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In this article, we will explore the intricacies that come with inheriting Australian assets for Australians and U.S. tax residents residing in the United States.
Australia doesn’t have an estate tax. Despite not having an estate tax, Australia still taxes assets from the sale of a deceased estate as there is no step-up in basis on most investment assets (although there are some exceptions for tax dependents inheriting a superannuation account or a primary residence).
In addition, income and gift taxation in Australia is handled solely by the ATO. In the U.S., in addition to the federal estate tax, each state may also have its own estate and/or inheritance tax.
Tax treatment of Australian assets depends entirely on:
To understand the way Australian assets are inherited in the United States first we need to go through how a deceased estate is administered.
When someone passes away in Australia, the assets and cash of the deceased individual will be placed into a deceased estate trust. This deceased estate trust operates domestically in the same way most other trusts will, in that it is managed by a trustee. But in the case of the deceased estate trust, the trustee is also the executor of the estate.
The will of the deceased and legal precedent determine how the assets are transferred and whether they are sold within the trust.
For taxation purposes, what matters most is:
When assets pass to a non-resident beneficiary (non-resident of Australia) something called a capital gains tax event K3 will occur (CGT event K3). This CGT event K3 is a deemed disposal.
This means that the ATO sees that the ownership of the asset is moving outside of Australia, and thus will want to tax the asset immediately, as if it had been sold.
Taxation will also vary depending on the type of asset that is being transferred.
An Australian stock portfolio is one of the most common types of assets inherited by U.S. tax residents.
There are two potential options in Australia:
U.S. beneficiaries will likely want to avoid the second option as having the stock portfolio directly transferred to a U.S.-based beneficiary can pose problems.
First, not only is the U.S. beneficiary required to pay the tax on the asset, but they are receiving a non-liquid asset. One can easily see how this can create issues: A U.S. beneficiary receives an asset with no proceeds, but they are still required to pay taxes on the asset.
In addition, non-residents pay a higher rate of tax than Australian residents.
To avoid triggering the CGT event K3, many Australians with beneficiaries who live in the U.S. may want to consider having the estate sell the assets. The estate pays the resident tax rate and can also take advantage of the 50% CGT discount. Then they can have the non-resident beneficiaries assume the cash.
From the perspective of the U.S., the death benefit of Australian life insurance is non-taxable in the U.S. It is received in the same manner as one would receive a U.S. death benefit. If the policy was held within a Superannuation account however, the death benefit would be subject to a 15% tax as the benefit, presumably, is being paid to a non-tax dependent.
If you have a permanent type policy with cash value, any investment gain would be taxable. However, this would generally entitle you to a foreign tax credit for any tax paid to Australia.
To answer this question, first we must define primary residence.
Primary residence means that the property:
When a primary residence is inherited, CGT event K3 will not be triggered. Australian real estate is still considered taxable Australian property, so there is no realization event as there would be with a stock inheritance.
As mentioned earlier the tax treatment on the sale of the property will vary depending on whether it’s sold as part of the deceased estate trust, or sold as a non-resident. Non-residents do not receive the 50% CGT discount and are taxed at higher non-resident rates. On low-basis assets (i.e. those with big gains built in), these two factors will significantly increase the Australian tax.
If the primary residence later becomes an investment property after the deceased passes away, the following tax rules apply in the U.S.:
First, the CGT event K3 will not apply, because the asset is not being transferred to the U.S., but is remaining in Australia, thus remaining taxable Australian property.
Assuming the property was purchased after the introduction of Capital Gain Tax in (9/20/1985), the basis will be the fair market value at the date of death. If purchased prior to the introduction of CGT, there will be no CGT.
As mentioned earlier the tax treatment on the sale of the property will vary depending on whether it’s sold as part of the deceased estate trust, or sold as a non-resident. Non-residents do not receive the 50% CGT discount and are taxed at higher non-resident rates. On low-basis assets (i.e. those with big gains built in), these two factors will significantly increase the Australian tax.
As with any transaction conducted by a U.S. tax resident, there will be a U.S. tax assessment to see if any additional U.S. taxes are owing. However, beneficiaries will receive foreign tax credits for Australian taxes paid.
Here is a scenario to illustrate the difference between inheriting a primary residence vs. an investment property as a non-resident:
You inherit a property worth $600,000 AUD today. It was originally acquired for $300,000 AUD 10 years earlier. If it is an investment property, your Australian cost basis is $300,000 whereas your US cost basis would be $600,000 AUD with the step-up in basis the U.S. provides. As it’s Australian situs property, you will be assessed a $300,000 capital gain, taxable at non-resident rates by the ATO.
