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Estates & Trusts

US Estate Tax on US Realty

Originally published in Canadian Tax Highlights, Volume 15, Number 5, May 2007.  Reprinted with permission.

Many Canadians are seeking to purchase vacation properties or second homes in the United States. The warmer climate, beautiful locales, and only occasional hurricanes make US-situs real estate attractive, but unfortunately Canadian owners are exposed to US estate tax. With proper planning, estate tax may be completely avoided.

A Canadian citizen and resident is subject to US estate tax on his or her US-situs assets at death. Under the Code, a non-US citizen and non-US resident is entitled to an estate tax credit of US$13,000; thus, US$60,000 of US-situs assets may pass free of US estate tax on the individual's death. The Canada-US treaty's 1995 protocol affords additional relief to a Canadian citizen and resident, potentially providing a larger US estate tax credit that exempts an amount bearing the same ratio to a US citizen's exemption that the value of the Canadian's US-situs assets bears to the value of his or her worldwide estate (the prorated exemption). The prorated exemption is determined by multiplying a US citizen's estate tax exemption (currently $2 million) by a fraction whose numerator is the value of the decedent's US-situs assets and whose denominator is the value of the decedent's worldwide assets.

The treaty also allows a marital exemption equal to the prorated exemption. If a Canadian citizen dies owning US-situs assets and leaves them to his or her spouse in a manner that would qualify for the US marital deduction if the surviving spouse were a US citizen, the exemption amount is effectively doubled. In some cases, use of the prorated exemption and marital exemption eradicates most or all of the US estate tax exposure at the Canadian's death, although special estate planning may still be required to minimize the taxation of the assets in a surviving spouse's estate.

Assume, for example, that Mr. and Mrs. C are both Canadian citizens and residents. Mr. C dies owning a house in Florida worth US$1 million, his only US-situs asset; his worldwide estate totals US$10 million. His will creates a credit shelter (or bypass) trust; the remaining assets pass outright to Mrs. C. Mr. C's prorated exemption under the treaty allows $200,000 of assets to pass free of estate tax.

Even though Mr. C's exemption can be doubled to $400,000 by virtue of the treaty's marital exemption, $600,000 of his US property remains exposed to US estate tax at a top rate of 45 percent. Furthermore, if Mrs. C owns all or a portion of the property at her death, it is likely to attract US estate tax again in her estate.

US estate tax exposure in both Mr. C's and Mrs. C's estates may be avoided through the use of a residence trust. A residence trust can be used in many situations, but it works most effectively for a married couple. The structure avoids the inclusion of the US real property in either spouse's estate for US estate tax purposes if specific requirements are met. One spouse (the grantor) creates the residence trust and contributes funds; neither event is taxable for US gift tax purposes. To avoid the trust's inclusion in the grantor's estate, the grantor cannot be a beneficiary or a trustee. Instead, the grantor's spouse and descendants can be the trust beneficiaries and the grantor's spouse can be the trustee, so long as distributions of income and capital are limited by an ascertainable standard. The trust then purchases the US-situs realty with the assets that the grantor contributed to the trust. It is essential that the purchase contract be in the name of the trust and that the funds for closing come from a trust account.

The grantor's spouse and descendants, as trust beneficiaries, can use the property rent-free during their lifetimes. Under certain provisions of US law, the grantor may use the property rent-free during his or her spouse's lifetime and can contribute funds to the trust to cover any related costs. Upon the grantor's death, the trust property is not included in his or her estate for US estate tax purposes, nor is it included in the spouse's estate at the spouse's death, even if he or she is the trustee, provided that trust distributions are limited by an ascertainable standard. If Mr. and Mrs. C had purchased the Florida property within a residence trust, the entire $1 million value of that property could have passed to their children without the imposition of any US estate tax. In Mr. C's estate, $270,000 of US estate tax would have been saved, and additional savings realized in Mrs. C's estate. Moreover, Mr. and Mrs. C's US estate tax exemptions would remain available to shelter any other US-situs assets.

The residence trust protects the property held in the trust from creditor claims, and if the property is held for more than one year the US long-term capital gains rate applies on a sale. At present, this rate is 15 percent federally, versus the 34 percent capital gain rate for real property held by a corporation.

The residence trust has a few disadvantages. If the grantor's spouse predeceases the grantor, the grantor must pay rent to continue to use the property. Moreover, if the grantor and his or her spouse divorce, the spouse can continue to use the property to the exclusion of the grantor. Nonetheless, for wealthy Canadian citizen and resident couples contemplating the purchase of US real property, the residence trust may be an effective mechanism to completely avoid US estate tax exposure on the property and preserve US estate tax exemptions.

Britta L. Lukomski