U.S. President Joe Biden’s American Families Plan would increase estate, capital gains and income tax rates, as well as exposure to the gift tax. The proposals will adversely affect many Canadians with U.S. assets and U.S. citizens residing in Canada, so now’s the time to help your clients plan.
U.S. estate tax
The Internal Revenue Service (IRS) can tax Canadians on their U.S assets upon death but not their worldwide assets. U.S. assets for Canadians include U.S. stocks, mutual funds, life insurance policies, real estate (including mortgage debts owed by U.S. persons to Canadians on U.S. real estate sales) and even boats. Under the 2017 Tax Cuts and Jobs Act, Canadians with U.S. assets at death are exempt from U.S. estate tax where their Canadian and worldwide assets (that includes all assets) have a market value of less than US$11.7 million (the exemption amount).
That’s obviously a high bar, and most Canadians with a personal-use Florida condo will be under the exemption amount and pay no U.S. taxes when they die. Under Biden’s plan (as well as proposed bills from Democratic senators Bernie Sanders and Chris Van Hollen) the exemption amount on worldwide assets is expected to drop to approximately US$3.5 to US$5 million (all figures below are in U.S. dollars).
What does that mean for Canadians? A Canadian who dies with U.S. real estate in their name personally — with, for example, a Florida residence worth $500,000 — and a worldwide estate above the new exemption amount would be subject to estate tax on the U.S. property’s market value — not the gain, as is the case under the Canadian tax system. In the Sanders bill, the tax rate would rise from the current 40% to 45%, and then up to 65% after the next year. The tax would apply to clients whose property is titled in their name or in a revocable trust. The Canadian owner of that Florida residence would owe U.S. estate taxes of well over $100,000 upon death if no tax planning was set up.
Is there a way for Canadians to better plan their ownership of U.S. property? Clients could buy the U.S. personal-use property in a transnational irrevocable trust (TNIT) rather than in their personal name. This works well for those planning to purchase, or for those who already own but whose property hasn’t increased in net value. The TNIT should shield Canadians from U.S. estate tax on the value of the U.S. property at death. It won’t matter what the value of the property is at that date: there shouldn’t be any estate tax application if the trust is prepared properly and the proper administration is followed.
(Interestingly, in the Van Hollen tax bill, assets in a non-grantor or irrevocable trust will be deemed sold every 21 years, triggering a gain on any unrealized appreciation. If that sounds familiar, it’s because that’s the current Canada Revenue Agency rule for irrevocable trusts, other than for spousal trusts.)
The situation is more complicated for clients who already own property in the U.S. For example, if a client paid $500,000 for a Florida condo that’s now worth $1 million, a transfer to the TNIT would be considered a deemed disposition — triggering Canadian capital gains tax. Instead, a better plan would be to transfer the property on a tax-free basis to a cross-border restricted partnership (CBRP) to shield the property from U.S. estate tax on death.
Capital gains, gift tax and income tax
Currently there are two rates for U.S. capital gains tax: short-term and long-term. For sales of U.S. property held for less than one year, the rate is 39% on the net gain. When the property is held for more than a year, the long-term tax rate is 20% regardless of whether the title is personally held or in a TNIT or a CBRP.
Under the Biden plan, next year the 39.6% rate will apply to any gains over $1 million. Clients expecting a large gain may want to trigger it now under the lower rate.
Additionally, Biden plans to eliminate the “step up” in cost basis on death, which resets an asset’s capital gains at fair market value on the date of death (unlike in Canada). This would result in a forced recognition of unrealized gains when assets are transferred at death. The proposal includes a $1-million exemption on death. Again, this may be an avoidable tax where title is held in a TNIT or CBRP.
As for income tax, the highest U.S. federal tax rate of 39.6% is reached at an annual income of just over $600,000. Under the Biden plan, that rate would apply over $400,000 of U.S. income. This change will only apply to rental property income and would not affect Canadians with personal-use vacation properties.
What should Canadians and U.S. citizens living in Canada do? It’s time for clients to review their cross-border tax planning as there will likely be lower exemptions and a higher transfer tax on death. The changes will probably go into effect on Jan. 1, 2022. And they likely won’t be retroactive, so there’s time to plan now.
David A. Altro, B.A., LL.L., J.D., D.D.N., F.Pl., TEP, is managing partner of Altro LLP, which specializes in cross-border tax and estate planning, U.S. real estate and immigration. The firm has offices in Canada and the U.S.