As a result of some U.S. tax legislation that was introduced in late 2012, there have been some changes to the U.S. estate tax rules as it applies to Canadian residents owning U.S. property.  While the details on how U.S. estate tax are beyond the scope of this memo, I wanted to point out the following:

1.    The U.S. estate tax exemption is now $5.25 million for 2013 and will be indexed for inflation.

2.    For Canadians owning U.S. property, this $5.25 million exemption is reduced by the ratio of U.S. assets to worldwide assets.  Essentially, if your worldwide assets are less than $5.25 million, then no U.S. estate tax would be applicable on your U.S. based assets.

3.    If your worldwide assets are worth more than $5.25 million then you may have some U.S. estate tax exposure based on the ratio of U.S. assets to total assets multiplied by the $5.25 million (it is not quite this simple but this would be a good rule of thumb).

4.    If you pass away and Will the U.S. assets to your spouse then you effectively get to double up on the exemption in most cases, but these rules are very complicated.  On the spouse’s death, the assets will be exposed to U.S. estate tax (using the basic exemptions and ratios discussed above to determine the tax).

5.    It is preferable to own U.S. property personally if you do not have U.S. estate tax exposure. This is because any capital gains would be taxed at the U.S. reduced capital gains rates for individuals (ie. approximately 20%) and would be taxed at Canadian marginal capital gains rates.  Canada would provide a credit for the U.S. tax paid resulting in an overall effective rate of no higher than 23.2%.  If property is owned in a Canadian or U.S. corporation then double tax could be applicable as tax is paid at the corporate level and then again when funds are extracted from the company.  Also, the U.S. capital gains tax rates for corporations is at least 34%.

6.    If you have U.S. property in an LLC (which is usually treated as a flow through entity for U.S. purposes) then any capital gain would be taxed on a U.S. personal tax return that would have to be filed by the shareholder of the LLC.  However, for Canadian purposes, this capital gain is a corporate gain.  When the funds are distributed from the LLC, they would be treated as foreign dividend income and be subject to ordinary income tax rates.  The effect of this inconsistency between the Canadian and U.S. tax system could result in double tax.  For this reason, we generally recommend that Canadians not own U.S. properties in a LLC if it is expected that capital gains will result in the future.

7.    There are Canadian trust structures that can be put in place to avoid U.S. estate tax.  These would only be useful in the case where an individual’s worldwide assets exceed the $5.25 million.  Also, the establishment of these trust structures can be fairly expensive.  Therefore, in some cases it is cheaper to buy life insurance to cover the U.S. estate tax then it is to put the trust structures in place.

Typically, a Canadian trust structure would be set-up such that the trust would be funded through a cash contribution by spouse #1.  Spouse #2 and their children would be the beneficiaries of the trust.  A third party would be named as a trustee.  The trust would then acquire the property and hold it for the benefit of spouse #2 and the children. Spouse #1 would only be able to use the property at the invitation of spouse #2 and the children.

The impact of the above is that spouse #1 has no beneficial ownership in the property resulting in no estate tax.  Spouse #2 and the children have no direct ownership of the property, thereby, avoiding U.S. estate tax if they were to pass away.  This structure avoids U.S. estate tax completely if implemented properly.

If anyone has a client that is exposed to U.S. estate tax and wishes to pursue the trust alternative then please contact me.

8.    Owning the property jointly would generally result in only half of the value of the property being included in the decedent’s estate on first death.  However, the U.S. will ignore the “joint ownership” and treat the property as 100% owned by the decedent if they feel that the decedent funded the entire acquisition.  Therefore, joint ownership will not guarantee that only half of the property is included in the estate tax calculation.  Apparently, owing as “tenants in common” makes it more difficult for the I.R.S. to make this case.  A better solution would be to ensure that both spouses have sufficient funds to pay for the property.

9.    The above comments apply to U.S. Federal estate tax.  Some states (but not Florida) have their own estate tax with their own rules.

For further advice or assistance with these or any other financial issues, please contact a Millards representative at (519) 759-3511.