Canadians have long-sought to escape our harsh winters by heading to the American South. In recent
years, a number of factors including the Canadian dollar being near parity, depressed USA real estate
values, and a relatively strong Canadian economy, have heightened our interest in purchasing that ideal
winter get-away home. However, what many Canadians do not realize is that purchasing real estate in the
USA is not as simple as purchasing a vacation home in Northern Ontario, or in PEI.
There are a myriad of issues that must be considered when a Canadian contemplates a US property
purchase, whether that property be rented out to generate income, or remain a personal use vacation
home. Any effort to understand how best to structure the purchase of U.S. real estate, first requires an
understanding of the key differences in Canadian and the United States tax regimes.
Part I of this article provides an overview of these differences. Part II subsequently focuses on the 4
different ways to structure the purchase of U.S. real estate for Canadians and some of the financial
planning and risk management issues that need to be considered with each ownership method.
U.S./Canada Tax Differences – An overview
Canada assesses tax based on residency (regardless of citizenship) on their worldwide income. Canada
does not have an inheritance tax or a gift tax. Instead, Canada imposes a deemed disposition (capital
gains) tax on the transfer of property ownership (whether or not for consideration) and at death. Each
deceased tax payer is deemed to have disposed of their capital property immediately before death. The
primary exception to this is a rollover of property that passes to the deceased taxpayer’s spouse or to a
qualifying spousal trust. This rollover acts as a deferral only, and income tax is imposed upon the
surviving spouse’s death. Capital gains are taxed in Canada by applying the income tax rates to a portion
of the gain over the adjusted cost base (ACB) that is included in income. Currently the inclusion rate for
capital gains is at 50%.
In contrast, U.S. estate taxes apply on the death of individuals at graduated tax rates to the value of their
worldwide estate. The same rates apply whether an individual is a U.S. citizen, a U.S. resident, or a nonresident.
The difference is that for Canadians who are non-residents of the U.S., only the value of the
property with a U.S. location or connection (this is referred to as U.S. situs property) is included in
calculating the estate that is subject to tax.1 Please note, the reference here to a non-resident of the U.S.
does not refer to a U.S. citizen living in Canada – that’s a different matter altogether.
Canadians and U.S. Gift Taxes
It is important to be aware that although we have no gift tax in Canada, Canadians who are not U.S.
Citizens and not U.S. Residents are still subject to U.S. gift tax on transfers of US property. U.S. situs
assets for U.S. gift tax purposes include those that are individually owned (or through a look-through
entity such as partnerships and certain kinds of trusts) and interests in real property and tangible personal
property (the contents of real property, including boats and vehicles) located in the U.S., as well as U.S.
Stocks and debts of U.S. persons or companies. However, most U.S. bonds, U.S. Bank accounts and U.S.
life insurance policies are expressly excluded from gift tax.
There is no U.S./Canadian tax treaty to cover gift tax. This means that a Canadian who transfers a U.S.
situs asset such as a vacation home located in the U.S., or a vehicle that is titled and garaged in the U.S.,
is subject to U.S. gift tax. The gift tax and the estate tax exemptions are actually combined in the U.S.
For U.S. Citizens the current lifetime exemption amount is $5.12 million and the tax rate is at 35%.
However, without Congressional action this lifetime exemption will drop to $1,000,000 and the tax rate
will move up to 55%, effective January 1, 2013. Whether there is any political will to see estate taxes
climb this much is doubtful. Currently as of Sept 2012 the majority consensus is that Congress will likely
introduce legislation to set the exemption somewhere around $3.5 million, however, this largely depends
on the outcome of the November election and will not be known until the end of 2012. If the exemption
does drop, as most expect it will, than 2012 would prove to be a great opportunity to give assets away to
lock in the current $5.12 million exemption. It’s important to note however, that the $5.12 million
exemption is not available to Canadians where gift tax is concerned – only for estate taxes. All that is
available currently for Canadians to reduce the gift tax is an annual exclusion of USD $139,000 in 2012
for outright gifts to a non-citizen spouse, and USD $13,000 annually to all others.
