Hello real estate investor, my name is Allan Madan; I’m a chartered accountant and tax expert in the Toronto, Mississauga and Oakville regions of Ontario, Canada. This short write-up aims to serve as a concise tax guide for Canadians buying U.S. Real Estate.
There is no dearth of people who wish to know about the tax implications of investing in US real estate, and this is because it’s the perfect mix; the Canadian dollar is high, U.S prices are at unprecedented historic low levels, and rents are pretty good. This tax guide for Canadians buying U.S. Real Estate will focus on the four best methods.
Through an LLC – Tax Guide for Canadians Buying US Real Estate:
The first is through an LLC (Limited Liability Corporation). Despite what you’ve heard in your seminars by American gurus, this is not the right way to invest for a Canadian. This works well only for U.S. residents or U.S. citizens. By way of background, an LLC allows for limited liability protection, which means that in the event of a lawsuit your personal assets aren’t at risk. Also, an LLC does not pay any income tax. Instead, shareholders or members of the LLC are responsible for all tax liabilities.
LLCs do not work well for Canadians because LLCs are treated as foreign corporations by the Canada Revenue Agency (CRA). This means that any tax paid on the income earned by a LLC is not credited to you on your Canadian personal tax return. Additionally, any cash distributed from the LLC’s profits to you, will be subjected to dividends tax in Canada. As you can see, you’re being taxed twice.
Although the numbers may vary based on the figures involved, Canadians residents operating an LLC on rental properties may have to pay upwards of 70%-80% in taxes on their property income or capital gain. This figure is further compounded by the increase in the dividend tax rate that is coming into effect in 2014. Please see our article should I pay myself salary or dividends as a business owner for more information regarding this increase.
Just how do we go about buying a U.S. property then? This brings us to the second tax structure for Canadians acquiring American real estate.
Under Your Own Name:
You buy the property in your own name. In this particular case you file a U.S. tax return known as the 1040-NR which is due on June, 15th. On this tax return you will report the gross rents collected and the expenses paid. Expenses are tax deductible and they include
• Property taxes
• Mortgage interest
• Fees paid to your property manager
While you pay tax in the U.S. on the net rental income, you also include the net rental income on your Canadian return. Sounds like you’re being double taxed? You’re actually not, because you will receive a foreign tax credit on your Canadian personal tax return for the US taxes paid. More information regarding the foreign tax credit can be found at the Canada Revenue Agency website.
If there is more than one individual investing in the U.S. real estate property, you could have all of the investor’s names listed on the title of the deed of purchase. This means that each person would file his/her own 1040-NR US return and their own personal tax return in Canada. Each investor involved would include their share of the rental profits on their tax returns.
With a General Partner:
The third structure discussed in this tax guide for Canadians buying US Real Estate is a little more complex and we’ll go through it in detail.
This structure has 3 main components:
1. Limited partnership that owns the American property
2. A Canadian corporation that is a general partner in the limited partnership. The general partner bears all of the risk.
3. Individual investors known as limited partners. Limited partners are only at risk for the amount they invest.
What’s great about this structure is that it’s classified as a flow-through for tax purposes. This means that the partnership does not pay tax, but the investors are responsible for paying all tax liabilities.
In addition, any U.S. taxes paid will be credited to you on your Canadian personal tax return, thereby avoiding double taxation. Additionally, the majority of the risk is borne by the general partner. This structure works great when you have two or more individuals investing in the U.S. real estate.
Through a Canadian Trust:
Holding American real estate through trust is a great option to avoid U.S. estate tax as part of a tax plan for Canadians buying US real estate. The structure of a trust involves a settlor (the person who provides assets to the trust) and the trustees (the people who hold and becomes ‘owners’ of these assets and administers them for the benefit of the beneficiaries). The trustees can use the funds from the trust to acquire real estate assets which will then be registered under the trust’s name.
The advantages are that the trust continues to exist even following the death of the individual(s) so it does not trigger U.S. estate tax. Additionally, Canadian capital gains tax will not be triggered and foreign tax credits will remain available if there is any capital gain when and if the property is sold.
The only problem is that the Canadian trust must be established prior to the offer and purchase of the targeted real estate property. So it is essential to plan far ahead.
