Ask the Spud: Am I Vulnerable to US Estate Taxes?

Q: I am ready to follow the Couch Potato and would like to use the US-listed Vanguard ETFs that you recommend in your model portfolios. But when I checked with my accountant, he warned me that I could face US estate taxes when I die. Is this true? — Karl W.

It’s possible, yes. Canadians with a high net worth and significant holdings in US assets (including ETFs listed on an American exchange) may be subject to estate taxes levied by the Internal Revenue Service. This tax can be up to 35%.

Before we go any further, let me remind you that I am not a tax expert, and it is essential that you consult an accountant or other qualified advisor if you think you may be in this situation. It’s also crucial to understand that US estate tax laws have changed several times in recent years (most recently in December 2010) and will likely change again after the presidential election next year: the current law is only valid until the end of 2012. It’s your responsibility to stay on top of these changes.

With that out of the way, here’s the situation today. Canadian residents who die before the end of 2012 are subject to US estate taxes if they meet both of the following criteria:

• The total value of their estate is at least $5 million (USD). This means all of their worldwide assets, including their home, any recreational or rental properties, their investment portfolio, and certain life insurance policies.

• Their estate includes a minimum of $60,000 in US situs assets. This term refers to any property that is situated in the US, including real estate and securities such US-listed stocks or ETFs. (US bank deposits, however, are excluded.) Note, however, that Canadian-domiciled mutual funds and ETFs that hold US stocks are not considered US situs assets. For example, the iShares S&P 500 Index Fund (IVV), listed on the New York Stock Exchange, is a US situs asset, but the TSX-listed iShares S&P 500 Index Fund (XSP) is not.

Does that mean me?

Let’s say you die next year with a $5 million (USD) estate, which includes $50,000 in a US-listed ETF and no other US situs assets. In this case, you meet the first condition, but not the second, so you would not be subject to estate taxes.

However, if you have a $6 million estate, including a condo in Florida as well as some US-listed ETFs, then you may be subject to the tax on those US situs assets, because their total value exceeds $60,000. The calculation is quite complicated, and it depends on the proportion of US situs assets in your overall estate. For examples of how the estate tax is calculated, see this helpful document from BDO Canada and this page at TaxTips.

If your estate is valued at less than $5 million, but you have US situs assets over $60,000, then you won’t be subject to the tax under the current law. However, your executor should still file IRS Form 706-NA within nine months of your death.

The bottom line is that Canadian investors of modest means do not have to worry about holding US-listed ETFs. However, if you have significant wealth, then you need to keep on top of US estate tax laws. As it happens, if no new law is enacted, the exemption will drop from $5 million to just $1 million in 2013, and the maximum tax rate will be 55%.

If you’re in your golden years and you think you’re vulnerable to US estate taxes, it may be prudent to use Canadian-listed ETFs for your foreign equity holdings. The higher MERs will be well worth it if they save you from the IRS.

The information in this post should in no way be considered tax advice tailored to specific individuals. Always consult a qualified advisor before making any investment decision for tax purposes.