U.S. Estate Tax Considerations For Canadians Buying U.S. Real Property
March 2008
Two aspects of the U.S. estate tax make it significantly more costly than Canadian tax at death. First, U.S. estate tax is imposed on the value of property, not the appreciation in property. Second, the U.S. estate tax rates are high-up to 45% of the value of the property. Furthermore, deductions, exemptions and credits to reduce U.S. estate tax for U.S. citizens or U.S. residents are generally available on only a reduced basis, if at all, for Canadians. Although the U.S. estate tax is scheduled to be repealed in 2010, it is only scheduled for repeal for that year (and such repeal may be reversed before then in any event), and most U.S. practitioners believe the U.S. estate tax system will continue indefinitely.
Here is a typical example of the potential magnitude of U.S. estate tax for a Canadian owner of U.S. real estate. Assume an unmarried Canadian with worldwide assets of $10M1 buys a U.S. property worth $1M, and that is the value at his death (which occurs in 2008). The U.S. estate tax would be approximately $270,000, whereas no Canadian tax would arise. Even if the individual were married, there would be limited relief - which comes at the cost of significant complexity - and which only defers, and does not eliminate, U.S. estate tax.
The good news is that there are several potential options for Canadian investors to reduce or eliminate exposure to U.S. estate tax on U.S. real property.2 The appropriate option depends on the specific facts of each situation, of course. The rest of this article discusses such options.
1 All amounts are in U.S. dollars.
2 There are a couple of approaches not mentioned herein, including use of a corporation or a partnership structure, because in our experience these options do not work well.
Option #1 - Plan With Exemptions/Credits
For some Canadians, the "pro-rated unified credit exemption" under the Canada-U.S. Tax Treaty ("Treaty") may be sufficient to avoid - or at least reduce - U.S. estate tax, and thus taking title to U.S. real estate in individual name may be sufficient planning. In calculating a taxable estate, a Canadian is entitled to a proportion of a U.S. citizen's unified credit (which presently allows an exemption of $2M), as follows:
value of U.S. situs assets
$2M X value of worldwide assets
This pro-rated exemption amount is approximately doubled if the U.S. property is left to a Canadian spouse, under the "marital credit" provisions of the Treaty.
Numerically, this means that for Canadian couples with less than approximately $4M in worldwide assets, the U.S. estate tax can be virtually eliminated at either spouse's death, regardless of which spouse holds title. Of course, this planning does not take into account either a change in the exemption amount, or a growth in the couple's assets. Thus, for couples close to the $4M level now or in the near future, the next option - utilizing a trust - may be a better approach.
Even if the pro-rated and marital credits are available to eliminate estate tax, there is still a requirement to file a U.S. estate tax return and probate must be undertaken in the state where the real property is located. These factors increase the costs of taking title in individual name.
One important caveat to any planning where title to U.S. real property is to be taken individually is that title should be taken in the name of one spouse only, or in each spouse's name as "tenants in common". U.S. real property owned jointly with rights of survivorship, as "husband and wife", or in a "tenancy by the entirety", may lead to U.S. estate taxation in each spouse's estate with no ability to plan through Wills, because the property by operation of law passes to the surviving spouse. Moreover, a "rollover" as under Canadian law is generally not available without significant post-mortem structuring.
Option #2 - Own U.S. Real Property Through A Canadian Trust ("Residence Trust")
For married couples, this approach often is the most optimal. It works best if structured before purchase of the U.S. real property. A Canadian discretionary family trust typically does not have the appropriate terms to qualify for U.S. estate tax protection, so a trust with special terms is required. The Residence Trust is created by one spouse (the "Settlor Spouse") who funds it with the cash needed to purchase the U.S. real property, for the benefit of the other spouse (the "Beneficiary Spouse") and usually children. The Settlor Spouse can not be a trustee or a beneficiary, but the Beneficiary Spouse can be either or both. A beneficiary's powers over the Residence Trust as a trustee or otherwise must be carefully circumscribed, while still providing liberally for the beneficiaries, in order to keep the U.S. real property in the Residence Trust from being subject to U.S. estate tax. We often recommend the flexibility of giving the Beneficiary Spouse the right to add an unrelated trustee at some point, since such an "independent trustee" can have absolute discretion over distributions to beneficiaries.
