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Investing in U.S. Real Estate -
Don't Let Tax Ruin Your Bottom Line

By Karl Dennis, KPMG LLP  &                                              December 15, 2004 
     Angela Yu, KPMG LLP

During the dark, damp days of Vancouver winter, many members of the BC real estate industry will no doubt be vacationing in sunnier places. If they happen to visit San Diego, for example, they will notice familiar names dotting the landscape as a number of Vancouver developers are transforming the Southern California condominium market. It is only natural that some travelers may just consider getting involved in an investment property or two themselves.

The purpose of this article is to highlight some of the Canadian and U.S. tax issues that arise with respect to investments in U.S. real estate. As tax advisers, we often find that the role taxes play in cross-border investments is underestimated. There should be more to the tax analysis of any cross-border real estate investment than simply applying a tax rate to the bottom line. Failure to do at least a little tax planning before making a cross-border investment can substantially reduce the expected return.

Because most real estate investments have fewer than six employees, we will focus on the tax considerations of these types of investments rather than those with six or more employees (different Canadian tax rules apply to real estate businesses with six or more employees). We also will not discuss state tax or U.S. estate tax issues, although these issues are usually relevant to cross-border investors.
 

The Tax Rate

Consider the following scenario: A Canadian privately owned corporation owns real estate located in British Columbia. In 2005, the corporation earns $100 of net rental income and distributes the net after-tax profits to its shareholders. Under these circumstances, a total of $48 of corporate and personal Canadian income tax is paid. In contrast, if the same corporation earns $100 of net rental income from real estate located in the United States, by the time all the profits are distributed back to the Canadian investors, over $70 of U.S. and Canadian income taxes might have been paid.

Although it is usually possible to reduce the effective tax rate to below 50% for income or gain from U.S. real estate investments, the actual rate will depend upon several factors, such as the investment structure chosen. The key to achieving a lower rate is to perform tax planning before making the investment. In any event, the widespread belief that U.S. tax rates are much lower than those in Canada is clearly not accurate and an investment into the United States should never be made on this assumption.
 

Cross-Border Tax Complexity – Canadian Rules

Before we even begin to consider some of the applicable U.S. tax rules, we need to be aware of how complex the Canadian tax rules are in the context of a cross-border real estate investment. Generally, Canadian resident individuals and corporations are subject to tax on their worldwide income. Canadian investors traditionally have attempted to defer Canadian tax by investing in foreign corporations operating in offshore tax havens. In order to combat these offshore strategies, Canada has developed anti-deferral rules to eliminate the tax benefits associated with holding investments in foreign corporations.

Even though the United States is not a "tax haven", these Canadian anti-deferral rules still may apply when Canadian investors use a U.S. corporation to acquire U.S. real estate. If the rules apply, the investors would be required to report the investment income (e.g., certain real estate rental income) of the U.S. corporation on their Canadian tax returns even if no cash has been received in the year from the U.S. corporation. Similar rules also may apply to investments by Canadians in certain non-corporate entities (e.g., trusts).

Any Canadian tax due as a result of these anti-deferral rules generally may be offset by a credit for U.S. income taxes paid. In some cases though, the credit is not available and double taxation will result. The calculations are extremely complex. In addition, the Canadian tax authorities, the Canada Revenue Agency have been increasing their audit activity in this area. Given the choice, most Canadian investors would prefer to steer clear of the application of these anti-deferral rules.
 

Cross-Border Tax Complexity – U.S. Rules

Rental income earned from real estate located in the United States is subject to U.S. income tax whether the income is earned by a U.S. person (e.g., a U.S. corporation) or a foreign person (e.g., a Canadian corporation). Similarly, gains from the sale of U.S. real property interests by a non-U.S. person are subject to U.S. income tax. The Canada-U.S. Income Tax Treaty provides little relief to Canadian persons who invest in U.S. real estate.

