By Peter Cuttini
In the past few years, many Canadian residents have taken advantage of the depressed real estate market in the United States, which means we have seen more and more questions about the US Estate Tax.
Normally, investors refer to this tax with fear in their eyes, especially when people start throwing around numbers of a 40% tax.
So, let’s get rid of the fear and try to understand more about this tax, what it is, and some planning techniques you can use to minimize the estate tax.
Estate tax – a brief overview
Unlike Canada, the U.S. applies an estate tax on the value of your U.S. property at the time of your death. Property can be, of course, real estate, but also investments, and so on. The estate tax starts at 18% and increases to 40% for estates with U.S. assets that are greater than $1 million. The good news is that if the fair market value of your worldwide assets, at the time of your death, are less than $5.34 million in 2014 there will be no estate tax.
Fortunately, Canadians can see some relief from the U.S. estate tax via the Canada-U.S. Tax Treaty. The Treaty has two specific credits Canadians can use:
- the unified credit
- the marital credit
The unified credit allows you to reduce your U.S. estate tax by the greater of:
- $2,081,800 multiplied by the value of your U.S. assets divided by the value of your worldwide assets
If you transfer your U.S. assets to your spouse upon death, the Treaty also allows your estate to reduce the estate further using the marital credit, which is the lesser of the unified credit and the estate tax.
For example, Stephanie owns a U.S. property worth $1.5 million. At the time of her death, the estate tax before credits would be $545,800. If the fair market value of her worldwide assets at her death was $7 million, the unified credit would reduce the estate tax by $416,360. If Stephanie’s will were to transfer the U.S. property to her husband, Jackson, the estate tax would be reduced to zero.
Stephanie’s US property = $1.5 million
Unified Credit = ($2,081,800 x $1.5 million) / $7 million = $416,360
Estate Tax (40%) = $545,800
Total (Estate Tax – Unified Credit) = $129,440
With proper tax planning, you CAN reduce the estate tax.
A few common tax planning strategies to reduce the estate tax are as follows:
- Purchase life insurance to cover the estate tax. This can be expensive and needs to be revisited often, as the value of your assets change.
- Reduce the value of your NON-American assets before death. For example, look into gifting, or transfers of assets to spouses or children. This will increase the unified credit upon death.
- If you finance your U.S. property using a non-recourse mortgage, the mortgage will reduce the value of your U.S. assets. A non-recourse mortgage has to do with what assets a lender can go after if the borrower doesn’t repay a loan – it prevents a lender from going after personal assets in the event of foreclosure. They can only foreclose on the property. This option will need to be reviewed often as you continue to pay off the mortgage; the benefits of the mortgage on the estate tax will be reduced over time.
- Own the property, directly or indirectly, with a Canadian corporation. Because a corporation never dies, this will eliminate any exposure to U.S. estate tax. The problem with a corporation is that you pay more on income tax and capital gain tax. So, it’s a balancing act that you need to assess with your financial and accounting advisors.
- Use a U.S. Qualified Domestic Trust. However, this can be a complicated structure. A US trust is complicated to set up and, therefore, costly.
All of the options should be discussed with the appropriate professional advisor before implementation and reviewed often to determine if the tax planning is still valid, as rules change over time.
This is an extremely brief overview of the US estate tax. It’s critical for you to seek the advice of a qualified cross-border advisor when discussing your US assets as a Canadian resident.
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Peter Cuttini, CPA, CA, LPA, CPA (Illinois) is a real estate investor and cross-border accountant. He often speaks on cross-border issues and has written numerous articles on the topic. Contact him at: firstname.lastname@example.org.