Many Canadians inherit money from relatives in the United States. There are generally no issues on either side of the border if a Canadian inherits property or money through a will. That being said, many U.S. residents plan their estates by using a trust rather than a will for the purpose of avoiding probate. U.S. tax law pretends this trust does not exist. As such, there is a bump in cost basis when the person who set up the trust dies, meaning that there is no capital gains tax when the assets are later liquidated.
Canada takes a different view, however, and this can cause tax problems for Canadian residents who inherit from U.S. trusts.
Let’s use a simple example to illustrate this point. John is a U.S. resident. John’s sole heir, Carl, is a U.S. citizen who lives in Canada. (Although this example features a U.S. citizen, it applies equally to anyone inheriting money from a U.S. trust, regardless of citizenship.)
Imagine John bought one share of Apple Inc. in 1990 for CA$10. He then put it in a trust to protect his estate from U.S. probate when he dies. On the date of his death, the share is worth CA$25. The trust ends up selling the share a few months after his death for CA$27. In the United States, the trust’s cost basis in the asset is CA$25 (the stock’s value on the date John died). This means that the trust only realizes CA$2 of capital gain income when it sells the stock at CA$27 and when the money is distributed out to Carl, he only has CA$2 of taxable income in the U.S.
The Canadian treatment will be different. In Canada, the trust’s cost basis in the asset does not increase to CA$25 as a result of John’s death. Instead, it remains at CA$10. So, when the trust sells the stock, the capital gain in Canada could be as high as CA$17 (CA$27 sale price – CA$10 cost basis). If this money was distributed to Carl immediately, he would have a capital gain in Canada of CA$17 on the trust distribution. That’s not a great outcome. Instead, let’s look at three possible solutions.
Solution 1: Capital distribution
Property from a U.S. trust should be distributed to Canadian-resident beneficiaries in the year following its sale. Put simply, this converts the distribution from income to capital. And, since distributions of capital are tax-free in Canada, the inheritance received by Carl would be tax-free. This strategy can be used for both revocable and irrevocable trusts. There are some technical details that need to be ironed out for this strategy to work (for instance, if the beneficiary has an immediate right to the income, it will not work), so Carl should get tax advice before proceeding.
Solution 2: Make the trust immigrate to Canada
The second solution is to move the trust north by making Carl the trustee before the trust sells the property and distributes the property to Carl. Under Canadian tax law, a trust’s residency is determined by the location from which it is managed and controlled. Once Carl, a resident of Canada, becomes trustee, the trust will likely be managed from Canada. It will likely therefore become a resident of Canada for Canadian tax purposes and have Canadian tax filing obligations.
When a trust moves to Canada, it gets a bump on the value of all its assets for Canadian tax purposes as of the date it moves to Canada (much the same as an individual would). This means that when property is later sold, the capital gain will be calculated on the new cost basis for Canadian tax purposes. There would be a bump in the cost basis for U.S. federal tax purposes as at the date of John’s death. In Carl’s case, this would mean that the trust would immigrate to Canada and its cost basis in the stock would rise to CA$25 for Canadian tax purposes. If the stock was later sold when it was worth CA$27, there would be only CA$2 of capital gain income in both the U.S. and Canada, and Carl has avoided a big tax bill.
Solution 3: Distribute the estate through a will
The third solution is to scrap the trust and simply have John use a regular will to plan his estate. This would mean that Carl would inherit the stock with a cost basis of CA$25 in both countries. When he later sells the stock, there would be a capital gain of CA$2. This may mean that John would have to pay probate fees, but those will be substantially less than the capital gains tax he would otherwise owe.
The problem faced by Canadian residents who inherit money from a U.S. trust is quite specific – Canada will not increase the trust’s cost basis upon the U.S. resident’s death. There are three possible solutions:
- distribute money to the Canadian resident in the year after the trust sells the property;
- move the trust north by making the trustee a Canadian resident; or
- adjust the U.S. estate planning strategy to eliminate the trust.
While all solutions require professional help, the third strategy is the simplest. But it requires talking to the person who set up the estate. The second strategy works well where there are not many beneficiaries, but does create extra accounting paperwork. The first strategy is the most flexible and may be best if there is a sole Canadian beneficiary, as it does not require significant adjustment to the estate’s administration.
Whatever route is chosen, those who inherit from a U.S. relative have to pay attention to the tax issues on both sides of the border.