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Lured by balmy weather and a hotter national currency, Canadians have been flocking to the U.S. to shop for vacation properties. Easily overlooked in the swirl of excitement surrounding a purchase, however, are the tax implications of ownership.

The U.S. imposes a federal estate tax on the worldwide estates of all its citizens, as well as U.S. residents. It also imposes an estate tax on non-citizen non-residents who own U.S. situs property, which includes stocks of U.S. corporations, even if the stocks are owned in a Canadian brokerage account, and U.S. real property. If however, the real property is owned by a properly structured residence trust, it will not be subject to U.S. estate tax.

For Canadians who are concerned with the estate tax implications of becoming a U.S. property owner, the first step is to determine their potential estate tax liability. American citizens and residents enjoy a tax credit that shelters the first $5 million of their estate from taxation, but the Internal Revenue Code reduces the exemption to a meager $60,000 for non-citizen non-residents. While the $60,000 may be able to protect a few U.S. stocks from estate tax, it’s a safe assumption that for most snowbirds it will not be enough to shelter an entire vacation home. The federal tax is applied at a maximum rate of 35 per cent (which is subject to future legislative change) and additional state tax may be due, depending on where the property is located.

The U.S.-Canada Income Tax Treaty increases the exemption for Canadian residents, allowing them a portion of the $5 million available to U.S. citizens and residents. The amount of the treaty exemption is determined by multiplying the $5 million exemption by a fraction, the numerator of which is the value of the decedent’s U.S. situs property and the denominator of which is the decedent’s worldwide property (including jointly owned property, retirement accounts, beneficial interests in certain types of trusts and possibly even life insurance benefits paid on the decedent’s death). The prorated exemption can be doubled for property passing to a surviving spouse.

The difficultly in determining whether the purchaser will have enough exemption is the great unknown of what the U.S. Congress will do next. The $5 million exemption is scheduled to decrease to $1 million on Jan. 1, 2013. Congress may enact legislation extending or even increasing the $5 million exemption or they may allow it to roll back to $1 million. Considering that non-citizen non-residents are only entitled to a prorated portion of the exemption, many Canadians who would not have any estate tax liability when the exemption is $5 million may have to pay U.S. estate tax if the exemption returns to $1 million.

If a purchaser determines after crunching the numbers that they could benefit from using a residence trust, they should answer these two questions before any comprehensive planning takes place: First, if a mortgage is required, will the bank allow the property to be owned in trust? Second, does the homeowner’s association, condo board or like organization allow real property to be owned in trust? If the answer to both questions is yes, the purchaser can proceed with a residence trust.

The key feature of the residence trust strategy is that the person funding the purchase may not be a beneficiary or a trustee of the trust — it is only by giving up all rights to the property that it can be excluded from the purchaser’s estate. If the purchaser is married, the purchaser’s spouse and descendants (and anyone else the purchaser chooses) can be beneficiaries of the trust. So long as the spouse is alive, the purchaser can use the property rent free. But after the spouse’s death (or if the purchaser is not married), the purchaser must pay fair market rent to the trust in order to continue to use the property. A U.S. advisor should be consulted when drafting the trust to make sure it contains the provisions needed to keep the property from being included in the purchaser’s, beneficiaries’ or trustee’s U.S. estate.

Several formalities must be followed in order for the residence trust to remain outside of the purchaser’s estate. The sale contract should be signed by the trustee and the trustee should open a bank account in the name of the trust. The person funding the purchase would then transfer funds to the account and the trustee uses this account to complete the purchase.

Even though the use of a residence trust involves some additional planning and cost on the front end, if implemented correctly it can result in significant U.S. estate tax savings down the road.

Catherine Eberl is a lawyer at Hodgson Russ LLP in Buffalo, New York who focuses her practice on cross-border and U.S. estate planning.