Canada: Canadians Owning U.S. Vacation Property After 2018 U.S. Estate Tax Changes

By now most Canadians are aware that the 2017 U.S. tax reform bill increased the estate tax basic exclusion amount under IRC 2010(c)(3) from US $5m (US $5.49m for 2017) to US $10m (indexed for inflation occurring after 2011) for individuals dying after January 1, 2018.¹ This should come as welcome news for Canadians who own U.S. vacation real estate because under the new law, Canadians will be subject to estate tax only if their worldwide net worth at death exceeds US $10m. With proper planning, a husband and wife would be subject to the estate tax only if their worldwide net worth exceeds US $20m. However, an often-overlooked requirement to get this result is that the estate must file an estate tax return and disclose the treaty position that affords it. Further, if the estate fails to do so, a 2015 law will deem the basis in the property to be zero until the estate tax return has been filed.²

On July 31, 2015, the U.S. enacted the Surface Transportation and Veterans Health Care Choice Improvement Act of 2015, which added new sections 1014(f) and 6035 to the Internal Revenue Code. On March 2, 2016, the IRS released regulations to effectuate the new rules. The rules require consistency in the reporting of property values between estates and beneficiaries and are effective for U.S. estate tax returns that are either required to be filed after July 31, 2015 or are, in fact, filed after that date.

Under these rules, if a U.S. estate tax return was required to be filed but was not, the presumption is that the basis in the inherited property is zero, even if no U.S. estate tax is otherwise owed. These rules highlight the importance of knowing when a Canadian resident (who is not a U.S. person) is obligated to file a U.S. estate tax return; and will likely come as a rude surprise for their beneficiaries.

Most Canadian practitioners are aware that a Canadian resident who owns U.S. real estate is subject to U.S. estate tax on the value of that property. Further, most Canadian practitioners are aware that Article XXIX-B:2 allows a Canadian decedent a pro-rata portion of U.S. unified credit equivalent (U.S. $5.49m for 2017), thus a Canadian decedent will be subject to U.S. estate tax only to the extent that the value of her U.S. "situs" property exceeds the credit equivalent amount.

However, many Canadian practitioners are unaware that IRC 2102 limits the credit equivalent to U.S. $60,000, and to claim this pro-rata credit equivalent amount the decedent must file a non-resident U.S. estate tax return (form 706-NA). Under the new rules the failure to file this form will deem the basis in the hands of the beneficiaries to be zero.

The regulations issued on March 2, 2016, are broad, detailed, and apply to many situations that Canadian decedent's will typically not encounter. However, the following analysis illustrates how they apply to a Canadian resident (who is not a U.S. person) who owns U.S. real property:

1. 1014-10(b) limits the new basis consistency requirements of IRC 1014(f) to property that is: a) included in the decedent's gross estate under IRC 2031; or b) subject to tax under IRC 2106; provided such property generates tax liability in excess of allowable credits.
2. 1014-10(b)(3) provides that "if a liability under chapter 11 is payable after the application of available credits...then the duty of consistency applies to the entire gross estate."
3. IRC 2102(b)(1) limits the credit equivalent to U.S. $60,000 to decedents who are neither U.S. citizens nor U.S. residents for estate tax purposes.
4. IRC 2102(b)(3)(A) allows a noncitizen who is not a U.S. resident for estate tax purposes a pro-rata unified credit if allowed by treaty.
5. Article XXIX-B:2 of the Treaty allows fort the pro-rata unified credit "...only if all information necessary for the verification and computation of the credit is provided." Note, neither the Treaty nor the IRC require the benefits of the XXIX-B or 2106(b)(3)(A) to be claimed on a timely filed return.
6. IRC 6114 generally allows an individual treaty benefits regardless of whether a timely election has been made.
7. New regulation 1.1014-10(c)(3)(ii) provides that if no return has been filed, then the value of the property described in regulation 1.1014-10(b) shall be zero.

Thus, until the U.S. estate tax return has been filed, the beneficiaries of an estate will have no basis in the inherited U.S. situs property, even if there would be no estate tax otherwise owing. However, once the estate tax return has been filed the basis in the property will be adjusted to the value as of the date of death.

Unless a U.S. estate tax return has been filed, this result will be especially problematic for beneficiaries who wish to sell inherited U.S. real estate. It will also be problematic for beneficiaries who inherit income producing property because with zero basis they will lose the ability to take depreciation until an estate tax return has been filed.

Footnotes

1 The estate and generation-skipping transfer tax is scheduled to be repealed entirely on December 31, 2024. At that time the gift tax rate is scheduled to fall to 35%.

2 See, Berg, Roy Canadian Decedents with U.S. Real Estate: New Regulations under IRC 1014(f) and 6035, 24 Canadian Tax Highlights 5 (May 2016)

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