It is not possible to inherit a superannuation account, but you can inherit the proceeds of the account when paid out.
There are multiple components within an Australian superannuation fund and these components determine how the proceeds are taxed.
These are generally the:
The superannuation account has a specific ratio of these three elements. When the distribution is made, the beneficiary receives the appropriate proportion of each of those components. This is called ‘the proportioning rule’.
The tax treatment for the distribution of superannuation funds depends entirely on which component is being distributed (a subject of another blog post).
Another key consideration is whether as the beneficiary you are a tax dependent of the superannuation member or not. Tax dependents may be entitled to certain concessions in each of these three areas.
Who is a tax dependent?
A dependent can receive an income stream and/or lump sum. One can receive an income stream generally up to 25 years of age, then it must be paid out in lump sum.
In contrast, non-dependents can only receive a lump sum distribution.
The taxation on the distribution depends on the classification of the beneficiary under tax law:
Brian is a United States citizen and tax resident. Brian's mother was and has always been an Australian resident. She has no ties to the United States. She has recently passed away, leaving a considerable portfolio of cash and assets for her son.
Brian is 35 years of age, and not financially dependent on his mother.
Brian is seeking guidance on the tax implications of the inheritance.
Assets Brian will be acquiring:
Stock Portfolio
First, we will take a look at the stock portfolio. The Australian basis of the portfolio is $2,000,000 AUD. When received by Brian, a step up in basis is provided in the U.S. This means that the U.S. basis is $5,000,000 AUD.
If maintained as taxable Australian property, no Australian taxes will apply on the date of transfer. If not, a $3,000,000 AUD capital gain will be taxable on the date of transfer (and at non-resident rates).
This presents Brian with a big challenge. If he distributes the stock portfolio in the U.S., he will receive a significant tax bill. One planning strategy Brian may consider is moving to Australia for a year, becoming an Australian tax resident, and distributing the account while an Australian tax resident… What does Brian decide to do?
In this scenario, Brian sells the portfolio one year later, for $6,000,000 AUD. The portfolio was deemed taxable Australian property. The Australian capital gain is $4,000,00 AUD and is paid at non-resident tax rates. The U.S. capital gain is $1,000,000 AUD, with foreign tax credits likely available for Australian taxes paid.
Cash Proceeds From Family Home
The deceased estate trust in Australia disposed of the family home before the cash distribution. Thus, the deceased estate in Australia would pay any domestic taxes applicable prior to the transfer. The $500,000 AUD cash proceeds received by Brian in the United States will be non-taxable.
Investment Property
At the date of transfer, the fair market value of the investment property is $1,000,000 AUD. The Australian cost basis is $200,000 AUD, with no exemptions available. The U.S. cost basis is $1,000,000 AUD.
This property is automatically considered taxable Australian property, therefore there is no capital gain in Australia on the date of transfer. All rental earnings must be declared in both the United States and Australia. The U.S. will offer a foreign tax credit for Australian taxes paid.
Let's say Brian wishes to sell the investment property two years later.
The current fair market value is $1,500,000 AUD. The capital gain in Australia would be $1,300,000 AUD, to be taxed at non-resident rates. The capital gain in the U.S. would be $500,000 AUD, with foreign tax credits possible for Australian taxes paid, thus avoiding double taxation at a Federal level (there could be U.S. state level tax owing).
Superannuation Account
If the superannuation account is distributed upon the death of Brian's mother, it will consist of two main components: the tax-free component and the taxable component.
Australia will not tax the tax-free component. However the taxable component will be subject to taxes, and the tax rate will depend on whether Brian is a tax-dependent or a non-tax-dependent.
Because Brian is not a tax dependent, he will receive no tax concessions for the taxable component. Brian will be subject to ordinary income tax at Australian non-resident rates on the $50,000 taxable component. As 15% was already withheld by the Super fund, and with a 32.5% rate applying, Brian would need to file an Australian tax return and pay the supplementary tax owing.
Inheriting Australian assets as a non-resident is one of the most complex situations you can face. Because each asset has its own rules of inheritance, the tax implications will vary widely, depending on the type of asset and your relationship to the deceased. Without careful planning, beneficiaries may face very punitive tax rates on their inheritance. Many inheritance situations require a case-by-case analysis to determine the best course of action.
If you are an Australian living in the U.S., or an American who will be receiving an Australian inheritance, diligent estate planning is critical to ensure you do not run into unforeseen financial difficulties.
At Areté Wealth Strategists, we have experience dealing with complex cross-border estate planning issues, and can work with you to develop a plan that meets your unique needs. Don't wait until you are faced with the daunting task of managing an Australian inheritance, schedule your complimentary consultation now.
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