By Peter Cuttini, CPA, CA, CPA (Illinois)
The climate for investing in US real estate has changed over the last five years, but the questions we get as real estate accountants from Canadians looking to invest in US properties have remained the same. Here are the top five.
1) How should I structure my US investments?
Canadians have a variety of potential ownership structures when purchasing US real estate. However, each of these ownership structures has different tax implications and filing requirements to ensure that you stay on the right side of the IRS and the CRA.
When dealing with US real estate, you need to look at three main structures:
- personal ownership,
- corporation ownership, and
- LLP ownership.
Owning the property personally is the simplest and easiest ownership structure. Besides the ease of this structure, the advantages to owning the property personally are lower capital gains tax rates on long-term capital gains (i.e., held for more than 12 months) in comparison to a US corporation, and potentially no state income tax depending on the location of the property. The main disadvantages of personal ownership are the exposure to US estate tax and the personal legal liability should any significant event occur at the property.
When owning properties personally in the United States, the following is a list of common tax implications to be aware of:
- In most circumstances, taxpayers elect to treat the income from the rental property as effectively connected income to the United States. This will tax the rental income on a net basis at the US graduated tax rates or lesser under the tax treaty. If you do not make this election, the tax will be 30% of the gross rent. To make this election the owner must provide a W-8ECI form to the property manager or renter. If not provided, the property manager or renter must withhold 30% of the gross rent to the IRS on a monthly basis.
- Unlike Canada, annual depreciation of the property and all other capital assets is mandatory. Depreciation is calculated using the Modified Accelerated Cost Recovery System (MACRS).
- If the property was also used for personal use, the expenses will be limited to only the percentage of time the property was rented.
- In most cases, real estate rentals are considered passive investments. If the property is operating at a net loss for US tax purposes, the loss will be carried forward to a future year to be applied against future income.
- You must have an IRS-issued Individual Taxpayer Identification Number (ITIN) for the tax return. If you do not have an ITIN, you can apply for one with the tax return. To receive your ITIN, you complete Form W-7: Application for IRS Individual Taxpayer Identification Number.
Another ownership structure is to own the property in a US corporation. Depending on the ownership structure of the corporation, US estate tax may be avoided. The use of a US corporation may also mitigate any personal legal liabilities. Some of the negatives involved with corporation ownership are potential higher income and capital gains tax rates and higher annual costs associated with the tax filings for a corporation. Another negative is that there is potential for double taxation when the funds are ultimately returned to Canada, depending on the timing of the transactions.
Over the past few years, we are seeing an increase in US property being purchased by Canadians using a limited liability partnership (LLP) structure. The LLP structure can be used to minimize legal liability risks while allowing preferential tax treatment of a flow-through entity to the individual partners.
Note that an LLP is different from a limited liability company (LLC). Many US advisors automatically recommend LLCs, which may be great for Americans; however, there can be some very negative consequences from a Canadian perspective.
2) How much tax am I going to have to pay?
This really depends. Let’s look at an example:
- Taxpayer is in Ontario at top bracket (assume 50% tax bracket)
- Property is in the state of Florida
- US corporation declares dividend to Canadian shareholder each year
2016 US individual tax rate for non-resident taxpayers
|$0–$9,275||10% of taxable income|
|$9,275–$37,650||$927.50 plus 15% of excess over $9,275|
|$37,650 –$91,150||$5,183.75 plus 25% of excess over $37,650|
|$91,150– $190,150||$18,558.75 plus 28% of excess over $91,150|
|$190,150– $413,350||$46,278.75 plus 33% of excess over $190,150|
|$413,350–$415,050||$119,934.75 plus 35% of excess over $413,350|
|$415,050+||$120,529.75 plus 39.6% of excess over $415,050|
2016 US corporate tax rates for non-resident taxpayers
|$50,000–$75,000||$7,500 + 25% of excess over $50,000|
|$75,000–$100,000||$13,750 + 34% of excess over $75,000|
|$100,000–$335,000||$22,250 + 39% of excess over $100,000|
|$335,000–$10,000,000||$113,900 + 34% of excess over $335,000|
|$10,000,000–$15,000,000||$3,400,000 + 35% of excess over $10,000,000|
|$15,000,000–$18,333,333||$5,150,000 + 38% of excess over $15,000,000|
|Over $18,333,333||Flat 35%|
3) How do I report my income and expenses from foreign properties?