To ensure that foreign investors do not escape the U.S. tax net, U.S. payors (e.g., tenants) are required to withhold 30% tax on the gross rents they pay to non-U.S. owners, unless the owners elect to treat net the rental income as business profits. Similarly, purchasers of U.S. real estate are required to withhold 10% of the gross purchase price unless the seller is able to show that he/she is a U.S. person who is ordinarily subject to U.S. income tax. The withheld amount is generally remitted to the Internal Revenue Service(IRS) as a prepayment of the landlord/seller’s U.S. tax liability. The landlord/seller may claim a refund of the taxes to the extent the withheld amount exceeds his/her actual U.S. tax liability. See IRS Publication 515 for more information.
 

Cross-Border Tax Planning

The ideal investment structure should minimize the impact of both Canadian and U.S. taxes. It is not realistic to expect a cross-border tax plan to completely eliminate U.S. and Canadian taxes. An overall tax rate that is comparable to the Canadian domestic rate (48%) is usually sustainable. A bad tax plan (or no tax plan) will result in complexity and more tax than is necessary.

The number of structuring alternatives is endless. The use of partnerships, corporations, limited liability companies (LLCs) or other hybrid entities (treated as a flow-through in one country but treated as a corporate entity in another) is common. What is best? The answer will depend on both tax and non-tax business considerations.

In many cases, the use of flow-through entities, such as partnerships, minimizes the overall tax burden by eliminating entity level taxation. Partnerships also provide flexibility for different investors to divide the profits from a particular investment. However, corporations are more appropriate in certain circumstances (e.g., to provide additional protection against legal liability associated with the investment).

Many Americans prefer LLCs over other investment vehicles because LLCs provide flow through treatment (i.e., LLCs do not pay income tax, their owners do) while providing a high level of liability protection for the owner(s). However, for reasons beyond the scope of this article, LLCs often provide disastrous results from a Canadian income tax perspective. In some instances, the effective tax rate of a Canadian investor holding an interest in an LLC can exceed 70%! Suffice it to say, Canadian investors should avoid LLCs unless they have thoroughly considered both the Canadian and U.S. tax consequences of using an LLC.

Investors should also consider debt financing part of any U.S. real estate investment in order to further reduce the effective tax rate.
 

Filing of Returns

It is not uncommon for people to acquire a U.S. rental property and then "forget" to file any U.S. income tax returns. Such a failure allows the IRS to levy tax directly on the gross revenue earned, disallowing deductions for any expenses incurred to earn the revenue (e.g., interest, depreciation, etc.).

In addition, filing returns annually enables a taxpayer to keep track of losses that may be carried forward to offset any gain arising on the disposition of the underlying real estate. Often, rental properties are operated at a loss (when depreciation and interest costs are taken into account). These losses are only available for carryforward if a return is actually filed. Note that losses can be carried forward for up to 20 years in the United States (as opposed to only seven in Canada).

Of course, actually filing the necessary U.S. returns each year will cost time and money but will minimize the risk of a cruel surprise in the form of potential interest, penalties, and even disallowed deductions, and will also provide peace of mind (which is often undervalued).
 

Summary

The United States offers real estate investment opportunities that Canadian investors often find difficult to ignore. Canadians who choose to invest in the United States are wise to consider the impact of taxes before committing to any investment. In most cases, a little forethought and planning can prevent a costly and unnecessary loss of investment returns.
 

Karl Dennis
U.S. and International Tax Senior Manager, KPMG LLP
(604) 691-3045
kpdennis@kpmg.ca

Karl Dennis is a Senior Manager with KPMG in the U.S. and International Tax practice in Vancouver. His particular emphasis is the integration of U.S. and Canadian income tax rules and planning strategies for large private and public companies, including those in the real estate industry. Karl is a gold medallist on the Uniform Final Exam and is completing his Masters of U.S. Tax.
 

Angela Yu
U.S. Tax Partner, KPMG LLP
(604) 691-3383
angelayu@kpmg.ca

A partner since 1997, Angela Yu transferred to KPMG’s Vancouver office from KPMG’s Washington National tax practice. Prior to 1997, Angela served as a member of the U.S. legislative policy and drafting group, the Staff of the Joint Committee on Taxation. With over 20 years experience, Angela brings a wealth of knowledge and understanding to KPMG’s U.S. Cross Border Tax practice in Vancouver. Angela’s focus is on the provision of integrated Canada-U.S. tax advice, particularly in the real property sector.

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