1. Owning Property in Personal Name
When purchasing a property in the U.S. there are several different ways to take title. Some may sound familiar, e.g. Joint tenancy, but as buyers, you will need to understand how each different method can work for or against you. For example, if not purchased properly, Joint Tenants with Rights of Survivorship can have adverse estate tax effects on the survivor, whereas Community Property or Tenancy in Common may prevent these adverse estate tax effects, regardless of the source of the funds used to purchased the property. With the proper advice, you can sidestep costly mistakes and take advantage of the same opportunities.
Another consideration is liability exposure. If you are renting your property, you are exposing yourself to more risk than if you occupied the home yourself. When taking the title in your own name, you are personally responsible for any liability issues that arise. Although you can purchase insurance to protect yourself from some liability, your liability is unlimited and the insurance coverage may not be enough to cover the liability, whereas using a business entity may limit your liability.
2. Owning Property Through a Foreign Company
This is one of the most common mistakes that people make when purchasing property in the U.S. While you may desire to keep all of your investments within one entity, the very act of owning U.S. real property within your company causes additional tax filing requirements and can cause adverse tax results, including potential double taxation. In the rare occasion that the benefits of owning property in a Canadian entity outweighed the cost, this is the exception to the general rule and should not be considered without the proper cross-border tax advice. Additionally, there could be jurisdictional disputes that would increase your legal fees.
3. US Business Structures
How do you protect yourself against the liability associated with an income-producing property, e.g. rental property, yet not have the double tax or burdensome tax reports that are associated with a foreign entity? Deciding between which business structures to use can be the difference in having positive or negative cash flow.
The optimum tax structure will depend on three sets of laws: U.S. tax law, your home country’s tax law (Canada), and the U.S.-Canada tax treaty. Without looking at the ramifications in each of these three separate taxing authorities, you run the risk of getting hit with a double tax, additional taxes, additional tax filing, and the aggravation, time, and money it takes to correct the corporate structure. Doing it right the first time is critical!
4. Income Tax
Now that you own real property in the U.S., you may have a tax filing and liability in the U.S. attributable to this income. If the property that you own produces any revenues, e.g. rental income or capital gains on sale, you will be required to file a non-resident tax return by June 15th the year following the creation of the income. For example, if you sold your U.S. property in 2011, then the income tax return is due by June 15, 2012. However, you will want to file early so that your Canadian accountant can file the Canadian return and take the appropriate tax credit.
Each owner of the property needs to file a separate tax return to report their share of the gain (or loss) on the property. Just because you have a loss on the property does not mean you do not have to file. You still are required to file the tax return. However, as a general rule, any taxes that you pay to the US will be a credit in Canada when you file your Canadian T1.
5. Estate Tax or The Death Tax
The US estate tax is computed on the Fair Market Value (FMV) of the assets and not the capital appreciation. Therefore, it does not matter if the home is worth less than what you bought it for, you still could have a US estate tax liability. As a rule, non-residents of the U.S. are allowed to exempt US$60,000 of their US assets from estate tax, US$120,000 for married couples. Under the US/Canada Tax Treaty Canadians are allowed a pro-rata amount of U.S. resident exemption, which is currently US$5,000,000 (2011). In many cases, the pro-rata amount is sufficient to exempt the second home from estate tax.
Owning the property through an entity may sidestep the estate tax issue on the personal level. However, because the ratio is extremely dependant on each individual situation, it is critically important to review your circumstances with a qualified cross-border tax professional to ensure that you fully understand all ramifications.
The U.S. is generally more litigious in nature than other countries, including Canada. Because of this, you will want to ensure that you have adequate liability protection for both your personal use properties as well as your investment properties. Generally speaking, investment properties have more risk than personal use properties, because you have other people staying in the property. Owning the property in an entity may stop the liability exposure personally, but depending on the cash flow of the property, holding period and other factors, there maybe less-expensive ways to protect yourself and your assets from liability risks.
An inexpensive way of mitigating your exposure is to purchase an excess risk (umbrella) policy in addition to the liability coverage that is built into regular homeowners properties.
7. Cash Flow
If you are purchasing an investment property, you want more revenues than expenses, otherwise why do it? There are several drags on cash flow. One common expense that is forgotten about is the amount of accounting and tax preparation fees. Without carefully planning ahead of time, the amount of tax returns you could end up filing will wipe out any gains that you have experienced. You need enough cash flow to support the structure that you develop. For example, a simple Limited Liability Partnership return can cost $1,200 or more. If you only have one single family home in the partnership and you gross $1,000 per month, then you have just spent 1/12th of your gross rent just to support your corporate structure, and you still have to file a personal tax return for each of the partners. If you are buying multiple properties, there may be ways to structure the purchases in an overall more cost-effective manner.
8. Qualified Advice
Purchasing property in another country presents several challenges, least of which is what happens to your tax situation in your home country. As explained before, there are three sets of laws that should be considered. The person giving the advice should be able to address most if not all of the different taxing authorities. There are many examples of how clients relied on advisors who did not understand the different areas that cost them thousands or hundreds of thousands of dollars in professional fees, taxes, and tax filings.
A common recommendation of U.S. advisors is to set up a Limited Liability Company for Canadians. From a U.S. standpoint this is a perfectly good recommendation. However, because the U.S. advisor does not understand the Canadian tax issues, they are unaware of the double tax situation that they just created for their clients. Whereas a qualified cross-border advisor will be able to ask all the right questions and be able to discuss the implications on both sides of the border and prevent the adverse effects of this type of mistake.
9. Foreign Investment in Real Property Tax Act of 1980 (FIRPTA)
Foreign Investment in Real Property Tax Act of 1980 is a law that was designed to ensure that nonresident persons who have a tax liability on appreciated US real property pay their taxes. When a nonresident person sells U.S. real property, FIRPTA requires a 10% withholding tax based on the gross selling price. However, certain forms can be filed before the close of escrow that can reduce the withholding to 10% of the gain, rather than on the sales price. Further, withholding does not apply to all sales transactions.
Many times the title companies, the people who handle the withholding, will not understand the rules and will try to apply the rules unnecessarily. If this happens, the sellers cannot get their money back until they file the tax returns the following year. This is one of those areas that if you do not know the rules or if you do not have a qualified advisor helping you through this process, it can create frustration and cause an unnecessary loss of access to your money.
10. Don’t Let The Tax Tail Wag The Investment Dog
When purchasing US property, non-US persons often get so bogged down with the tax implications that they lose focus on the big picture. These things are simply business transactions whereby you invest some time upfront to determine how to structure things, after which you can go make money. Taxes are important, but they are the tail of the animal that we call investing. As long as you have hired a qualified cross-border advisor, they should be able to guide you through the maze of issues to give the best tax result. You can focus on what you do best and let your International Accountant help you with the planning and tax advice.