Non-Recourse Mortgage & U.S. Estate Tax for Canadians

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1 Non-Recourse Mortgage & U.S. Estate Tax for Canadians Reduce exposure to U.S. estate tax on real estate located in the U.S. Sam De Cillis, Financial Advisory Consultant, Financial Advisory Support If one of your clients were to die today, would their estate be subject to U.S. estate tax? If you think the answer is yes and your client owns real estate located in the U.S. the strategy discussed in this article may be of interest to your client. This article will provide information on how a Non-Recourse Mortgage (NRM) may minimize or eliminate your client s exposure to U.S. estate tax and potentially maximize the value of their wealth. Note that a NRM strategy applies to Canadian residents who are not U.S. citizens, U.S. green-card holders or U.S. residents domiciled in the U.S. This internal use only article is for information only and is not legal or tax advice. Your client should consult with a cross-border tax or legal professional to assist them in determining whether an NRM strategy is right for them. U.S. Estate Tax for Canadians If your client is a Canadian resident who is not a U.S. citizen, green-card holder or a U.S. resident domiciled in the U.S. and they die, their estate may be subject to U.S. estate tax based on the fair market value (FMV) of the U.S. situs assets that they own. U.S. situs assets are considered to be assets located or deemed to be located in the U.S. and include assets such as U.S. real estate and shares in U.S. corporations. Before U.S. estate tax will apply, the value of your client s U.S. situs assets and gross worldwide estate must exceed certain threshold amounts. For example, if the value of your client s U.S. situs assets does not exceed US $60,000 or if the value of their worldwide estate does not exceed US $5 million (for deaths in 2010 to 2012) there is no U.S. estate tax. Note that without further legislative action, the U.S. estate tax will change in the maximum estate tax rate will jump from 35% to 55% and the threshold amount for worldwide estates will reduce to US $1,000,000. This will result in a greater exposure to U.S. estate tax due to a smaller threshold amount and a higher tax rate. You can provide your client with a copy of the article titled U.S. estate tax for Canadians clarified for 2010 to 2012 ( pdf) for a more detailed discussion regarding U.S. estate tax. How does a Non-Recourse Mortgage reduce U.S. estate tax? The U.S. tax laws allow a deduction for outstanding debt in determining one s U.S. estate tax liability. However, for certain types of debt like a conventional mortgage, where the lender has recourse to seize other personal assets of the borrower (e.g., bank accounts), only a portion of the outstanding mortgage may be deducted from the borrower s U.S.

2 situs assets in calculating their taxable estate. The portion that is deductible is calculated by multiplying the outstanding mortgage balance by the ratio of the value of the borrower s U.S. situs assets to the value of their worldwide estate. An NRM is a type of mortgage where the sole recourse of the lender in the event of default is to foreclose on the real estate property used as collateral. The personal assets or the estate assets of the borrower cannot be seized by the lender in the event of a default. If the property is insufficient to cover the outstanding loan balance (for example, if real estate prices have dropped), the difference between the value of the property and the loan value becomes a loss for the lender. This feature of the NRM may be helpful for calculating your client s exposure to U.S. estate tax. It means that the entire outstanding mortgage balance is deducted dollar for dollar in arriving at the estimated value of your client s taxable estate. However, this feature also means that NRMs have a higher interest rate and a lower loan to value ratio compared to conventional mortgages. A typical loan to value ratio for a NRM ranges from 55% to 65%. This provides more collateral to the lender than would be typically needed for conventional mortgages. Interest Deductibility If your client refinances a U.S. property they own free and clear with either an NRM or a conventional mortgage they may create a tax-deductible investment loan if they use the loan proceeds to purchase securities in a non-registered investment account. If these securities pay or have the potential to pay interest or dividends, your client may be able to deduct the interest incurred on the loan on their Canadian income tax return. Of course, any strategy involving the use of a loan to purchase securities is not appropriate for everyone. Your client should consider their risk tolerance and their own personal circumstances. An NRM has a greater potential to substantially reduce one s exposure to U.S. estate tax as compared to a conventional mortgage even though the loan to value ratio is greater for conventional mortgages. At the same time you get to create a tax-deductible investment loan that may increase your wealth and reduce your annual income taxes. Note: if your client invests in U.S. securities these investments may be considered U.S. situs assets; whereas, an investment in Canadian securities would not. Example illustrating benefits of an NRM Let s assume your client s worldwide estate is valued at US $12,500,000 and this includes a personally owned vacation home located in Florida worth US $2,000,000 and shares of a U.S. corporation worth US $1,000,000. For comparison purposes we will calculate the U.S. estate tax under the following scenarios: 1. Your client currently has no outstanding debt on the property

3 2. Your client refinances the Florida home using a conventional mortgage for US $1,300,000 on the Florida home and invests the proceeds in Canadian securities in a non-registered account 3. Your client does not have a mortgage but decides to refinance the Florida home using an NRM with a 65% loan to value or US $1,300,000 NRM, and invests the proceeds in Canadian securities in a non-registered account. Your client s U.S. estate tax is calculated taking into consideration certain credits including a marital credit that is available when assets are left to a surviving spouse. A surviving spouse is defined as someone of the opposite sex who you are legally married to. The calculation of U.S. estate tax in the table below assumes that your client will leave their assets to a surviving spouse. An NRM or conventional mortgage invested in Canadian securities in a non-registered account both have the potential to increase your client s wealth and reduce their Canadian income taxes if the client is able to deduct the interest on the loan. As illustrated in the table, the U.S. estate tax with an NRM is much lower than the U.S. estate tax with a conventional mortgage or with no debt. The NRM reduces the U.S. estate tax exposure by US $72,196 when compared to the U.S. estate tax exposure with holding a conventional mortgage. The U.S. estate tax savings with an NRM are even greater at US $94,994 when compared to the U.S. estate tax incurred with no mortgage. If these U.S. assets were not transferred to a spouse, the U.S. estate tax would be greater. Bulletin Wealth Management US situs assets (Florida vacation home and US shares) No Mortgage US $3,000,000 US $1,300,000 US $1,300,000 Conventional Mortgage 1 NRM 2 US $3,000,000 US $3,000,000 Deductible mortgage NIL (US $312,000) (US $1,300,000) Taxable Estate Worldwide Estate US$ 3,000,000 US$ 12,500,000 US $2,688,000 US $1,700,000 US$ 12,500,000 US $12,500,000 U.S. estate tax US $200,016 US $177,218 US $105,022