The last option is through a corporation. There are two types of corporation structures in the United States, the first is the small business corporation also known as an S corporation and the general corporation otherwise known as a C Corporation. We will focus on C Corporations since S Corporations do not allow foreign ownership.
A ‘C Corporation’ is generally a good structure to acquire many different assets; unfortunately for Canadians buying real estate, it is not one of them. This is because of the number of different layers of taxes that will be levied:
- Corporate Tax – The first is that any income earned by the corporation is subject to tax at the corporate rate.
- Personal Tax – The individual(s) that are paid either dividends or salary will also be taxed at the personal level. [Dividends are a not deductible expense for a C Corporation). Unlike in Canada, there is no American dividend tax credit to offset the double taxation.
- Withholding Tax – Additionally, dividends paid to Canadians are also subject to a 15% withholding tax. Therefore, there are three layers of tax which can potentially accumulate to a significant amount.
On top of these taxes, capital gains from a C Corporation are taxed at their full amount as opposed to the usual 50%.
Additional Ownership Options:
Community Property and Community Property with Rights of Survivorship
There are additional tax guides for Canadians buying US real estate depending on the state. Several American states allow for ownership through the usage of community property laws which concerns the distribution of property that is acquired by a married couple. The two types of structures for this are: (1) Community property, and (2) Community property with the rights of survivorship.
In community property structures, both the husband and wife own a half-interest each in the property. They can each pass or transfer their ownership stake within their property by will to any person or trust upon their death.
The structure for community property with survivorship is the same but with one key difference. When one of the spouses dies, the surviving spouse will automatically have entire ownership of the property. So the transferring of ownership in this structure can only be passed on to either spouse and not to another individual or entity (trust). Once one of the spouse controls 100% of the property then they are able to transfer it upon their death.
These community property structures apply for the following states: Texas, New Mexico, Nevada, Louisiana, Idaho, California, Arizona, Washington and Wisconsin.
Estate tax may also be applicable for both structures depending on the value of the US assets and the worldwide assets (see blow).
Non-Resident US Estate Tax for Canadians:
Estate tax is a common issue and an important part of any tax planning guide for Canadians buying and owning American real estate. When an individual becomes deceased, their assets including real estate properties are subjected to estate tax prior to their distribution. Canadians who are neither Americans citizens nor US green card holders are only subjected to estate tax on their US situated assets upon their death.
As a Canadian you will only be subjected to estate tax upon your death, if the value of your assets based in the United States is greater than US $60,000 and the value of your worldwide assets is greater than $US 5.25 million. In this situation, you will likely not be subject to estate tax if the fair market value of your assets is below these figures.
If your assets are above these figures, your estate tax liability can be further reduced through the ‘unified credit’ that is available for Canadians. This tax credit is different for Americans and Canadians. The amount for 2013 is equal to $2,045,800 but for Canadians this number is calculated on a prorated basis. So the new calculation is based on the ratio of the value of your US estate assets compared to your worldwide assets and then multiplied by the initial unified credit amount of $2,045,800. If you still have excessive amounts of tax liability after this credit, the graduated tax rates seen here in appendix B will apply.
John purchases a home in the United States for US $4,000,000 and his total worldwide assets are $10,000,000. His ratio is 40 percent (4,000,000/10,000,000). This 40 percent is then applied to the unified credit amount for 2013 ($2,045,800) to calculate his unified tax credit for Canadians. The result is that John now has a credit of $818,320 (40% x $2,045,800) which he can use to reduce his estate tax liability.
Additionally, the treaty also allows any estate taxes paid to be eligible for foreign tax credits when filing Canadian income tax.
Estate taxes can prove to be a real headache, so the best strategy would be to avoid it altogether. The best option is to ensure that the value of your worldwide estate is under the $5.25 million. Consider splitting ownership of your assets amongst your spouse, family members and even trusts to minimize your worldwide estate.
The information provided on this page is intended to provide general information. The information does not take into account your personal situation and is not intended to be used without consultation from accounting and financial professionals. Allan Madan and Madan Chartered Accountant will not be held liable for any problems that arise from the usage of the information provided on this page.