If you are a Canadian resident and own a property personally in the United States and derive Income from the property, you must file Form 1040NR: U.S. Nonresident Alien Income Tax Return. The normal due date for the return is April 15, but Canadians can get an automatic extension to file the tax return to June 15. However, any tax owing will still be due April 15. The government wants the money first and accepts the paperwork after the fact. A few more details:
- If the property is jointly owned, each spouse or owner must file their own US tax return.
- You may also need to file a state income tax return. (Some US states do not have personal income tax.)
- If you sold the property during the year, you must report any capital gains or losses. Long-term capital gains (property owned more than one year) are taxed federally at a maximum of 20% of the capital gains. Any previously taken depreciation is added to income as a Section 1250 gain. These Section 1250 gains are subject to a higher maximum federal capital gains rate of 25%.
If the property is owned by a corporation, the corporation must file either:
- Form 1120: U.S. Corporation Income Tax Return, if the property is owned by a US C corporation; or
- Form 1120-F: U.S. Income Tax Return of a Foreign Corporation, if the property is owned by a Canadian corporation.
Both tax returns are due on the 15th of the third month following the year-end of the corporation. You can file an extension to file the tax returns later for each return but, unlike personal income tax returns, the extensions are not automatic. To get an extension to file the tax return, 90% of the final taxes owing must be paid with the extension. This normally means that the taxpayer submits a larger-than-anticipated payment with the extension. The extension to file the tax return is requested by submitting Form 7004: Application for Automatic Extension of Time to File Certain Business Income Tax, Information, and Other Returns by the original due date of the tax return.
The corporation reports all of its income and expenses on the tax return. The corporation is taxed at US corporate rates on any net income generated from the property. Capital gains generated from selling a property are reported on Schedule D. The maximum US federal corporate capital gains rate is 35%.
The corporation must also file any applicable state and local tax returns, as required.
The partnership must file Form 1065: U.S. Return of Partnership Income to report the income and expenses of the property. The 1065 return is an information return and, hence, the partnership does not pay taxes. The income is flow through to each partner of the partnership, based on their percentage ownership of the partnership. The 1065 return is due on the 15th of the fourth month after the year-end of the partnership.
Each partner will receive a K-1 tax form from the partnership, which will indicate the partner’s proportional share of any income or loss from the partnership. Each partner will then have to report this income on their US tax return. If the partner is a Canadian individual, the income will be reported on Form 1040NR, as discussed above.
There may also be a state and local tax return required.
4) What are my Canadian obligations?
You definitely have Canadian reporting obligations, and they have changed in the last few years. As well, there are significant penalties for failing to file the required forms. Your disclosure requirements for Canada are:
- Form T1134: Information Return Relating to Controlled and Not-Controlled Foreign Affiliates (corporate or personal)
- Form T1135: Foreign Income Verification Statement (corporate or personal)
- Trusts have specific documents to file for disclosure requirements if owned in this manner.
Don’t forget to claim a foreign tax credit for any US federal and/or state income taxes paid. And take note: the Canada Revenue Agency has stepped up its reviews of these foreign taxes paid on personal tax returns, so be prepared to receive a letter after e-filing your personal return asking for proof of these amounts.
A Canadian owner of a C corporation in the United States does not have to report any income from the C corporation in Canada until that income is repatriated to Canada.
5) What’s the biggest “gotcha” from a tax perspective when investing in US real estate?
What works for Americans might not work for Canadians; in fact, what works for Americans may cause Canadians to pay significantly more tax. Therefore, finding an advisor who can handle the domestic and foreign tax implications is crucial to your success. Be sure to get qualified advice.
Peter is a partner at BDO Canada LLP and a real estate investor. He focuses on helping other investors with their business and accounting needs.
@petercuttini | firstname.lastname@example.org