4 1 In calculating the U.S. estate tax with a conventional mortgage the U.S. tax rules allow only a fraction of a conventional mortgage to be deductible against the value of the vacation home that is subject to U.S. estate tax. Since the value of the U.S. assets represent only 24% (US$3,000,000/US$12,500,000) of your client s worldwide estate, only 24% of the US$1,300,000 outstanding mortgage or US$312,000 can be deducted from the value of their U.S. situs assets. As a result, their taxable estate or the value of their U.S. situs assets subject to U.S. estate tax is US$2,688,000 (US $1,000,000 + US $2,000,000 US $312,000). If the proceeds of this loan are invested in Canadian securities, the interest paid may be deductible on the client s Canadian tax return. 2 With an NRM, the entire outstanding mortgage amount can be deducted from the value of your client s U.S. situs assets. Your client s taxable estate or the value of their U.S. situs assets subject to U.S. estate tax would amount to US$1,700,000 (US $1,000,000 + US $2,000,000 US $1,300,000). If the NRM proceeds are invested in Canadian securities, the interest paid may be deductible on the client s Canadian tax return. Does a Non-Recourse Mortgage Make Sense? If your client meets all of the following criteria, an NRM may be considered: 1. Your client is a Canadian resident (not a U.S. citizen, green-card holder or U.S. resident domiciled in the U.S.); 2. Your client s worldwide estate is greater than US$5,000,000 (subject to change to US$1,000,000 in 2013 unless further U.S. legislation is enacted); and 3. Your client personally owns U.S. real estate or plans to purchase U.S. real estate. In addition to meeting the criteria above, there are certain features of an NRM that should also be considered when evaluating whether an NRM will be appropriate in reducing your client s exposure to U.S. estate tax: 1) The interest rate on an NRM is generally higher than that of a conventional mortgage; however, this additional interest cost may be outweighed by the U.S. estate tax savings and any income tax savings resulting from the ability to deduct the interest cost on a Canadian tax return if the mortgage proceeds are used to invest in securities in a nonregistered account. If the mortgage is used to finance the purchase of a property used for personal enjoyment, then the interest is not deductible and the higher cost of an NRM needs to be carefully evaluated. 2) The loan to value ratios range from about 55% to 65% so the entire value of the real estate property cannot be mortgaged and some portion of the value of the real estate will be exposed to U.S. estate tax. This may be mitigated by the ability to claim a foreign tax credit on a final Canadian income tax return for U.S. estate tax paid. 3) An NRM today, based on the current value of your client s U.S. real estate, does not protect the future appreciation of their U.S. real estate from U.S. estate taxes. However, subject to the loan to value limits that apply to the NRM and your client s tolerance to carry debt, your client may consider refinancing their property again in the future with an additional NRM to ensure they minimize the value of the real estate property that is subject to U.S. estate tax.

5 RBC Bank (USA) NRM Program Highlights RBC Bank (USA) offers non-recourse mortgages under the following terms: Primary home / Second home (vacation) in any U.S. state except Alaska, Maine, Maryland and West Virginia as of the date of this article 3/1 & 5/1 Adjustable Rate Mortgage (ARM) 30 years amortization Fully amortizing and interest only options available; however, interest only is typically the preferred option, as customers will want to maximize principal balance available for non-recourse tax benefits Up to 65% Loan to Value (LTV) to $1M with excellent credit (60% in certain states) Reserve Requirements for 60-65% LTV are 2 months for conforming loan amounts and 6 months for non-conforming (jumbo) loan amounts Up to 55% LTV to $2M with excellent credit (50% in certain states) Reserve Requirement for 55% LTV is 12 months Eligible property types: single family home, condominium, PUDs, town homes and property less than 10 acres (note: non-warrantable condos and condotels are not allowed) 2 appraisals are required at application and an appraisal is also required every two years while the loan is outstanding Interest rate is adjusted by 50 bps Interest may be tax-deductible for Canadian tax purposes (borrowers should consult their tax advisors) Interest rate may be reduced by charging an origination fee Example (RBC Bank USA NRM Pricing): 5yr. Adjustable Rate Mortgage, Secondary Home Property Value: $1M LTV: 65% Loan: $650,000 Typical Fees for a U.S. Mortgage (closing costs may be included in refinance transaction up to maximum LTV): - RBC USA fees currently US$560 (subject to change) - 3rd Party Applicable Fees (e.g., Title, Insurance, Recording Fees, State/County Taxes, Appraisals, etc) RBC Bank (USA) NRM contact number (toll-free) Conclusion Under the right circumstances an NRM may be a useful strategy to reduce or eliminate your client s exposure to U.S. estate tax and enhance their wealth. Your client should ensure that a cross-border tax advisor is consulted to review your client s circumstances in detail and recommend whether the use of an NRM makes sense