Death and taxes American style

For years, Canadians who owned property in the Sunbelt so they could escape our long, cold winters found themselves facing a complicated and potentially expensive problem — United States estate taxes.

Well, there’s some good news. In most cases, you don’t have to worry about estate taxes any more. Major changes in U.S. law make estate planning much easier for snowbirds — at least for the time being.

The bad news is that if you live long enough, you may find yourself worrying all over again. Believe it or not, changes to the U.S. estate tax laws expire after 2010 and we’ll be back to square one unless something is done.

But before we get into all that, let’s look at some background.

The U.S. taxman’s approach to determining the value of an estate is quite straightforward. Essentially, he simply adds up the value of everything you own and applies the appropriate tax rates to it. There is no blanket exemption for spouses, although they do receive a partial tax break. Nor can you escape by giving your property away because the U.S. imposes a gift tax at the same rate as estate tax.

Until the mid-’90s, U.S. non-residents were entitled to an exemptn of $60,000 US on the value of their estate if they died. Anything beyond that was subject to American taxes at onerous rates that could run as high as 92 per cent (federal plus state), according to the Canadian chartered accounting firm of BDO Dunwoody.

And it wasn’t just U.S.-based property that was at risk. A Canadian estate could end up being taxed on anything with a U.S. connection, including bank accounts, stocks, bonds and other types of securities. It was a potential nightmare.

As a result of changes to the Canada-U.S. tax treaty in the mid-’90s, the exemption for Canadians was raised to $600,000 US, the same as that for U.S. citizens and residents. But that wasn’t an absolute amount. The exemption had to be pro-rated by the total value of your Canadian estate, which meant that it might not help once your home in Canada, your RRSP or RRIF, your Canadian investment portfolio, your cottage on the lake and anything else you owned were taken into account. So, many snowbirds with winter homes in southern states were still potentially on the hook.

In 1998, the U.S. Congress approved a measure to gradually increase the exemption for calculating estate taxes. The higher limits extended to Canadians under the tax treaty provisions. The limits have been rising gradually and were fixed at $700,000 US for 2002-03. After that, they were to escalate sharply, reaching $1 million US in 2006.

Next page: Not enough for the U.S. Republican Party

However, that was still not enough for the U.S. Republican Party, which historically has found its main constituency in the middle- to upper-income strata of Americans — who oppose estate taxes in principle. When George W. Bush was elected, one of the priorities in his massive tax-cutting program was the elimination of estate tax entirely.

Legislation, which appeared to fulfill that goal, was passed by Congress in May 2001. But, as the accounting firm of Ernst & Young commented after analyzing the measure in detail, “reports of death of the estate tax have been greatly exaggerated.”

Here’s where things now stand.

In 2002-03, the estate tax exemption has been increased to $1 million US. The federal estate tax rate is reduced to 50 per cent in 2002 and 49 per cent in 2003 (it was 55 per cent, with a five per cent surtax on certain estates worth more than $10 million US.) The exemption rises to $1.5 million US in 2004-05, with the tax rate dropping one percentage point each year.

From 2006-08, the exemption moves up to $2 million US, with the tax rate dropping to 45 per cent. In 2009, the exemption jumps to $3.5 million US and, in 2010, the estate tax disappears entirely.

But here’s the rub. The new act has a sunset clause, with the effect that all its provisions disappear after the end of 2010. Ernst & Young notes that this is a function of the Budget Act of 1974, which curtails the ability of the U.S. Congress to pass any tax cut that increases the federal deficit beyond certain limits.

In other words, a future Congress will have to decide whether to leave the estate tax abolition intact by passing new legislation. If nothing happens, the situation will revert to the status of 2001.

Clearly, this throws a monkey wrench into the entire process of U.S. estate planning. Canadians do not know what rules they will be operating under in the future, any more than Americans do.

The increased spending requirements brought on by the war on terrorism and the need to substantially beef up domestic security may cause a future Congress to think twice about extending the estate tax repeal. Even if it is believed to be fiscally sound to do so, a Democratically-controlled Congress under a future Democratic president may find the resurrection of the tax to be philosophically desirable.

Next page: What leading experts say

One of this country’s leading experts on snowbird issues and U.S. estate planning is Andrew Cumming, author of Florida Bound: The Essential Guide for Canadian Snowbirds and partner in the Toronto-based legal firm of Cass, Cumming LLP. As things stand now, says Cumming, only the most wealthy Canadians need to be worried about American estate taxes. But, of course, that will change in the future if the new laws are not extended to 2011 and beyond.

“Given the current exchange rates, a couple who own all of their property jointly would have to have a worldwide estate worth more than $3 million Cdn this year before they would need to be concerned,” he says. “That amount, of course, will increase as the U.S. exemption rises.”

Cumming estimates that only a few thousand Canadians have a high enough net worth to be subject to U.S. estate taxes under the new regulations.

In fact, he says that the more immediate concern for people with U.S. properties may be to take a new look at the ownership structure. When the estate tax exemption for Canadians was only $60,000 US, some people bought vacation homes and placed the ownership in single-purpose corporations to avoid tax exposure. These are no longer required in most cases and, in fact, may present some tax complications. Anyone in that situation should consult with a tax adviser.

Cumming also says that the belief that placing a large mortgage on a U.S. property will reduce exposure to estate tax is usually misguided. While it is correct that the value of real property for estate tax purposes is lessened by a mortgage, full relief is only provided if it is a “non-recourse” mortgage — that is, the property owner is not personally liable for mortgage payments. It’s almost impossible to get a mortgage like that in the U.S., says Cumming. If the mortgage does not fall into the non-recourse category, then only a portion of the principal is deducted from the fair market value of the property to determine the amount that is exposed to estate tax.

So where do we net out on all this? Here are some guidelines to help you:
1. Unless you’re very wealthy, don’t worry about the impact of U.S. estate taxes until 2011. If you think you still may be subject to estate tax even with the higher exemption, talk to a professional adviser.
2. Don’t take a hefty mortgage on your U.S. property if your sole aim is to reduce estate tax exposure.
3. If you own a U.S. property through a single-purpose corporation, review the situation with your lawyer or tax adviser to see if changes are warranted.
4. As the years pass, pay attention to new changes in U.S. estate tax laws to see if the repeal is extended or if the tax will come back after 2010. Plan accordingly.

In short, you probably don’t have to worry now. But you may have to worry later.