Structure your real estate investments to preserve your assets on a tax-effective basis
If you are making investments in U.S. real estate, 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.
Holding Investments in U.S. Real Estate
I recently advised my client, David, 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.