George Dube and Peter Cuttini discuss the different ownership options when investing in the U.S. to maximize tax savings and asset protection
Due to the severe recession that has gripped the United States economy and the subsequent reduction in housing values; a number of Canadians are now investing in U.S. real estate as second homes or investment properties. There are many tax structures an investor should consider when purchasing any property. When it comes to U.S. real estate there is no one solution that is right for everyone. Each investor should consult with an experienced cross-
border accountant and lawyer to determine which ownership structure is appropriate for their needs.
When a taxpayer receives rental income for a U.S. property the Canadian-U.S. Tax Treaty requires that a 30% withholding tax be remitted to the U.S. Treasury on the gross rental income received. Normally a taxpayer would elect to have this rental income treated as “effectively connect income,” file a U.S. income tax return and pay tax on any net rental income instead of the gross income. The taxpayer will also have to report the rental income in Canada and will receive a foreign tax credit for the U.S. federal, state and local taxes paid. Further, foreign property disclosures to the Canada Revenue Agency are generally required.
When determining the appropriate ownership structure, there are many factors that need to be considered. A sample of those factors are cost of the property, expected future appreciation of the property, the age of the taxpayer(s), the legal risks associated with the property, the intended use of the property, future acquisition plans and timeline for ownership. The taxpayer should not only plan around U.S. income tax but also U.S. estate tax. As many of you are aware the U.S. estate tax can be a significant tax cost on the death of any person owing U.S. situs assets.
The following are some typical ownership structures that a taxpayer may wish to consider when purchasing U.S. real estate.
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 U.S. corporation, and potentially no state income tax depending on the location of the property. The main disadvantages of personal ownership are the exposure to U.S. estate tax and personal legal liability should any significant event occur at the property.
A common technique used to minimize the estate tax is to have multiple family members on title for the property. The main drawback for this is that if adult children or any adult family member are added to the title of the property, they are considered to own their proportionate share of the real estate. Hence husband and wife may lose control of the property if three or more adult children are added to the title of the property.
Another ownership structure is to own the property in a U.S. corporation. Depending on the ownership structure of the corporation, U.S. estate may be avoided. The use of a U.S. 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 number of years, a various number of alternative and hybrid ownership structures have become popular. One of the more common alternatives is the use of residence trust or cross-border trusts. These trusts have become popular in many situations, but work best for a married couple. These trusts can help minimize the exposure to U.S. estate taxes while allowing access to the lower personal income and capital gains taxes rates. The reader should be warned that these structures are complicated and that significant legal fees may be incurred to set up these structures and potential higher annual filing requirement.
Limited liability corporation
Another potential structure is the use of a U.S. legal liability corporation or LLC. These LLCs can have the net income from the property flow through to the individual shareholders or to be taxed as a corporation using the “tick the box” election. Again, the use of an LLC is a complicated structure that may mitigate exposure to U.S. estate tax depending on the how the LLC was set up. If a taxpayer currently has or is considering using a LLC, a recent Canadian tax case has changed the rules in regards to LLC. The taxpayer should consult with an appropriate tax accountant and/or lawyer regarding this tax case. Caution should be exercised though in that many U.S. advisers automatically recommend LLCs, which may be great for Americans, however, there can be some very negative consequences from a Canadian perspective.
These are just a sample of some the ownership structures that are available to an investor. Each situation is unique and an investor should consult with an experienced cross-border accountant and lawyer to determine which ownership structure is appropriate for their needs.
Peter Cuttini and George E. Dube
A version of this article first appeared in Canadian Real Estate Magazine, February 2011. You can download a PDF version of the article: Download.
Tags: real estate, structure, US