Canadians Investing in U.S. Real Estate
If you are a Canadian considering investing in U.S. real estate, there are a number of issues you face. The start with U.S./Canadian taxation and are followed by asset protection and predatory lenders. Each of these obstacles is easily overcome provided you implement the appropriate structure for your investments. U.S. real estate is at historical lows, which makes it a phenomenal investment but it can also be a tremendous liability.
As an avid real estate investor and asset protection attorney, I meet many investors from North of the border who have taken advantage of the historically low U.S. real estate prices, but unknowingly made the 3 mistakes I mention above. Why? The answer is usually something like this: “the group I was working with to purchase real estate recommended I use John Doe to set up my asset protection structure. I assumed he knew what he was talking about, not to mention, he was recommended.” Having worked with thousands of investors to create asset protection plans, this problem is not Canadian specific but also plagues U.S. investors. The best way to protect against bad advice is to arm yourself with a basic understanding of asset protection tools and their tax implications. I always tell a prospective client that in my opinion, the best asset protection plan is one that considers the tax implications, asset protection benefits, and ongoing maintenance costs. I am sure you can understand my position. If you create a plan that provides great asset protection but increases your annual tax burden, while doubling your state filing fees coupled with added tax returns, you may begin to question the wisdom in putting your plan into action.
The following is a general guide to be used by the Canadian investor of U.S. real estate to assist with choosing the appropriate entity, if any, to protect your investment and minimize your U.S. and Canadian tax implications.
Taxes on Rental Income
The U.S. tax code treats rental income differently depending on the activity level of its owner. By default, rental real estate is a passive activity and is not considered a “trade or business.” For Canadians who desire to hold rental real estate in their own name, this can have negative tax ramifications from a cash flow standpoint. Canadian’s who engage in passive rental activity such as the typical lease situation in which the tenant pays rent and utilities, will have income subject to a flat 30 percent withholding tax applied to the Gross Income rather than the “net rent” (gross rent minus expenses) received. To make matters worse for Canadians, real estate taxes, operating expenses, repairs, interest/principal on any existing mortgages, and insurance premiums are notdeductible and if paid by the tenant, must be included in your gross income subject to the 30 percent withholding tax. To compound the problem, the 30 percent withholding will be remitted to the U.S. Treasury on a monthly basis. Most U.S. property managers are sensitive to working with Canadian investors because if they fail to withhold and remit the 30 percent, the IRS will hold the property manager liable.(The gross income and withheld taxes must be reported on Form 1042-S, Foreign Persons U.S. Source Income Subject to Withholding (PDF) to the IRS and the payee by March 15 of the following calendar year. The payor must also submit Form 1042, Annual Withholding Tax Return for U.S. Source Income of Foreign Persons (PDF), by March 15.)
Although the U.S. Treasury collects a flat 30 percent, a Canadian can elect to file a U.S. tax return each year and only pay tax on the net rental income, thereby receiving a refund for any excess taxes withheld. The U.S. Treasury may even thank you for the interest free loan.
Avoiding 30 Percent Withholding
There are currently two ways to avoid the 30 percent mandatory withholding on gross income:
- Engage in a U.S. trade or business such as the developing then managing and operating an apartment or commercial complex, or
- Elect to have your passive rental income taxed as if it were “effectively connected with a U.S. trade or business”
The first option is straight forward but the least likely solution for most Canadian investors. Unless you plan to actively buy and sell property, commonly referred to as flipping, your rental activity will not rise to the level of a trade or business. Thus, option 2 is the preferable course.
To make your rental income effectively connected with a U.S. trade or business you must attach a declaration to a timely filed U.S. income tax return (1040-NR). Once made, the election is permanent and will apply for all future years i.e., you will not be required to make the same election every time you purchase a new investment property. The advantage to this election is that you will no longer be required to withhold 30 percent.
CAUTION: You must timely file you tax return every year or you will lose the election and you will fall back into the 30 percent withholding.
