How Canadian Real Estate Investors Can Avoid the U.S. Gift Tax Through Marital Deduction Provisions

Canadians actively invest in U.S. real estate. When investing in U.S. real estate, Canadian investors often fail to consider the U.S. transfer taxes such as the federal estate and gift tax. With proper planning, Canadian investors can often avoid U.S. estate and gift taxes through careful structuring of their gratuitous transfers during life and death.

The U.S. estate and gift tax is assessed at a rate of 18 to 40 percent of the value of an estate or donative transfer. An individual foreign investor’s U.S. taxable estate or donative transfer is subject to the same estate tax rates and gift tax rates applicable to U.S. citizens or residents, but with a substantially lower unified credit. The current unified credit for individual foreign investors or nonresident aliens is equivalent to a $60,000 exemption, unless an applicable treaty allows a greater credit. U.S. citizens and resident individuals are provided with a far more generous unified credit from the estate and gift tax. U.S. citizens and resident individuals are permitted a unified credit of $13.61 million (in 2024). There are a number of planning opportunities available to non-U.S. residents to mitigate the harsh consequences of the tax.

If a Canadian investor holds U.S. situs assets such as real estate, upon his or her death, the real property will be subject to the U.S. estate tax. Fortunately, for Canadian investors, Article XXIX(B) of the U.S.-Canada tax treaty provides relief from the U.S. estate tax. Under the treaty, a Canadian real estate investor is entitled to relief from the U.S. estate tax, but the treaty does not provide any relief from the U.S. gift tax. A Canadian investor can claim a pro rata portion of the U.S. unified credit and marital credit for estate tax purposes. The pro rata portion is based on the percentage of the individual’s gross U.S. estate and gross worldwide estate.

Although the U.S.-Canada income tax treaty does not provide relief for the U.S. gift tax, married Canadian individuals are entitled to claim a marital deduction to avoid the gift tax. A marital deduction allows one marriage partner to transfer an unlimited amount of assets to their spouse without incurring an estate or gift tax. The interspousal transfer can occur during the couple’s lifetime or after one spouse’s death. The marital deduction applies to both estate and gift taxes. Typically, non-U.S. citizens are not permitted to utilize the marital deduction. However, with the enactment of treaty protocol, Canadian citizens are permitted to claim a marital deduction for purposes of interspousal transfers.

On November 9, 1995, the 1995 Canada Protocol entered into force. See TAM 9750002. The 1995 Canada Protocol provisions may be summarized through the following three illustrations. For purposes of these illustrations, Canadian residents are not subject to U.S. estate tax unless their gross worldwide estate exceeds $10 million (for 2018 calendar year). All amounts contained in the illustrations discussed below are in U.S. dollars.

Illustration 1.

Justin Lieber owns a vacation home in Florida with a value of $5,000,000, unencumbered by a mortgage. His other worldwide assets amount to $5,000,000. There will be no U.S. estate tax whether or not Justin Lieber is survived by his spouse.

A Canadian citizen who passes away owning U.S. assets is entitled to a credit against his U.S. estate tax liability in an amount equal to that proportion of the U.S. unified credit as his U.S. situated estate bears to his worldwide estate.

Illustration 2.

Bryan Bosling, a Canadian resident, owns two vacation homes in California and Hawaii, each of which is unencumbered by a mortgage and has a value of $5,450,000. Bryan also owns Canadian property with a total value of $10,900,000. When Bryan dies in 2018, his estate, for U.S. estate tax purposes, would be entitled to a prorated unified credit of $2,208,900 (i.e., $4,417,800 × ($10,900,000 / $21,800,000)). When applied against his computed gross U.S. estate tax of $4,305,800, this prorated unified credit results in a net U.S. estate tax liability of $2,096,900 (i.e., $4,305,800 – $2,208,900). If Bryan Bosling has a Canadian spouse and leaves property to her outside of a qualified domestic trust (“QDOT”), the U.S. will allow an election to be made for an additional nonrefundable marital credit up to the amount of the proportionate credit.

The estates of individuals not domiciled in the United States are generally not entitled to a marital deduction for U.S. estate tax purposes. Marital deductions refers to exceptions to gift and estate taxes for transfers made to spouses. Almost all property qualifies for this deduction and there is no limit. The deduction does not avoid transfer taxes completely, but rather, the spouse receiving the property must pay the eventual estate taxes. The marital deduction for non-U.S. citizens is limited to an annual exclusion of $175,000 for the 2023 calendar year.

Below, please find Illustration 3, which demonstrates how the marital deduction is applied under Article XXIX(B) of the U.S.-Canada income tax treaty.

Illustration 3.

The facts are the same as in Illustration 2, except that Bryan Bosling leaves one of his two vacation homes in the U.S. to his Canadian spouse. The additional marital deduction “credit” allowed under the U.S.-Canada treaty equals the excess of the computed gross U.S. estate tax over the estate tax computed without including the U.S. property passing to the Canadian spouse. The marital deduction credit is capped at the estate’s prorated unified credit. Here, the U.S. estate tax on the vacation home not passing to Bryan’s spouse is $2,125,800. Thus, the marital deduction credit equals $2,180,000 (i.e., $4,305,800 – $2,125,800). After taking into account both the prorated unified credit and the marital deduction credit, the net U.S. estate tax liability owed by Bryan’s estate is reduced to zero (i.e., $4,305,800 – $2,208,900 – $2,180,000). Any excess marital deduction credit does not result in a refund.

Conclusion

The foregoing discussion is intended to provide the reader with a basic understanding of marital deduction planning alternatives and the basic U.S. tax considerations of foreign investment in U.S. real estate. It should be evident from this article, however, that this is a relatively complex subject. As a result, it is crucial that Canadian real estate investors review his or her particular circumstances with a qualified U.S. tax attorney.

Anthony Diosdi is one of several tax attorneys and international tax attorneys at Diosdi & Liu, LLP. Anthony focuses his practice on domestic and international tax planning for multinational companies, closely held businesses, and individuals. Anthony has written numerous articles on international tax planning and frequently provides continuing educational programs to other tax professionals.

He has assisted companies with a number of international tax issues, including Subpart F, GILTI, and FDII planning, foreign tax credit planning, and tax-efficient cash repatriation strategies. Anthony also regularly advises foreign individuals on tax efficient mechanisms for doing business in the United States, investing in U.S. real estate, and pre-immigration planning. Anthony is a member of the California and Florida bars. He can be reached at 415-318-3990 or adiosdi@sftaxcounsel.com.

This article is not legal or tax advice. If you are in need of legal or tax advice, you should immediately consult a licensed attorney.