It is important to contact your tax advisor to determine your exposure to U.S. estate tax and to evaluate potential planning alternatives.
Joint Ownership of Property with Spouse or Family Members
When property is jointly held, the U.S. federal estate tax applies to the total fair market value of the property, except to the extent your estate can prove the surviving owners contributed to the purchase of the property including improvements and mortgage payments. Therefore, when purchasing U.S. real estate jointly, it may be helpful for each owner to pay for their share of the property with their own funds and to be able to prove it. In this case only your (the decedent’s) portion of the fair market value is taxed if you die, thus reducing the tax liability.
Sale and Leaseback
If you want to avoid any estate tax but still continue living in your U.S. residence, you may be able to sell the property at fair market value and then lease it back for a certain number of years with options for renewal. This would minimize or reduce taxes, such as Canadian and U.S. capital gains tax on any profit from the sale, and U.S. estate tax on the value of any mortgage you receive from the purchaser as part of the purchase price package (assuming the mortgage is properly structured). However, you must ensure that the sale and/or any mortgage involved do not constitute a sham and that full fair market value is paid for the property. Since everyone’s situation is unique, make sure you get specific tax advice from a professional tax advisor.
Buying Term Life Insurance
This is an option to help pay for any future estate tax liability shortfall. For many older Canadians, however, it is not a realistic option, because it is either impossible to acquire or too expensive. Even if you could afford to acquire enough coverage, you would need to increase the face value if the property appreciates in value. You should attempt to buy a policy that enables you to increase the face value up to a certain amount, without having to undergo a medical exam each time. If you can’t obtain term life insurance, you may want to consider the cheaper accidental death insurance.
Owning Your Foreign U.S. Real Estate or Investments Through a Canadian Holding Company
Provided the original purchase of U.S. real estate is made with a non-U.S. corporation and the corporation is properly structured, maintained and operated as the true owner of the property, the IRS heretofore has not levied estate tax on such indirect ownership of the real estate.
However, if the real estate is a personal use residence, this is often not practical for a Canadian resident since the CRA may levy a shareholder benefit on the personal use of the property. An exception applies to certain grandfathered Canadian “single purpose” companies. However, the structure may still be practical for U.S. rental real estate and the investment in U.S. securities.
Placing a Non-recourse Mortgage on Your U.S. Real Estate
Under U.S. regulations, if your U.S. real estate is subject to a valid “non-recourse” mortgage (i.e. you have no personal liability in the event of default), then only your net equity in the real estate (not the full fair market value of the property) is subject to U.S. estate tax. However it is often difficult to find a source for such a mortgage. You may be able to arrange such a mortgage among family members or family entities, but such a “related party” mortgage must avoid the characteristics of being a “sham.” Thus it is possible that interest must be paid, which could trigger taxable income to the lender without a compensating tax deduction to the borrower.
Purchasing the Property Through an Irrevocable Non-U.S. Trust
Under this potentially controversial scenario, an irrevocable Canadian trust would be formed to purchase a U.S. personal use residence. Generally beneficiaries and others involved with an irrevocable trust are not subject to U.S. estate tax on their death if property is owned by the trust. However there are potential pitfalls with regard to the formation of the trust and the ultimate sale of the property by the trust. Please consult your international tax advisor before proceeding.
Purchasing the Property Through a Canadian Partnership
As indicated above, ownership of your U.S. real estate through a Canadian holding company has the potential to avoid U.S. estate tax. However, the income tax rate on corporate gains is generally higher than the income tax rate on individuals. If you own the U.S. property through a Canadian partnership and you sell the property for a gain, you will be taxed at the lower tax rate for individuals. If the partnership has a very active business in Canada and none in the United States it is possible (though definitely not a certainty) that there will be no estate tax on the death of a partner if the partnership does not terminate. Be sure to consult your tax advisor before proceeding.
Giving the Property to Your Beneficiaries During Your Lifetime
Under this scenario the U.S. (and Canadian) gift tax rules may apply.
Leaving Your U.S. Property to a Qualified Domestic Trust (QDOT)
The purpose of this strategy is to defer rather than eliminate estate tax until the death of the second spouse. If it is structured properly, the QDOT may also conform to the Canadian tax laws in terms of being considered a spousal trust. That would mean that the CRA would not consider the transfer to be a deemed disposition and therefore charge capital gains on your death. This strategy is worth considering if there are insufficient liquid assets in your estate tax to pay the estate tax.
Investing in U.S. Securities through Canadian Pooled Fund Corporations or Canadian Mutual Funds
Canadian mutual funds may be formed (organized) as either corporations or trusts. If you purchase a Canadian mutual fund that is organized as a corporation that invests in U.S. securities, there will generally be no U.S. estate tax on your death. However, if the mutual fund is organized as a trust, the IRS attitude is unclear. It is possible you would be subject to U.S. estate tax on the mutual fund’s underlying U.S. securities. Read the fund prospectus and obtain professional tax advice in advance.
There may be other strategies that could be beneficial in your particular situation to reduce or eliminate U.S. estate taxes, which you should discuss with a tax advisor knowledgeable in U.S./Canada tax strategies.
