Are you considering purchasing property in the United States? If so, you need to examine your exposure to U.S. estate taxes and consider ways to avoid or limit them.
Upon an individual’s death, an estate tax is imposed in the U.S. on both its citizens (based on their worldwide estates) and non-citizens (to the extent that they hold certain U.S.-situs assets, including real estate).
For U.S. citizens, whether they live in the U.S. or abroad, the first US$11.7 million of worldwide assets are exempt from estate taxes, and worldwide assets in excess of this amount are taxed at a rate of up to 40 per cent. This exemption and rate will expire on Dec. 31, 2025, and, unless action is otherwise taken, they will revert to the pre-2018 exemption of US$5 million (indexed to inflation, so more likely to be close to US$6-US$7 million) and a tax rate of up to 45 per cent.
Non-U.S.-citizen Canadians who are subject to U.S. estate taxes have their exemption “ground down” based on the proportion of their U.S.-situs assets to their worldwide estate and are subject to U.S. estate taxes on the value of their U.S.-situs assets in excess of the ground-down exemption. Thus, a Canadian whose U.S.-situs assets comprise only 10 per cent of his worldwide assets at death will only be entitled to an exemption of US$1.17 million in 2021, and any U.S.-situs assets in excess of this amount will be subject to estate taxes at a rate of 40 per cent in 2021.
So what’s the impact of the U.S. estate tax on non-U.S.-citizen Canadians who own U.S. real estate?
Suppose Mr. Jackson has a worldwide estate of US$15 million and is considering purchasing U.S. real estate for US$1.5 million, or he already owns U.S. real estate worth US$1.5 million. If the U.S. real estate is Mr. Jackson’s sole U.S.-situs asset and if he holds it personally, on his death Mr. Jackson will be subject to U.S. estate taxes of roughly US$132,000 in 2021. If he dies in 2026 or beyond, however, his U.S. estate tax will be between US$360,000 and US$450,000 (based on what the exemption will be based on inflation on the $5 million amount).
Given the magnitude of those U.S. estate taxes, it’s no wonder that many Canadians have been seeking alternative ways to hold U.S. real estate to avoid estate taxes on death.
Keep property out of your estate
One of the most frequent forms of alternative ownership is the use of a Canadian discretionary trust. Its main, if not sole, purpose is to purchase and hold U.S. real estate (whether from a third party or the individual himself). So long as the U.S. real estate is held in this trust, the property will not form part of the individual’s estate and thus no U.S. estate taxes will be owing upon death with respect to the property.
This type of trust is most commonly settled and funded – with the amount necessary to purchase the U.S. real estate – by one spouse (the “grantor spouse”) while the other spouse (the “trustee/beneficiary spouse”) is often the sole trustee of the trust as well as a beneficiary along with the couple’s issue. (The trust may also be used in a number of other circumstances including situations where there is only one spouse who will act as the grantor spouse.) The trust provides for discretionary payments of income and/or encroachments of capital to one or more of the beneficiaries, but such payments/encroachments are limited to the “ascertainable standard” (health, education, maintenance and support in reasonable comfort) unless an “Independent Trustee” is then acting, who can make unlimited income payments and/or capital encroachments.
The major limitation of the trust is that the grantor spouse has no beneficial interest in the trust’s property and can only use the U.S. real estate – while it is held in the trust – with the trustee/beneficiary spouse while he/she is alive. If the trustee/beneficiary spouse is the first spouse to die (or if there was only one spouse initially), the grantor spouse must pay fair market value rent to the trust in order to use the U.S. real estate.
It is likewise possible that Canadian capital gains taxes will be owing upon the sale even though there has been a decrease in value for U.S. purposes.
And while the trust structure can be unwound if necessary (by distributing the property to one or more of the beneficiaries of the trust), the grantor spouse (because he/she is not a beneficiary of the trust) will forever extinguish his/her right to the U.S. real estate, proceeds from the disposition thereof, and the funds used to acquire it.
Another limitation is that the trust’s useful lifespan may be limited to 21 years as a result of certain Canadian tax laws that may give rise to Canadian tax consequences if a trust’s property is not distributed prior to its 21st anniversary. However, a number of factors will have to be considered at that time as, among other things, the potential U.S. estate tax exposure may outweigh the Canadian tax that will be triggered upon the trust’s 21st anniversary if the trust’s property is not otherwise distributed.
Watch those capital gains, too
If the U.S. real estate has not yet been acquired, the use of a trust is relatively straightforward, but it is best to have the trust in place as soon as possible. Where U.S. real estate is already owned, however, additional factors must be considered. In particular, capital gains taxes may be owing – in the U.S. and/or in Canada – upon the sale of the property by the individual to the trust. In circumstances that warrant the use of the trust, U.S. capital gains taxes will almost always pale in comparison to the potential U.S. estate tax exposure, although income tax would have to be paid immediately as opposed to on death.
As for Canadian taxes, a capital gain will be triggered on the sale (taxed at a rate of up to 26.765 per cent in Ontario in 2021) to the extent the fair market value of the U.S. real estate (adjusted for the exchange rate at the time of the sale) exceeds its cost base, adjusted for the exchange rate at the time of acquisition. As a result of the adjustments, however, it is possible that no Canadian capital gains taxes will be owing upon the sale in spite of increases in the value for U.S. purposes, and it is likewise possible that Canadian capital gains taxes will be owing upon the sale even though there has been a decrease in value for U.S. purposes.
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In any event, if Canadian capital gains taxes are owing on the sale, some or even total relief may be available (i.e., foreign tax credit, principal residence exemption).
If you are considering the purchase of property in the U.S., a tax advisor should certainly be consulted to understand your U.S. estate exposure and how to avoid or limit such exposure.
Matthew Getzler is Partner, Tax, Wills & Estates, at Minden Gross LLP in Toronto. For further information, please contact the author or any member of the Minden Gross Tax or Wills & Estates groups.