,000 per year, composed of $12,000 that Susan earns in a consulting business and $30,000 per year rent from two oil wells on their property. They are keeping the rights to that revenue stream.

Sounds like a decent retirement, but there’s a major glitch. Susan is a dual citizen and Uncle Sam wants his taxes — even though she lives in Canada.

Farm Financial Planner asked Don Forbes, a specialist in farm finances who heads Don Forbes & Associates/Armstrong & Quaile of Carberry, Manitoba, to work with George and Susan. Her net liability is established by Canada, which has higher nominal taxes. She therefore claims a foreign tax credit on her U. S. return, which wipes out her need to pay further income tax to the U. S., Mr. Forbes explains.

“But Susan is worried that she may have to pay what amounts to a U. S. surtax on her Canadian retirement income,” Mr. Forbes says. Appropriate tax planning is needed to reduce that burden.

THE GRITTY DETAILS

Canada and the U. S. don’t recognize each other’s exemptions. So Susan’s problem, in a nutshell, is that the U. S. does not recognize Canada’s $750,000 Qualified Farm Property Capital Gains Tax relief. For its part, Canada does not recognize the U. S. deduction for interest paid on residential mortgages, Mr. Forbes notes.

The U. S. does exempt up to US$91,400 of Canadian-source employment income under a foreign-earned income exclusion. But the exemption does not cover investment income in Canada, which remains taxable as the world-wide income of a U. S. citizen. Her unearned income, including capital gains on sale of farmland, will remain a potential object of taxation.

What is required, therefore, is a way to manage the U. S. tax exposure on the sale of farmland and equipment. The best course is to sell the property and equipment over a few years to average out gains. Land can be sold before equipment. Some U. S. tax will be payable, but amounts paid can be used as a credit on the couple’s Canadian tax returns. Forbes suggests that sales be subjected to test returns by the couple’s accountant to ensure that the best combinations of sales, income, and tax are achieved.

THE U. S. TAXES CANADIAN INCOME

Susan needs to file IRS Form 8891 by June 30 each year for each RRSP plan. The IRS form allows her to invest and receive income from RRSPs in the usual fashion as long as she is a resident of Canada. Were she to become a U. S. resident, she would lose the exemption and the U. S. would then tax the RRSPs as taxable in full based on the date she moves back.

Arranging for the passing of farmland or family and personal assets to their children is easy for tax purposes in Canada and much more complex in the U. S.

Canada taxes only accrued but unrealized gains on property, not including a principal residence. The U. S. taxes the full value of an estate subject to certain exemptions. This year, the exemption is US$3.5 million. In 2010, the exemption drops to US$1.5 million. She should consult U. S. tax counsel about setting up a trust or corporate structure for her interest in the farm and other assets. If done correctly under U. S. law, the structure could bridge her death and help avoid U. S. death duties, Forbes notes.

The alternative to a post-mortem solution for assets is to gift them to her children. Canada has no gift tax per se. The only taxes involved in a transfer arise through recognition of accrued gains on defined assets and attribution of income.

The U. S., on the other hand, aggressively taxes gifts in the full amount of transferred assets. Each U. S. citizen has an annual limit of US$13,000 to any recipient and US$133,000 to a spouse who is not a American citizen. There is a lifetime exemption of US$1 million for each U. S. citizen.

Finally, Susan has to declare all of her Canadian and other worldwide assets to the U. S. Internal Revenue Service each year on form TDF 90-22.1 by June 30 for all assets of a value over US$10,000. This information is cross-checked with her income tax returns and other filings to ensure that she is paying her taxes. The paper burden is onerous, but penalties for noncompliance are substantial.

The solution to this web of tax liabilities is for Susan to make spousal contributions to George’s RRSP in years when her income is high or to gift some of her investments to her children or spouse each year within the U. S. limits.

SOLUTIONS FOR THE FARM SALE

First option: Sell everything, leave the farm, and move to town. They will have $600,000 left after payment of all debts and taxes. They can invest in financial assets and aim for a six per cent annual return or $36,000 per year. In this scenario, a child would have to buy $150,000 of land, which is the old, undivided farmyard, and the parents would take back a mortgage from that child. (The rest of the farm land would be rented out.) They would do this because the land cannot be gifted tax-free under U. S. tax rules at fair market value. Susan can then forgive or gift up to US$13,000 per year.

Selling assets over a three-to four-year period will allow transfers using this method to avoid U. S. gift taxes, Mr. Forbes explains. The combination of income from $600,000 of investments plus CPP income, OAS benefits, Susan’s off-farm business, RRIF income, and oil well income will eventually produce total retirement income of $57,600 per year in 2009 dollars.

Second option: Rent out 300 acres of irrigated land. Rental income from the farm would be used to service remaining mortgage debt. Susan would have to keep reporting her assets each year to the IRS. If they choose this method of retirement, they will wind up as active asset managers rather than farmers. Their incomes will be similar to what they would have under the sale scenario while they are paying off their mortgages for the first 10 years. After that, their income would be free of interest charges. Their income would then rise to $106,000 per year, Mr. Forbes estimates.

Which path to take? Sale makes their lives easier. Retention of the land is more complex, but eventually produces higher income. Keeping the farm will also put them at risk that Alberta farmland may not appreciate at a rate above the rate of inflation, and will keep them fairly undiversified in Alberta farmland. And land can fall in value. “Just ask Americans how it feels to be in a declining property market,” Mr. Forbes says.

Andrew Allentuck is author of When Can I Retire? Planning Your Financial Life After Work, published earlier this year by Penguin Canada.

About the author

Columnist

Andrew Allentuck’s book, “Cherished Fortune: Build Your Portfolio Like Your Own Business,” written with co-author Benoit Poliquin, was recently published by Dundurn Press.

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