US estate tax in general

Many Canadians own US-situs real estate, whether it is in New York, Florida, California or elsewhere in the US. It is often a surprise (or a “trap for the unwary”) to Canadian clients (or for that matter, any non-US client) to learn that there is a US estate tax imposed on the value of this US-situs property at death. The US federal estate tax rate generally is 40%. Also, while US persons have a relatively large estate tax exemption ($12.92 million per person in 2023), non-US persons have a relatively tiny estate tax exemption amount of $60,000. As an example, a Canadian client with a $1 million second home in the US would owe approximately $400,000 in US estate tax if he or she simply owns the US-situs property in his or her own name at death. (This tax also applies to other US-situs assets, such as shares of stock in a US corporation.)

US-Canada estate tax treaty

The US-Canada Income Tax Treaty contains relief provisions relating to US estate tax. First, the treaty allows a Canadian resident to claim a proportionate share of the US “unified credit,” which is based on the ratio of US-situs assets to worldwide assets.

For example, if a person has $1 million of US-situs assets and $5 million of worldwide assets, he or she would have an available US unified credit of 20% of the full unified credit amount. The full unified credit amount is currently approximately $5.11 million, and allows the first $12.92 million of assets to pass free of US estate tax.

Second, the treaty provides for a “marital credit,” which is available when a surviving spouse inherits US property on the death of the first spouse, and which allows the deceased spouse’s estate to not be subject to US estate tax. The marital credit is in addition to the proportionate unified credit, and is equal to the lesser of the unified credit amount and the amount of US estate tax due.

Third, the treaty allows Canadian residents to claim a foreign tax credit on their Canadian income tax returns for the year of death equal to the amount of any US estate tax paid. It is worth noting that Canada does not have an estate tax, but does impose a capital gains tax upon death, calculated as if a Canadian decedent disposed all assets at their fair market value upon the date of death.

Some structuring alternatives

While the US-Canada tax treaty does provide relief to the imposition of US estate taxes, there are some drawbacks to this approach. Asset values and US rules may change over time, so it is unpredictable as to how much of an exemption from estate taxes a Canadian resident will actually have at death. Also, the estate of a Canadian decedent must file a US estate tax return to claim the treaty position and apply the available credits. Filling this return requires the disclosure of the decedent’s worldwide assets. This step imposes costs and may be missed. Moreover, the US real estate generally will be subject to probate proceedings in the US, which itself has costs and takes time.

Accordingly, Canadians who own or are purchasing US-situs real estate may consider structuring alternatives to avoid the imposition of US estate tax at all. For example, if the Canadian resident has children living in the US, he or she could consider creating a US trust to own the US-situs property. The trust could provide for the benefit of the US children and name one or more of the US children as trustees. The Canadian resident could transfer cash to the trust, and the trust could purchase the US property, which then would not be subject to US estate tax on the death of the Canadian resident grantor.

Another possible structure is to create a Canadian corporation to be the owner of the US-situs real estate. With this structure, the Canadian individual does not own the real estate directly, but rather owns shares of a Canadian corporation, which would not be subject to US estate tax. There are nuances to this approach – for example, (1) the Canadian corporation often will own a US corporation that owns the real estate, as this will avoid FIRPTA, branch profits tax, and other potentially adverse tax issues, or (2) the Canadian corporation could make an election to be treated as a US corporation for FIRPTA purposes. But the “foreign corporation” approach should be effective to avoid the imposition of US estate taxes.

Conclusion

Each client situation is unique. Canadians who are purchasing US-situs real estate are well-advised to consider the relevant US income and estate tax considerations and plan accordingly.