This article originally appeared in the May 5, 2008 issue of The Lawyers Weekly, published by LexisNexis Canada, Inc.
For many Canadian, the southern United States is a favorite vacation destination. Now, the strong Canadian dollar and favorable real estate markets have made purchasing a vacation home in the US even more attractive. But owning US real property can be a tax trap for the unwary. A Canadian owner of US real property is exposed to US estate tax on the full fair market value of the property at death, at rates as high as 45%. However, planning with a properly structured residence trust can eliminate US estate tax completely.
A Canadian citizen and resident is subject to US estate tax only on his or her US situs assets. US situs assets include, among other things, real property physically located in the US. Relief is available under US domestic law, but it is limited. Under the US Internal Revenue Code, the estate of a non-resident non-citizen ("NRA") is allowed a credit which exempts $60,000 of US property from US estate tax. Additional relief is available under the Canada-US Treaty, and more specifically, the 1995 Protocol to the Treaty. Under the Protocol, an NRA is entitled to an expanded credit which yields a potentially greater exemption amount based on the ratio of the decedent NRA's US situs assets to his or her worldwide assets (the "prorated exemption"). The prorated exemption is calculated by multiplying the exemption amount afforded a US citizen (currently US $2 Million) by a fraction, the numerator of which is the value of the NRA's US situs assets and the denominator of which is the NRA's worldwide assets.
The Treaty also allows a marital exemption equal to the prorated exemption. If a married NRA dies owning US situs assets and leaves it to his or her spouse in a manner that would qualify for the US marital exemption if the surviving spouse were a US citizen, the exemption amount is effectively doubled. In some cases, planning for the use of the prorated exemption and the marital exemption can alleviate all or most of the US estate tax exposure at the NRA's death, although special planning may still be needed to minimize the US estate tax exposure in the surviving spouse's estate. A properly structured residence trust eliminates both the risk that the Treaty credits will not shield the full fair market value of the property in the NRA's estate and the need for special planning for the surviving spouse because it eliminates the US estate tax exposure altogether for both spouses.
A residence trust structure can be used in many situations, but it works most effectively for a married couple. One spouse (the "grantor spouse") creates the trust and provides to the trustee the funds to purchase the property. Neither the creation of the trust nor the funding is taxable for US gift tax purposes. Title to the real property is taken in the name of the trust. To avoid inclusion in the grantor spouse's estate for US estate tax purposes, the grantor spouse may not be a beneficiary or a trustee. It is permissible for the grantor's spouse to be the trustee, provided distributions are limited to what is known as an ascertainable standard (typically, health, support, maintenance or education). As a practical matter, if the property is held for personal use, there will be no distributions, but inclusion of the ascertainable standard is critical if the spouse acts as trustee.
The trust beneficiaries are the grantor's spouse and descendants who may have rent-free use of the property during their lives. The grantor spouse may also enjoy rent-free use of the property during the spouse's lifetime. On the death of the grantor, the value of the property is not included in his or her estate for US estate tax purposes. The spouse continues to enjoy rent-free use of the property until the spouse's death. As with the grantor, the value of the property is not included in the spouse's estate for US estate tax purposes.
The trust may be structured so that the beneficiaries provide for the maintenance (including ordinary repairs) of the real property, or the grantor may contribute additional funds to the trust to cover expenses. Capital improvements, however, should be undertaken only with funds contributed to the trust by the grantor.
If the property is held for personal use (meaning there is no income earned by the trust), there are no US tax filing requirements. Further, if the property is held for more than one year, then the US capital gains rate (currently 15% versus 34% for real property held by a corporation) applies if the property is sold.
The residence trust does have a few disadvantages. First, if the grantor's spouse predeceases the grantor, then the grantor spouse must pay rent to the children in order to continue using the property. Of course, if the grantor intends to continue to maintain the property in any event, this may not be overly burdensome. Second, if there is a divorce, the beneficiary spouse may continue to use the property to the exclusion of the grantor.
The residence trust has good upside potential and very little downside. For Canadians contemplating purchasing US real property, the residence trust is an effective mechanism for avoiding US estate tax.
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