Tax Insights: Estate tax update – Owning a US vacation home (2018 edition)

Issue 2018-05

In brief

The estate of a Canadian resident may be required to pay US estate tax on a US vacation home owned by the deceased. However, the Canada-US Tax Treaty (the Treaty) provides some relief.¹ In addition, US President Donald Trump recently signed into law the Tax Cuts and Jobs Act (TCJA), which includes provisions to enhance the US estate tax exemption. As a result, Canadian residents will now have a US estate tax liability only if their worldwide assets are valued at more than US $11.2 million.² This exemption is effective for 2018 through 2025. Unless permanent legislation is enacted, the exemption will return to the pre-2018 regime in 2026. 

While US estate tax applies to other US assets, such as US securities, this Tax Insights discusses the estate tax only as it applies to US real estate. All amounts are in US dollars. 

This Tax Insights applies to personal-use properties only. If you own a US rental property, other considerations should be taken into account. 

In detail

How is US estate tax calculated?

If you own a US property, you will be required to pay US estate tax based on the fair market value of the property at the date of your death. Estate tax rates start at 18% and reach 40% for properties worth more than $1,000,000.

You can reduce your estate tax liability by claiming a tax credit (referred to as the unified credit) equal to the greater of:

• $13,000
• $4,425,800³ x the value of your US assets ÷ your worldwide assets

Therefore, if your US home accounts for 10% of the value of your worldwide assets, you will be entitled to a unified credit of $442,580 ($4,425,800 x 10%).

An additional credit is available if the US property passes to a Canadian spouse. The good news is that in many cases these tax credits will eliminate the US estate tax liability. The estate may still be required to file a US estate tax return to claim the credits provided in the Treaty.

Example: The $1,000,000+ property

Consider Steve and Michelle, married and residents of Canada (neither are US citizens). Steve owns a Florida home worth $1.5 million. His worldwide assets are worth $15 million. Steve’s estate tax liability on the Florida property, before any tax credits, is $545,800.

If the property passes to Michelle, the Treaty provides further tax relief, through the marital credit, equal to the lesser of the unified credit and the amount of the estate tax. As the table shows, the marital credit is sufficient to eliminate Steve’s US estate tax. 

Additional examples are in the table further below.

Canadian tax implications

US estate tax is often greater than Canadian tax. On death, a taxpayer will pay Canadian income tax on the accrued capital gain on the US home and will also be subject to US estate tax on the value of the home. Canada will provide a foreign tax credit for US estate tax paid on the US home.

Because Canadian capital gains rates are significantly lower than the top US estate tax rate and Canadian tax applies only to the gain in the property rather than its fair market value, the estate likely will pay tax at the US estate tax rate. In addition, the provinces and territories generally do not allow a foreign tax credit for US estate tax paid. As a result, the deceased may be subject to some double taxation. 

Ownership options to reduce exposure

Personal ownership

Personal ownership may be appropriate if the estate tax liability can be managed or eliminated through the credits available under the Treaty. In the case of a married couple, to maximize the unified credit available under the Treaty, the best approach may be to put ownership in the hands of the spouse with the lower net worth. However, Canadian income tax attribution rules have implications that should be considered.

If the home is owned personally, the owner’s will may need to be changed. For example, if Steve’s Florida home passes to Michelle under his Will, she may be exposed to US estate tax on her death. A properly structured spousal trust created under Steve’s will could protect Michelle from estate tax.

Even if the estate tax exposure cannot be fully eliminated, it might be possible to obtain additional life insurance to cover the estimated estate tax. This could be the simplest solution, particularly if the individual is young and has access to low-cost insurance.

Personal ownership in joint tenancy

Many Canadian couples hold property in joint tenancy. However, joint tenancies between spouses who are not US citizens can cause US gift and estate tax problems.

For US estate tax purposes, if the surviving spouse is not a US citizen, 100% of the value of the property is included in the estate of the first spouse to die, unless the executor can prove that the surviving spouse contributed funds towards the purchase of the property. For Canadian tax purposes, no deemed disposition will occur until the death of the surviving spouse⁴.  If US estate taxes are owing, this can result in foreign tax credit problems.

These US gift and estate complications mean that joint ownership generally is not a recommended form of ownership if an individual likely will have a US estate tax liability. In addition, joint tenancy may not allow the spouse to undertake effective will and estate planning for US estate tax.

An alternative to joint tenancy may be to hold the property as tenants in common. This could allow each spouse to undertake will planning to protect his or her 50% interest.

Canadian discretionary trust

If the estate tax exposure cannot be dealt with through personal ownership and will planning, the individual may want to consider establishing a Canadian discretionary family trust to own the property. Two key advantages are that:

• estate tax may be avoided on the death of both the individual and the individual’s spouse
• if the property is sold, any increase in value will be subject to the same capital gains rates as if the property were owned personally

This structure generally appeals to Canadians for more significant property purchases where it does not constitute a significant portion of the individual’s net worth. This is because the individual must be willing to give up control over the trust property to his or her spouse and children. In addition, due to Canadian income tax rules, the trust likely will have to be terminated before its 21st anniversary date. Therefore, the trust structure may not appeal to younger families.

Non-recourse mortgage

A non-recourse mortgage may be an alternative, particularly if the property is already owned by a Canadian resident (who is not a US citizen). A non recourse mortgage is collectible only against the specific property and not against any other assets of the individual. 

For US estate tax purposes, the value of the property is reduced by the value of the non recourse mortgage. For example, if Steve obtained a non recourse mortgage of $1,000,000, his taxable estate would be reduced to $500,000. As a result, his US estate tax exposure would drop to about $8,273 in 2018. 

It is unlikely that a commercial bank would be willing to lend more than 50% to 60% of the value of the US real estate. Therefore, it is unlikely that you can eliminate the total value of the property by obtaining a non-recourse mortgage through an arm’s length lender.

It may be possible to reduce the cost of financing if the mortgage can be structured to obtain an interest deduction in Canada. This means that the mortgage proceeds cannot be used to purchase the US vacation home, but must instead be used to purchase other income-producing investments.

Other options

Other available options include: 

• ownership through a Canadian corporation
• ownership through a partnership that is treated as a corporation for US tax purposes
• donation of the property to a US registered charity

Using a Canadian corporation may be problematic because the shareholder may be faced with a taxable benefit unless fair market rent is paid. 

We encourage you to consider your options before entering into a purchase agreement. Many planning techniques cannot be used after the property is purchased, because of US gift tax consequences associated with the transfer of US real estate.

Examples: US estate tax liability

^{[1.]  This Tax Insights addresses the tax issues for Canadian residents who are not US residents or citizens.} 

^{[2.]  The American Taxpayer Relief Act of 2012 establishes an exemption amount of $5 million and indexes this amount for inflation annually. The Internal Revenue Service (IRS) announced that the indexed exemption amount is $5.60 million for 2018. The Tax Cuts and Jobs Act has doubled the original exemption amount from $5 million to $10 million, indexed to $11.2 million for 2018.}

^{[3.]  $4,425,800 is the US estate tax on $11.2 million of assets. As mentioned in footnote 2, recent changes to US tax law doubled the estate tax exemption from $5 million to $10 million; the inflation-indexed amount for 2018 is $11.2 million.}

^{[4.]  The Canadian tax regime allows for a tax-free spousal rollover for assets bequeathed to the surviving spouse or a spousal trust.}