The Settlor Spouse cannot have any legal or beneficial right with respect to the real property owned by the Residence Trust, but the Settlor Spouse may permissibly use the property without U.S. estate tax concern because his or her use is (pursuant to IRS rulings) at the "sufferance" of the Beneficiary Spouse. Thus, if the Beneficiary Spouse dies before the Settlor Spouse, the Settlor Spouse must rent the property in order to maintain the integrity of the transaction.
As long as the Residence Trust exists, there is estate tax protection for the Settlor Spouse, the Beneficiary Spouse, and any other beneficiary, and there is no requirement to file a U.S. estate tax return. Also, there is no need to undertake probate.
A couple downsides to the Residence Trust approach may arise in the event of a divorce, or as the "21 year" term approaches. Even in those instances, appropriate drafting can mitigate adverse effects.
Option #3 - Use of Nonrecourse Mortgage
This technique may be a good option for Canadians who already own U.S. real property (especially if the property has appreciated) or for unmarried Canadians. A nonrecourse mortgage reduces the value of the property in the estate on a dollar-for-dollar basis. Thus, in the introductory example, if a $500,000 nonrecourse mortgage were obtained, the U.S. estate tax would be approximately $78,000, which is a reduction in tax of almost $200,000 without such planning.
We do not recommend obtaining a nonrecourse loan from a related person, as this may not be respected by the IRS. There are U.S. banks in vacation areas with large Canadian populations (e.g., Florida) that offer nonrecourse financing. As the term "nonrecourse" means there is no personal liability and the bank can only look to the value of the property if there is a default, banks generally use a loan-to-value ratio of about 50-60%. Also, the interest rate on a nonrecourse loan may be higher than on a conventional mortgage to reflect the added risk to the bank.
The fact that the U.S. real property can not be mortgaged on a nonrecourse basis to the full extent of the value of the property is one flaw with this approach. Particularly if the property appreciates, this may mean continued exposure to U.S. estate tax, albeit on a reduced basis. There are upfront and ongoing costs involved in such financing, as well. Furthermore, estate tax filings and probate are not eliminated with this approach.
Option #4 - Life Insurance
Planning for exposure to U.S. estate tax with life insurance may seem simple (and thus appealing), but there are a couple disadvantages. First, of course, is the ongoing cost to maintain the life insurance. Second, the value of the life insurance does not reduce the U.S. estate tax, and may in fact increase the tax, unless a properly-drafted life insurance trust is used to own the policy. The increase occurs because the proceeds of the life insurance add to the value of the worldwide estate, so the pro-rated exemption amount is reduced. Furthermore, to avoid the U.S. real property from being subject to estate tax at each spouse's death, testamentary trusts should be created, as discussed below. This approach does not avoid the necessity of filing a U.S. estate tax return nor is probate eliminated.
As with Option #4, this may be an attractive approach for an unmarried Canadian.
Option #5 - Spouse With the Least Assets Takes Title, and Testamentary Trusts are Drafted
This approach is a variation on planning based on the pro-rated and marital credits discussed in Option #1. In this situation, the spouse who owns less assets (ideally less than $2M) would take title to the U.S. property. At the same time, the couple would change their Wills to create testamentary trusts, which would have terms very similar to those of the Residence Trust described in Option #2.
Relying solely on this approach is flawed in a number of ways, however. First, as noted previously, the credit amounts and asset values on which this approach is premised may change in the future. Second, it is at least as costly as the Residence Trust to implement this planning, with none of the certainty of eliminating estate tax if exemptions or values change. Third, a couple may not like having more restrictive testamentary spousal trusts over all their assets, simply to eliminate U.S. estate tax. Finally, estate tax filings and probate are not avoided.
The U.S. estate tax is likely here to stay, and thus needs to be of continued concern to Canadians who wish to own U.S. property. With proper planning - especially if done before U.S. real property is purchased - there may be several options, however, for reducing or eliminating U.S. estate tax exposure.
Carol A. Fitzsimmons
Partner
Hodgson Russ LLP*
cfitzsim@hodgsonruss.com
www.hodgsonruss.com
150 King Street West (Sun Life Centre)
PO Box 30, Suite 2309
Toronto, Ontario Canada M5H IJ9
416.595.5100
The Guaranty Building
140 Pearl Street, Suite 100
Buffalo, NY 14202. USA
716.848.1477
*Practice Restricted to U.S. Law
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