To file a return you must obtain an Individual Taxpayer Identification Number (ITIN) from the IRS
The U.S. tax regulations provide that if a tax return of a foreign national is not filed within 18 months of the original due date, the IRS will disallow all deductible expenses.
If you are using a property manager, you should provide him a completed IRS Form W-8ECI. If you are not using a property manager, then this must be provided to your tenant. Without this form, your property manager will continue to withhold 30 percent of your gross rents. One final point before I move on to the sale of real estate, these rules apply to individuals and entities owned by Canadians.
Sale of Real Estate
If a Canadian sells real estate located in the U.S., a withholding tax of 10% of the gross sales price is normally payable under FIRPTA (the Foreign Investment in Real Property Tax Act of 1980). The tax withheld can be offset against the U.S. income tax payable on any gain realized on the sale, and refunded if it exceeds the tax liability. The 10% withholding requirement on the gross sales price applies regardless of your adjusted basis in the property.
CAUTION: Failure to file an annual 1040 NR will result in double taxation for a Canadian investor when he sells U.S. real property. Under the U.S. tax code real property is automatically depreciated regardless of choice. Depreciation is a deduction in the year it was incurred or carried forward to future years. When investment property is sold, the depreciation is automatically recaptured and taxed at a flat 25%. If a Canadian investor does not file an annual return claiming the depreciation deduction, it will be lost to him but he will be forced to recapture it for tax purposes. Effectively this results in a double tax on the sale of the real property.
There are two exceptions to FIRPTA’s 10% withholding requirement which may reduce or eliminate the requirement.
Exception 1: Sales price less than U.S. $300,000
FIRPTA will not apply if the property is sold for less than U.S. $300,000 and the purchaser intends to use it as a principal residence. The buyer need not be a U.S. resident. For this exception to apply, the purchaser must have definite plans to reside at the property for at least half of the time the property is in use during each of the two years following the sale. However, the gain on the sale will still be taxable in the U.S. and a U.S. tax return must therefore be filed. Thus, if a Canadian is selling U.S. real estate, for less than U.S. $300,000 to a buyer who intends to occupy it as a principal residence, the seller will receive the full purchase price rather than having 10% withheld by the buyer and remitted to the IRS.
Exception 2: Withholding certificate
The second exception allows for reduced or eliminated withholding, where the Canadian obtains a withholding certificate from the IRS on the basis that the expected U.S. tax liability will be less than 10% of the sales price. The certificate will indicate what amount of tax should be withheld by the purchaser rather than the full 10%. A withholding certificate issued after the transfer of the property may allow the seller to receive an early refund. (See IRS Publication 515 for details) Any tax paid in the U.S. will result in a foreign tax credit, which can be used to offset your Canadian taxes.
Asset Protection for Canadians
When it comes to holding U.S. real estate, the Limited Liability Company (LLC) is preferred over all other forms of business entities. The LLC offers its owners liability protection from claims associated with the rental estate e.g., slip and falls, mold contamination, contract claims, etc., and protects the LLC and its assets from claims asserted against the LLC members individually. The LLC is likewise preferred for its flow through tax treatment. Unlike a U.S. Corporation, the LLC passes all gains or loss directly through to its owners (members) based upon their overall ownership in the LLC. This is especially attractive for real estate because items of depreciation or gain are taxed at preferable rates.
It sounds perfect. As a Canadian you will have asset protection but as I stated earlier, this must be balanced against taxation and this is where it begins to unravel for Canadians investing in the U.S.
Do not Fall Prey to Mistake #3 – The person with whom they were dealing does not understand Canadian tax issues.
A LLC formed in Canada is treated as a corporation for tax purposes. In the U.S., a LLC is considered a hybrid entity because a LLC can elect to be taxed as either a corporation, partnership or disregarded for tax purposes. Herein lies the problem. The Canada-U.S. tax treaty allows Canadians to avoid double tax on certain types of income. The treaty allows a Canadian resident to avoid double taxation by determining which taxing jurisdiction has the right to tax that income. A company is only considered resident for treaty purposes if it is subject to taxation on its worldwide income. The use of LLCs is problematic in that Canada does not view an LLC as being a resident for treaty purposes because the LLC is not subject to U.S. taxation on its income. Instead, the LLC’s members are subject to U.S. taxation on the LLC’s income.
