Holding property titled in personal names is the most common, simplest and least expensive way to go about owning US real estate. Be forewarned, however, that the issues that can arise in such an ownership structure are important ones and the consequences of not planning appropriately can be costly.
Avoiding Probate and Bypassing Guardianship Procedures
Probate is the legal procedure required to transfer legal title to children or beneficiaries upon your death. As per Florida statutes, for example, probate may cost up to approximately 3% of the value of the Florida estate upon the date of death. If a Florida property costs $200,000 USD to purchase, probate fees and expenses translate into approximately $6,000 USD. Of course, it is highly likely that the value of the property will have greatly appreciated at the time of death and that probate expenses would be significantly higher.
Other U.S. real estate title ownership issues include an incapacity hearing and guardianship determination if you are deemed to be incapacitated. A guardianship proceeding is a legal proceeding under which a person who lacks the ability to manage certain functions of daily living is declared by a court to be incapacitated and loses the legal right to make certain decisions. The court must make a finding of incapacity and then determine whether to appoint a guardian to exercise the decision-making rights that were removed. Guardianship proceedings require legal representation and can be costly.
Since probate and guardianship procedures are also time consuming and freeze the estate, we prefer to structure ownership of U.S. real estate to avoid probate and guardianship procedures.
Minimizing U.S. Estate Tax
Canadians who own U.S. assets may be subject to U.S. estate tax. This tax is based on the fair market value of all U.S. assets owned at the time of death such as U.S. real estate and shares of stock of U.S. companies. It can climb up to 40% depending on the value of the U.S. asset and the value of the worldwide estate.
However, not all Canadians who own U.S. assets will be subject to U.S. estate tax. The law in 2014 is that Canadians’ U.S. estate tax liability depends on the following two questions:
1. Is the value of their U.S. estate more than $60,000? and
2. Is the value of their worldwide estate greater than $5,340,000?
If the answer to the first question is “yes” but the answer to the second question is “no,” then Canadians are exempt from paying U.S. estate tax. The $5,340,000 exemption amount is current for 2014 and will rise with inflation in coming years.
So, if a Canadian owns a U.S. vacation property worth $200,000, but his or her worldwide estate is $1,000,000, that person will not owe U.S. estate tax upon his or her death.
It is important to note that everything is included when calculating a Canadian’s worldwide estate, including RRSPs and life insurance. However, the IRS does not tax 40% on the value of the worldwide estate – only the value of the U.S. asset is taxed.
A Potential Solution: The Cross Border Trust (“CBT”)
To reduce U.S. estate tax exposure, if applicable, and to avoid the other issues discussed above, we often recommend that individuals and couples purchase property in a CBT.
For married couples, we create one CBT for each spouse. Each CBT would then own 50% of the property. CBTs are structured so that upon the death of the first spouse, the 50% value of the property does not get added to the surviving spouse’s half but stays inside the trust of the first to die. That way, only 50% of the property is in the estate of the second spouse to die. Upon second to die, the property in the trusts would be divided into two equal shares in trusts for children or other beneficiaries.
With CBTs in place, probate expenses and procedures related to the property will be completely avoided in the U.S. and Canada. Aside from reducing U.S. estate taxes, a CBT structure also protects successive beneficiaries against their creditors and/or a beneficiary’s divorcing spouse from realizing rights to the property in the CBT.
Lastly, CBT assets are not generally subject to the jurisdiction of the guardianship court if either spouse were to become mentally incapacitated. Rather than going through a guardianship proceeding, a CBT enables the successor trustee to step in to manage assets without court intervention.
In each spouse’s respective CBT, they are the grantor, trustee and beneficiary, while the spouse serves as a co-trustee. No one else is involved in the CBT while the grantor is alive. There are no annual filing requirements either to the IRS or Canada Revenue Agency (CRA) unless there is rental income. Nor will there be any requirement for an accountant or attorney for annual administration or maintenance fees. Once established for the first property, the trust structure is ready to accept any additional property purchased in in the U.S. without further amendments or expense. Should the couple no longer own U.S. properties, no dissolution, wind-up procedure, or legal or accounting services are required. The CBT is basically maintenance free and revocable if any clauses need to be amended or deleted.
Furthermore, should a property in a CBT ever be sold, the sale proceeds would flow to the individual as opposed to the trust.
The CBT and Valuation Discounts
The IRS bases its determination of estate tax due on an asset’s fair market value. Fair market value is defined as the price at which the asset would change hands between a willing buyer and a willing seller, neither being under compulsion to buy or sell. Fair market value is often a grey area, leaving the worth of the asset and the resulting tax due open to dispute.
Valuation discounts may substantially decrease the value of an asset and therefore lower the tax. They apply to real estate and businesses depending on how title is held. Let’s assume a married couple, Brad and Angelina, owns a Florida condo valued at $15 million USD in a two-CBT structure. Brad and Angelina’s worldwide estate is valued at $6.5 million USD, so they are exposed to U.S. estate tax. If Brad tries to sell his 50% interest on the open market, he may not be able to find a buyer because buyers rarely want to own something over which they have no control. For example, if the buyer subsequently wanted to sell the property, Angelina, who holds the remaining 50%, may not be interested.
Since Brad may have a hard time finding such a buyer, the marketplace would offer substantially less than the 50% pro-rata share of the total value. So why should Brad’s estate (or Angelina’s, if she dies first) pay estate tax on the full 50%?
Based on our experience and research conducted on the matter, valuation discounts accepted by the IRS where title is structured into two separate CBTs are between 20% and 33%. Being conservative, we use the 20% mark.
Therefore, with the described valuation discounts, and where title is structured into two separate CBTs, Brad’s estimated taxable estate for U.S. estate tax purposes may be reduced to $600,000 USD ($750,000 USD minus 20%). This will reduce the amount of U.S. estate tax owing.
U.S. estate planning can be very helpful in smoothing out some of the bumps so that negative consequences of ownership issues do not arise. Of course, the appropriate structure can only be determined once all of the facts are laid out, but oftentimes a CBT structure is an excellent strategy for Canadian owners of U.S. real estate to consider.