Capital Gains and Gifting: A matter of difference in timing
There is a difference in the timing of taxation when it comes to gifts of U.S. property with unrealized
capital gains. The U.S. does not generally tax capital gains immediately on gifted assets. Under U.S. gift
law, if property is gifted with unrealized capital gains, the person receiving the gift acquires it with the
same capital gains tax liability as the person who gave the property. Ultimately when the receiver sells
the asset they will pay capital gains tax at that time – it doesn’t matter how long into the future the
property is sold. However, Canada generally requires that capital gains be paid at the time the gift is
made. If there were no treaty, a Canadian citizen transferring appreciated U.S. property could face
Canadian capital gains at the time the gift is made, while the person receiving the property could face
U.S. capital gains tax when the asset is sold.
To avoid the double taxation that this difference of timing causes, the Canada – U.S. Tax Treaty allows
the Canadian giver to be treated for U.S. capital gains tax purposes as if he or she had sold and
repurchased the asset just before giving it. This election triggers a capital gain in the hands of the Canadian giver
(as capital gains tax is due in Canada anyway upon giving an appreciated property) and allows the capital gains
tax to be triggered in the U.S. (as the asset is deemed sold before it is gifted). The Canadian giver then
applies a foreign tax credit to avoid double taxation on the U.S. capital gains tax liability arising from the
Canadians and U.S. Estate Taxes
Upon death, the estate of a Canadian citizen domiciled in Canada, but with U.S. property may be subject
to both (a) Canadian income tax on any appreciation of U.S. property and (b) U.S. estate tax on the full
market value of US situs assets valued at more than $60,000. The U.S. estate tax laws apply to all
property in the U.S., regardless of that property owner’s citizenship or residence status. The Canada-U.S.
Tax Treaty provides a “small estate” exemption to Canadian citizens whose entire gross world-wide
estate is less than 1.2 million USD in value upon death. Please note, however, that the estate value is
determined by U.S. estate tax rules, which include assets that do not normally form part of the probate of
an estate in Canada, such as a life insurance policy on the decedent’s life and any jointly-held property
held by the decedent. These rules also do not allow the estate value to be reduced by the amount of any
debts of the decedent.
Where a Canadian citizen’s estate is valued at more than USD 1.2 million (again, as determined by U.S.
estate tax rules), U.S. estate tax is imposed on the value of all U.S. situs property including stock issued
by U.S. corporations or held by U.S. mutual funds (but not Canadian mutual funds holding U.S. stocks).
The Canada – U.S Tax Treaty allows Non-U.S. citizens/residents to reduce their U.S. estate tax liability
by claiming a tax credit referred to as a unified credit. The unified credit for Non-U.S. citizens/residents is
equal to the greater of USD 13,000 and a prorated unified credit calculated as the tentative estate tax
liability that would otherwise correspond to the USD 5 million exclusion amount ($1,730,800 in 2012,
$345,800 in 2013 and beyond, if the 2010 Tax Act ins not extended) multiplied by the value of the
deceased’s U.S. property over the value of the worldwide estate (see calculation below). This amount is
then used to offset the estate tax owing, which in 2012 is 35% of the U.S. situs asset. In addition to the
enhanced unified credit, there is a marital credit available, if the U.S. assets pass to a spouse on death.
The marital credit equals the lesser of the unified credit and the amount of the estate tax.
Canadian giver (as capital gains tax is due in Canada anyway upon giving an appreciated property) and
allows the capital gains tax to be triggered in the U.S. (as the asset is deemed sold before it is gifted). The
Canadian giver then applies a foreign tax credit to avoid double taxation on the U.S. capital gains tax
liability arising from the election.
Effective exemption limit and top rate of U.S. estate tax:
For 2012 the graduated estate tax rates are as follows:
For example if a Canadian non-resident alien owns a U.S. property worth $450,000 and their worldwide
estate is worth $4,000,0000, they would have a unified credit of $194,715. At 34%, their estate tax would
be $153,000. Then the $194,715 credit would be applied and there would be no estate tax owed.
If, however, in 2013 the unified credit drops to $345,800 and the top U.S. estate tax rate rises to 55%,
using the above example the calculation would go as follows:
Unlike the previous example, there would be estate tax owing, even if the decedent left his entire estate to
his spouse, unless the spouse was a U.S. citizen, or the estate was rolled into qualified domestic trust (see
under Marital Transfers below). Please note, the executor of a Canadian citizen who dies owning U.S.
situs assets is required to file a U.S. Estate Tax Return within 9 months of death, if the U.S. assets is
greater than USD $60,000.
