Common Tax Pitfalls with Real Estate Investments
Structure your real estate investments to preserve your assets on a tax-effective basis
In a variety of real estate investments, you can avoid common pitfalls and take full advantage of opportunities by using appropriate structures to preserve your assets and do so on a tax-effective basis.
Investing Through Limited Partnerships
I recently advised David, a successful real estate investor and , to use a limited partnership (“LP”) for a new project instead of his usual practice- a corporation alongside other corporate investments.
I cautioned against using a separate corporation for each venture, because in Canada we do not have consolidated reporting of affiliated groups for tax purposes.
By arranging to have each new venture structured as an LP, those with profits can be offset by those with losses at the end of each taxation year. Accordingly, there is no need to have one entity, generally a corporation with a loss, charge a management fee to another affiliated corporation with a profit, in order to have one offset the other, as is a common, but risky, practise. This arrangement has been successfully attacked by the Canada Revenue Agency (“CRA”), as being artificial and motivated strictly by tax savings.
A partnership is not viewed as a separate legal entity distinct from its members but an aggregation of those parties. An LP is a form of partnership that can be registered under a local statute, e.g. Limited Partnership’s Act (Ontario), to give the firm separate status for certain commercial purposes. A limited partner’s liability exposure is the amount of capital invested, not the partner’s personal assets.
For income tax purposes, the income or loss at the end of the limited partnership’s fiscal period will be allocated to the partners in accordance with the partnership agreement. Typically in an LP, the general partner will get a nominal allocation, say, 1%, and the limited partners will get the balance of, say, 99%.
The LP structure thus provides asset protection and tax efficiencies.
Holding Investments in U.S. Real Estate
David also asked me about an opportunity he was offered to invest in a U.S. real estate project. We started by identifying the structuring objectives:
- minimize U.S. taxation on income and exit gains
- avoid exposure to U.S. estate or gift tax
- avoid U.S. tax reporting obligations
- ensure Canadian tax credit for U.S. taxes paid
Cross-border tax concerns arise on a current basis if the investment in U.S. real estate produces income or capital gain, and there is the possibility of having both U.S. and Canadian tax apply to the same realization.
In addition, if a Canadian resident dies owning property with a U.S. situs in law, such as real estate located in the United States, he/she may be subject to U.S. estate tax at an escalating scale up to a maximum rate of 40%.
Under the Internal Revenue Code, a gift of U.S. situs property may also give rise to gift tax on a similar scale to the estate tax.
While a Canadian resident faces tax on death as well under the ITA, this is a tax on capital gains deemed to have been realized on the assets of the deceased at the time of death, not a tax on the gross value of an estate’s assets at the time of death. In addition, the maximum tax rate in Ontario on such capital gains is, effectively, about 26.5%.
Under the Canada/U.S. Tax Convention for the Avoidance of Double Taxation (the “U.S. Treaty”), there is some relief from double taxation at death resulting from the foregoing taxes, but the relief is inadequate. Moreover, there is no relief under the U.S. Treaty for any U.S. gift tax that may become payable by a Canadian resident transferring U.S. situs property.
Accordingly, we started with considering U.S. taxation of income from U.S. real estate: investment income subject to withholding tax, and business income subject to ordinary tax rates. Capital gains are taxed in the U.S. when a Canadian investor realizes a capital gain on the disposition of U.S. real estate, including equity ownership in a U.S. real property holding company or partnership.
Typically instead of using an LP, a U.S. investor in real estate will use an LLC, or limited liability company. It is treated as a flow-through entity (like a partnership) for tax purposes to a U.S. taxpayer, but at the same time provides limited liability protection without restrictions on participating in the management and control found with an LP.
For Canadian investors, a direct investment in an American LLC can be problematic. First, it can give rise to double taxation, because the CRA does not treat the LLC as a flow-through entity but as a separate foreign corporation, which in certain circumstances of earning passive investment income can result in current Canadian tax on so-called foreign accrual property income, or “FAPI”, imposed on the Canadian investor.
In addition, the Canadian member of an LLC will be exposed to U.S. estate and gift tax in relation to the value of the membership interest.
By structuring the investment in the LLC through a regular U.S. taxable corporation, those exposures are minimized. Moreover, if the LLC (or U.S. corporation) is considered to be carrying on an active real estate business (e.g. having more than 5 employees engaged full-time in the conduct of the U.S. business), the Canadian investor could invest in the U.S. corporation through a Canadian holding company to minimize both Canadian and U.S. tax on repatriated profits.
USA Family Trust
David told me that as a so-called “snowbird” going to Florida each winter, he wanted to acquire a vacation property there. I advised him that, as noted earlier, a Canadian resident who dies owning property with a U.S. situs in law, such as the Florida Property which is real estate located in the United States, may be subject to U.S. estate tax at an escalating scale up to a maximum rate of 40%.
Accordingly, unless proper tax planning is undertaken by a Canadian resident investing in U.S. situs property, there can be an onerous tax burden on death or from making a gift.
Instead, I suggested he consider establishing a Canadian discretionary family Trust to hold the American vacation property. Thus, on the death of either David or his spouse, there will be no exposure to U.S. estate tax. In addition, if the Trust sells the property for a capital gain, the Trust is viewed as a flow-through vehicle for U.S. tax purposes, and so the long-term capital gains rate of about 23% would apply to the individual Canadian beneficiaries. Because the top rate in Ontario for capital gains is about 26.5% and a foreign tax credit will be available to offset Canadian tax, only 3.5% tax would be payable in Canada.
Finally, David was concerned that with the growth in the future value of summer vacation properties near Toronto, there will also come increased tax liability associated with such a vacation property. David asked how to structure the ownership of this property, so that the transfer ultimately to his heirs could be done with minimal cost in terms of tax and administration.
I explained that, as noted above, on the death of each Canadian resident, he or she is deemed under the ITA to have disposed of all property, including ones such as this Canadian vacation property, and to have realized proceeds of disposition equal to the then fair market value of such property. Similar rules apply in respect of a gift of the property during his lifetime. In other words, capital gains tax may become payable on such transfers.
Furthermore, when his Will would be probated, the value of this Canadian vacation property will be taken into account in calculation of the applicable probate fee. Moreover, the filed Will would become a public document.
If he were to use a trust to hold this Canadian vacation property, the trust would be deemed to have disposed of this property every 21 years for proceeds of disposition equal to the then fair market value.
Instead, I recommended that David establish a non-share capital, not-for-profit corporation (“NPO”). David and his spouse would run the NPO like a recreational club. To be cautious the NPO would lease the vacation property to David and his spouse, and they would pay a minimum rental at least equal to the operating expenses.
As the NPO will continue after they die, there will be no capital gains tax on either death (the life interests merely expire). In addition, there would be no probate necessary. Their children as the successor directors and members would continue to run the NPO.
If the NPO were to sell the property, there would be no capital gains tax payable. The proceeds could be invested in another property to be used as a club and the tax deferral could continue.
If the proceeds were distributed, say, on a winding-up of the NPO, the member(s) would be considered to have realized capital gains on any increase in value above the initial cost when the property was purchased.