Because the LLC’s members, including its Canadian members, would also be subject to U.S. taxation on the LLC’s income (see above), the Canadian tax imposed on the LLC (remember Canada views the LLC as a corporation) would result in a second level of taxation. The treaty, which would normally limit worldwide taxation of a company’s income to the jurisdiction under which the company is incorporated or established, would not protect the LLC from Canadian taxation on its worldwide income since Canada does not grant treaty benefits to the LLC. Thus, a Canadian member who earns income through an LLC cannot claim the grossed-up deduction due the hybrid nature of an LLC. Hence, double taxation.
The tax issues surrounding LLCs and Canada are quite complex but bear this in mind, I am not implying that a LLC can not be beneficial for a Canadian investor; in fact, I will make such a recommendation in the next section. The key is how you structure your ownership in the LLC that will make all the difference.
Creating the Optimal Asset Protection Solution for Canadian’s Investing in U.S. Real Estate
There are three forms of business entities that offer the asset protection benefits of the LLC discussed above with the proper flow through tax treatment recognized by Canada; these are the limited partnership (LP), limited liability partnership (LLP) and limited liability limited partnership (LLLP).
A limited partnership is a form of partnership similar to a general partnership, except that in addition to one or more general partners (GPs), there are one or more limited partners (LPs). In a LP, only the limited partners have asset protection. The GP bears full liability for all debts and obligations of the LP. This is the price for serving as the decision maker of a LP. If you want control over the LP’s business, you must assume full liability exposure. (Limited partners do not have a say in the business of the LP. The GP has the authority as agent of the LP to bind all the other partners in contracts with third parties and run the business.) To address this flaw in the LP, another business entity such as a corporation or LLC is often used as the GP. Both of these entities allow an individual to act through them in controlling the LP without assuming personal liability exposure.
From a tax standpoint, the LP is a flow through entity that does not pay tax. All items of gain or loss pass through to the partners and is accounted for on the partners’ individual income tax returns.
Drawbacks to This Structure
One of the major drawbacks for Canadians using a LP is the necessity to create an additional entity to serve as the GP. The intent behind creating your asset protectionstructure to hold U.S. real estate is asset protection. However, if you serve as the GP in your individual capacity your protection is blown thus, the additional entity. When I create this structure for Canadian real estate investors, I will give my clients a 99 percent LP interests and set up a corporation or LLC with a 1 percent GP interest. If we limit the GP interest to 1 percent it will minimize the adverse tax consequences of using a LLC i.e., the amount of income allocated to the GP is to small to be of any consequence.
Who Should Consider
The LP is a partnership. Under U.S. tax law a partnership is created between two or more individuals. The problem arises when the Canadian investor is single and does not have a partner. For U.S. residents this is not a problem because we can use a single member LLC but as discussed earlier, this will not work for Canadian investors. Hence, we solve this problem by using the LLC, wholly owned by the Canadian investor, as the GP with a 1 percent interest and the Canadian investor, individually, as the 99% limited partner.
Limited Liability Partnership
A new entity option that offers similar benefits to the LLC without the negative tax implications is a limited liability partnership (LLP). Like the LLC, a LLP will protect its partners from the liabilities associated with the LLP’s assets provided the LLP is created in a full shield state. Further, all of the partners in a LLP have management control over the business.
In some states, the protection afforded by a LLP is slight and only protects against the misconduct of other partners, specifically excluding protection from contracts entered into by those partners. Other states’ LLP statutes provide limited protection from another partner’s errors, mistakes, misconduct, or incompetence. These states are called “partial shield statute” states, because the protection they provide does not cover the most important risk to the partners- the personal liability that they risk for business debts. Other states called “full shield statute” states protect the partners from personal liability of the debts of the business no matter how the debts were incurred.