Capital Gains/Estate Tax – Double Taxation Relief
The Canadian –U.S. Tax Treaty allows the provision of a credit for U.S. estate tax payable on property
located in the U.S. Generally speaking, due to the Canadian and U.S. tax credits, an estate will pay the
higher of the Canadian income tax or the U.S. estate tax, not both. Since the Canadian capital gains tax
rates are lower than the U.S. estate tax rates, the estate of a U.S. citizen with Canadian residency will
likely pay tax at the U.S. estate tax rates if their world-wide assets exceed the amount of the exemption
U.S Citizen Spouses
If both spouses are U.S. citizens there is an unlimited marital deduction that applies to both gift taxes and
bequests made between them. Therefore, essentially, gift and estate taxes may be deferred until the death
of the second to die of a U.S. citizen married couple.
Non-U.S. Citizen Spouse Gift Tax
If the surviving spouse is not a U.S. citizen, the marital deduction is limited to $139,000 per year for 2012
(indexed annually for inflation). For example, if a $450,000 property was gifted by the Canadian
individual to his non-U.S citizen spouse, the person making the gift would be subject to a gift tax of
$311,000 ($450,000 – $139,000).
Non-U.S. Citizen Spouse Estate Tax
If the surviving spouse is not a U.S. citizen, the unlimited marital deduction enjoyed by U.S. citizen
spouses is not available, only the $13,000 unified credit and $13,000 marital credit are available. Here
once again it is important to have undertaken proper planning by using a “qualified domestic trust”
(QDOT) to avoid unnecessary taxation. If properly structured, the QDOT can meet the tests of a spousal
trust under Canadian law. It is important to note however, that any marital credits available through the
Canada-U.S Tax Treaty cannot be used in conjunction with the QDOT deferral: it must be one or the
other. If the combined prorated unified credit and marital credit described above are not sufficient to
absorb all potential estate tax liability, than a qualified domestic trust can be used to further defer any tax
It should be noted that the QDOT has some restrictions and must be set up to satisfy 4 conditions: 1) the
surviving spouse is the only beneficiary during his or her lifetime; 2)the surviving spouse receives all of
the income of the trust; 3)there is a U.S. trustee; 4) the trust is subject to a U.S. jurisdiction. Furthermore
if the QDOT is funded with more than USD 2million, the trustee must file a bond or letter of credit with
the IRS, unless at least one trustee is a U.S bank or U.S. trust company.
Any cross-border insurance planning must consider the differences in how insurance proceeds will impact
a Canadian’s U.S. estate tax. For a U.S. resident (domiciled in the U.S) at the time of death the value of
any insurance policies on the decedent’s life are included in their worldwide estate at death and are
subject to U.S. estate taxes.
Although in Canada insurance proceeds are received by the beneficiary tax free, the value of the
insurance proceeds are included in the decedent’s worldwide estate for the purpose of determining the
prorated unified credit. Therefore, insurance proceeds could significantly reduce the prorated unified and
marital credits available to offset U.S. estate taxes and result in a greater U.S. estate tax liability for
Canadians owning large insurance policies.
While the rules and differences with respect to Canadian and U.S. taxation are complex, it is essential for
Canadians contemplating the purchase of a U.S. property to be aware of these differences when
considering how to structure the ownership of U.S real estate.
It is important to realize that the rules with respect to exemptions and tax rates for U.S. estate taxes are
always in flux. In addition, the values that really matter when calculating tax liabilities, are not the current
values of the U.S. property, but the values on the date of transfer, or the date of death. These values can
fluctuate considerably over significant periods of time, and the reality is that restructuring the ownership
of assets 5, 10 or 20 years from now, after as many years of appreciation, to accommodate new estate tax
rules is often not efficient given Canada’s deemed disposition rules and U.S gift tax rules.
Although it is difficult to predict how U.S. tax law might change over time, it is important to use the
information we know now to create a Financial Plan that projects these values into the future so that we
can properly plan for and anticipate tax liabilities and planning needs. As they say, there is nothing more
certain than death and taxes. To that end, it is evident that without proper planning at the time of
purchase a Canadian could face larger tax liabilities than necessary.
The first part of this two part article established a baseline understanding of some of the rules that are
relevant for Canadians who are considering purchasing U.S. property. In Part II of this series we will use
this information to consider the different ways that Canadians can structure ownership of their U.S. real
estate and gain a deeper perspective of the advantages and risks of each structure.
About the Writer:
The above article is copyrighted and ownership of the writer, Aileen Miga, CFP – Senior Financial Planning Consultant, Financial Planning & Advisory Services. Thanks to Walter Wysota, CFA, ScotiaMcLeod for his contribution as well.