Despite the exemptions and Treaty relief, some Canadian residents will still have a U.S. estate tax liability. The current estate tax exemption is not permanent and will expire in 2025. With constantly changing tax laws, planning becomes more complicated. One will want to implement a plan that will not cause other tax problems on an ongoing basis, and that can be easily changed in the future.
Some potential estate planning tools that can be used include:
Use a Canadian corporation to hold U.S. investment properties
If a Canadian corporation holds the U.S. property, it should be excluded from the shareholder’s U.S. situs assets on death. However, it should be noted that you may pay more combined Canadian and U.S. income tax on investment income and on the eventual capital gain by using a corporation. The Tax Cuts and Jobs Act reduced the top U.S. federal corporate tax rate from 35% to 21%, but there may still be an income tax cost to owning U.S. property through a corporation versus owning the property personally when you take into account Canadian taxes payable by the corporation and on dividends by the shareholder.
Note that during his presidential campaign, President Biden proposed an increase to the U.S. federal corporate tax rate from 21% to 28%.
The benefit of using this structure will depend on your U.S. estate tax exposure and other considerations. Such considerations might include liability protection if you are renting out U.S. real property.
Use a non-recourse mortgage to finance U.S. real estate
In general, liabilities of a Canadian resident will be applied on a pro-rata basis to reduce the value of U.S. situs and non-situs assets. However, if you use a non-recourse mortgage to finance U.S. real property, that liability will be allocated directly against the value of U.S. real property for estate tax purposes. Under a non-recourse mortgage, in the event of default, the lender has recourse only to the mortgaged property and not to the mortgagor personally.
Reduce the value of your Canadian estate
For some people, an estate liability can arise because the value of the individual’s worldwide estate is much higher than their U.S. estate. This is due to the proration of the Treaty exemption and the proration of general liabilities discussed earlier. So, if you can take steps to reduce the value of your total estate, a higher unified credit will be available after the proration. Also, a higher proportion of your general liabilities will be applied against your U.S. situs property if the value of your estate is reduced. Reducing the value of one’s estate below $11,700,000 would eliminate U.S. estate taxes completely for deaths in 2021.
Other more sophisticated plans are available, such as the use of a trust or partnership to hold U.S. situs property and U.S. qualified domestic trusts (QDOTs). In addition to these tax planning ideas, another option is to simply purchase life insurance to cover the expected estate tax liability. When using life insurance, one must keep the proration rule for the unified credit in mind, and professional advice on structuring life insurance is recommended.
Personal-use U.S. real property
Prior to 2005, many Canadians used a Canadian corporation (known as a “single purpose corporation”) to hold personal-use U.S. real property to avoid U.S. estate tax on the property. Shares of a Canadian company are not U.S.-situs property for U.S. estate tax purposes. As long as the sole purpose of the corporation was to own the U.S. property and all expenses related to the property were paid personally by the shareholders, the Canada Revenue Agency (CRA) would not consider the shareholders to have received a taxable benefit for the personal use of the property.
Current CRA policy does not allow new arrangements entered into after 2004 this favourable treatment with respect to the assessment of taxable benefits for shareholders’ personal use of the property (arrangements in place prior to 2005 are grandfathered).
In addition, as discussed above, using a corporation to hold the property can increase the total tax on any capital gain realized on the disposition of the property, although the tax differential may not be as significant as it once was due to the decrease in the U.S. corporate federal tax rate to 21%.
Furthermore, there may be an additional tax cost to your estate, because of the potential difference between the estate’s adjusted cost basis of the corporation’s shares compared to the adjusted cost basis to the corporation of the real estate held by the corporation.
The benefit of using this structure will depend on your U.S. estate tax exposure.
Rented U.S. real property
If you are renting your U.S. real property on an either a full-time basis or part-time basis, in addition to U.S. estate tax exposure you will also have U.S. income tax exposure. For further information on U.S. income tax implications of renting out your U.S. real property, contact your BDO advisor, and see the BDO Tax Bulletin U.S. Tax Issues for Canadians.
Gift of U.S. securities
Some people may consider gifting their U.S. assets to family members during their lifetime in order to avoid U.S. estate tax. This strategy may work for U.S. securities, since this type of asset is not considered to be a U.S. situs asset for U.S. gift tax purposes.
On the other hand, gifting a U.S. real property will result in U.S. gift tax, unless the recipient of the gift is a U.S. citizen spouse. In addition, the recipient’s cost basis of the property will equal the cost basis of the transferor for U.S. tax purposes, plus a portion of the U.S. estate tax paid, if any.
If a Canadian resident makes a gift to a U.S. citizen spouse, then the gift will qualify for the unlimited marital exemption. If a Canadian resident makes a gift to a non-U.S. citizen spouse, then the gift will qualify for the annual exclusion amount of $157,000 in 2020 ($159,000 in 2021). Gifts to someone other than a spouse would only qualify for the annual gift exclusion amount of $15,000 in 2020 ($15,000 in 2021) per recipient.
Note that gifting of U.S. assets could result in Canadian tax, especially when the assets are gifted to someone other than a spouse. Any gift tax paid will not qualify for a foreign tax credit in Canada.