Despite the differences in shields, this problem is easily solved by using a LLP filed in any state as a holding company for single member LLCs each owning one or more properties. The LLCs provide excellent asset protection, are disregarded for U.S. tax purposes, and will not create adverse tax consequences for the Canadian investor because they are held through a LLP.
Drawback to This Structure
One of the major drawbacks for Canadians using a LLP is in not using LLCs to hold the investment real estate. If the LLP is not set up in a full shield state, the investor risks liability exposure should something befall the property. From an overall cost perspective, unless the Canadian investor is only considering making one investment, utilizing multiple LLPs will greatly increase the cost of holding real estate because each LLP will require a separate tax return.
Another drawback of the LLP is its management structure. In a LLP each of the partners can exercise control over the business. For real estate investors this can add to the complexity of putting deals together because all of the partners must consent and sign agreements. Also, like the LP, a single investor considering using a LLP must establish a second entity to serve as the additional partner. Thus, the LLP would not make sense given the amount of protection the LP offers versus the LLP for a single investor.
Who Should Consider
The LLP is appropriate for situations where there are only 2 investors purchasing U.S. real estate. I limit the number to 2 because of the full control issue discussed above. Further, the LLP will allow full control over the investments without liability exposure provided the plan is properly structured.
Limited Liability Limited Partnership
Only in the U.S. can we contrive so many different ways to conduct business. Many times these new entity designations are a result of not getting it right the first time around, so we try and improve on that which is imperfect. Hence, the limited liability partnership (LLLP).
A LLLP begins life as a LP then files for a conversion to the LLLP structure so the general partner will have limited liability, similar to the limited partners. This is similar to the process of a general partnership registering to be recognized as a limited liability partnership (LLP), so that all of the owners have limited liability. The main advantage of the LLLP over the LLP is the asset protection benefits. A LLLP offers the same asset protection benefits of a LP with the additional shield for the decision makers. Unlike the LLP, in a LLLP the management does not have to be vested in all of the partners. This makes this entity extremely attractive for holding real estate.
Drawback to This Structure
One minor drawback to using a LLLP is cost and complexity. A LLLP is required to begin its life as a LP thus, for the Canadian investor considering this structure he must first pay a state-filing fee to create the LP then pay another fee to convert to a LLLP.
Some commentators will argue that the LLLP limited acceptance is a reason to avoid its use. Currently, the LLLP is recognized in the following states: Alaska, Arizona, Arkansas, Colorado, Delaware, Florida, Georgia, Hawaii, Idaho, Iowa, Kentucky, Maryland, Minnesota, Missouri, Nevada, North Carolina, North Dakota, Pennsylvania, South Dakota, Texas, Virginia. However, the LLLP should be set up to hold LLCs that own the real estate so the state of formation is irrelevant because the LLLP will not conduct business in the state where the property is held.
Who Should Consider
The LLLP is appropriate for all Canadian investors of U.S. real estate.
If you purchase U.S. real estate you will undoubtedly hear about land trusts. The land trust is a title holding vehicle only and does not offer its owners asset protection. However, it is critical when protecting encumbered real estate because it facilitates property transfers into LLLPs/LLCs/LPs/LLPs without alerting the bank to the transfer. This is extremely important when dealing with encumbered real estate. If a lender discovers that an investor transferred title to an asset protection entity, the Lender could make the note immediately due and payable. To avoid this unintended consequence, most U.S. real estate investors will transfer their investment real estate first into a land trust then assign the land trust to their LLC for asset protection. This 2 step process will provide asset protection for the property owner and protect him from the banks accelerating the note. A more detailed discussion on land trusts can be found here on my Blog.
If you are a Canadian who is considering investing in the U.S. and would like more information on your asset protection options, you may contact me direct at firstname.lastname@example.org/.or via email at
Originally posted on www.clintcoons.wordpress.com
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