Given the U.S. tax reform in 2018, we’ve been providing extensive advice on U.S. purchases being made by Canadian real estate investors. Indeed, they are by far the largest investors into U.S. real estate, contributing roughly USD$20 billion per year. So they must ensure they’re properly navigating the U.S. Tax Reform changes to protect these investments. If done right, there’s potential to maximize on tax savings and asset protection.
After getting some feedback from our real estate tax professionals, we wanted to share a few tips on how to approach U.S. real estate if you’re a Canadian investor and how U.S. tax reform can impact your investment.
Choose your investment structure
One of the first things you’ll want to consider is what ownership structure to use. For things like associated legal risks, costs, timeline of ownership, intended use of property, and future acquisition plans, the proper ownership structure is imperative. Below is a brief overview of what your options are for investing in the U.S. as a Canadian.
- Individual Ownership: The simplest of all the structures—where all ownership is on you personally.
- Canadian or U.S. Partnership: Allows for allocation of income to multiple partners and may lower overall estate tax.
- Canadian or U.S. Corporation: Owning the property through a corporation can limit exposure to estate tax and lessen personal legal liability.
- Specially Drafted Trust: Cross-border or residence trusts can help minimize the exposure to U.S. estate taxes.
As far as structures go, there is no ideal or one-size-fits-all solution. It’s the responsibility of the investor to consider the implications of all the options. We recommend that Canadians buying residential rental properties in the U.S. use an ownership structure that best suits their particular needs. Sometimes legal and operational requirements, such as ability of obtaining U.S. financing, may outweigh the need for high tax effectiveness.
Review the impact of U.S. tax reform
Up to now, ownership of U.S. real estate through partnerships or Canadian corporations seemed to be the most popular choice among Canadians. In these structures, and thanks to the tax treaty, Canadians were able to recover most of the U.S. tax cost of property ownership through foreign tax credits claimed in Canada. The reduction of the U.S. federal corporate income tax rate to an average of a flat 21% from 34% means that the tax cost of owning U.S. real estate through a U.S. corporation is now less expensive.
Canadians investing in U.S. rental real estate through U.S. partnerships or personally may also benefit from the new 20% deduction on the qualified business income. There are certain restrictions on when and how the deduction is available, but the availability of this tax incentive may make personal ownership of U.S. rental real estate appealing, especially since it can also reduce structuring cost.
U.S. tax reform severely limits interest deductibility. Before the law change, interest paid to third parties, such as mortgage lenders, was fully deductible for tax purposes. As of the 2018 tax year, interest deductibility is limited to 30% of taxable income. These limitations will have an immediate impact on Canadian owners with highly mortgaged U.S. properties.
All U.S. taxpayers can benefit from the new 100% deduction, allowing them to write off certain capital assets that were placed in service after Sep 27, 2017 and have useful life of less than 15 years. This bonus depreciation, as it is referred to, may reduce the cost of U.S. property investment by reducing the cost of property upgrades (for qualified assets), especially if the newly purchased U.S. property needs to be furnished and renovated.
Do your due diligence
The U.S. is a big place. Some states may be better options than others. A great starting point when considering real estate investing is to research specific state regulations and tax rules. Some states may levy special taxes in addition to income taxes, such as hotel tax for short-term rental.
Income generated from rental of U.S. real estate is subject to U.S. tax. Therefore you can expect extra filing and set-up costs when you have real estate investments in the U.S. Particular attention should be paid to U.S. real estate owned through Canadian or U.S. corporations. Personal use of such property by shareholders and their family members may create rental income to the corporations.
Also, remember that sales of U.S. real estate property usually attracts U.S. tax withholding of 15% on the gross amount of the sale price at the time of the sale or property transfer. In certain circumstances, the withholding amount can be reduced. This, however, may require the assistance of an experienced cross-border U.S. tax specialist.
Thorough research and planning is imperative to your success. That’s why it’s important to be in touch with an experienced professional through all steps of the process—especially if this is your first U.S. real estate investment.
Know what to avoid
Unlike U.S. residents, who also have an option of purchasing real estate through a Limited Liability Corporation (LLC), Canadians are better off avoiding direct interest in LLCs since these types of entities are not tax efficient in the cross-border setting. However, Canadians are not altogether barred from using LLCs for their investments if proper organizational structures are put in place.
There are also certain types of U.S. partnerships that do not receive favourable treatment under Canadian tax law. The income from these partnerships can be taxed differently than it would from regular partnerships. The entities that should be avoided by Canadians are U.S. partnerships that provide ‘super’ liability protection such as LLLPs.
Combat challenges with proper planning
Ultimately, Canadians can benefit from a U.S. real estate investment if all the right precautions are taken. It’s important to consult U.S. tax professionals along the way to ensure you’ve taken all the right steps. If you’re interested in learning more, you can contact John McCrudden below.
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Partner, U.S. Corporate Tax
John joined BDO in 2008 as a member of the firm’s U.S. tax practice in our large market region. With experience in Canada/U.S. cross-border corporate tax work, his practice focuses on serving Canadian corporations and operating in the U.S. His expertise is in planning for mergers and acquisitions, repatriations of assets, and tax structures that allow his clients to efficiently conduct their U.S. activities. John has worked with companies in a variety of industries.Tags: partnerships, real estate investors, real estate tax, U.S., United States