The computation of the estate tax is generally determined according to the net estate after the person dies. This calculation uses a formula that allows the use of certain fixed exemptions provided by law, and of other deductions for outstanding debt at the time of death.
With regard to the exemptions for U.S. citizens and residents — legal or undocumented — they each have an exemption of $11,400,000, as of today. This exemption, however, shall be modified again to lower it to $5,000,000 starting in 2026. This exemption will continue to be indexed to the annual inflation beginning in 2013 as if there had been no modification at all. On the other hand, foreign nonresidents only have an exemption of $60,000 dollars. This exemption is not foreseen to be affected or modified in any way.
Inasmuch as the deductions are concerned, the two most important and valuable deductions for the computation of the estate tax are the unlimited marital deduction and the mortgage debt deduction that may exist over property they used to own.
What Is the Unlimited Marital Deduction?
The unlimited marital deduction allows two spouses while alive, or the estate of the decedent, to transfer all of their assets in excess of the legal exemption, free of federal taxes, to his or her spouse, or the surviving spouse, as long as this spouse is a U.S. citizen. That is to say, every person, whether American or foreign, subject to U.S. estate taxes can transfer all of their assets in the U.S., while alive or after death, to the U.S. citizen spouse with whom they were married free of federal taxes, or rather, tax-deferred. This tax deferral lasts until the death of the surviving U.S. citizen spouse.
Conversely, if the spouse who receives the assets is not a U.S. citizen, then the unlimited marital deduction may not be used as such, and then a Qualified Domestic Trust or QDOT, by its acronym in English, or another strategy, would need to be used to accomplish the same objective.
How Is the Mortgage Debt Deduction Calculated by a Foreign Nonresident?
Generally, for citizens and resident-aliens, the mortgage debt deduction is quite simple to take at the time of computing the estate tax because all they need to do is to take the amount owed on a mortgage at the time of death and presto! For foreign nonresidents, however, to be able to take the same deduction on a mortgage over property located in the U.S., one of the following needs to be true: 1) The mortgage debt to be deducted is a non-recourse debt. This means that the creditor will only look at the mortgaged asset, and not the individual owner, to satisfy the debt in case of default. In this case, the debt is 100% deductible; or 2) The mortgage debt to be deducted, even if it’s not a non-recourse debt, is itemized and included in the appropriate return along with all the rest of the worldwide assets and their appraisal of the decedent.
In this second case, the mortgage debt may only be deducted in the same proportion that the U.S. assets has in relation to the rest of the worldwide assets of the estate. That is to say, if the U.S. property represents 10% of the value of the worldwide estate, only 10% of the mortgage debt will be allowed as a deduction. Generally, when the cost-benefit analysis is made for taking the mortgage debt deduction, the majority of foreigners prefer not to take the deduction.
There are other deductions, such as those made to charity donations, and tax credits that can be used, but generally, they result in a much lower tax impact compared to the tax to be paid. It is important to emphasize that certain free transfers made within three years of the death of the donor-decedent are not deductible from the estate tax.