By Anthony Diosdi
Canadians actively invest in U.S. real estate by speculating on land and developing homes, condominiums, shopping centers, and commercial buildings. The article attempts to summarize the Canadian and U.S. tax consequences surrounding a Canadian’s acquisition of different U.S. real property interests.
The most common way Candians hold U.S. real property is by direct ownership. Direct ownership by an individual Canadian resident of U.S. real estate is generally not recommended because the individual will be exposed to the commercial risks associated with the property. Personal ownership may also give rise to the U.S. estate tax and gift tax.
Personal ownership of U.S. real property may also trigger cross-border tax filing requirements. If a Canadian owns real property that is income producing, he or she will likely be required to file tax returns in Canada and the United States reporting the U.S. rental income. The income tax consequences of the U.S. rental income would be determined under both Canadian and U.S. tax laws, and the investor would pay the higher of the U.S. or Canadian income tax. There are also differences in compliance rules to consider. For example, the U.S. rules relating to depreciation, interest deductions, and foreign exchange gains differ from the Canadian rules.
A Canadian investor in income producing property must understand U.S. source income received by foreign persons are subject to two basic taxing regimes. Most forms of U.S.-source income received by foreign persons that are not effectively connected with a U.S. trade or business will be subject to a flat tax of 30 percent on the gross amount of the income received. Section 871(a) (for nonresident aliens) and Section 881(a) (for foreign corporations) impose the 30-percent tax on “interest *** dividends, rents, salaries, and other fixed or determinable annual or periodical gains, profits, and income.” This enumeration is sometimes referred to as “FDAP income.” The collection of such taxes is affected primarily through the imposition of an obligation on a person or entity making the payment to the foreign person to withhold the tax and pay it over to the Internal Revenue Service (“IRS”). The tax collected is, therefore, often referred to as a “withholding tax.” However, items of such income that are effectively connected with a U.S. trade or business will be taxed effectively connected income and subject to graduated rates. The Canadian investor must determine whether the ownership and operation of the real property should be viewed as a U.S. trade or business or not. This decision will likely have a significant impact on the amount of U.S. taxes the investors pays.
For example, if a Canadian investor intends to lease U.S. real estate and if that activity does not give rise to a U.S. trade or business, the rental income derived from the property is subject to U.S. withholding tax at the rate of 30 percent (unless an election is made under Section 871(d) or 882(d) of the Internal Revenue Code). This withholding rate is not reduced under the United States- Canada Income Tax Treaty. The withholding tax is based on gross rental income and would include real estate taxes paid directly by a tenant.
A Canadian investor must also understand the Foreign Investment in Real Property Tax Act of 1980 (“FIRPTA”). Under FIRPTA, gains or losses realized by foreign corporations or nonresident alien individuals from any sale, exchange, or other disposition of a U.S. real property interest are taxed in the same manner as income effectively connected with the conduct of a U.S. trade or business. This means that gains from the disposition of U.S. real property interests are taxed at the regular graduated rates, whereas losses are deductible from effectively connected income
A U.S. real property interest includes interests in any of the following types of property within the United States or the U.S. Virgin Islands:
1) Land;
2) Buildings permanent structures other buildings;
3) Mines, wells, and other natural deposits;
4) Growing crops and timer; and
5) Personal property associated with the use of real property, such as mining equipment, farming equipment, or a hotel’s furniture and fixtures.
For the purpose, an “interest” in real property means any interest (other than an interest solely as a creditor), including fee ownership, co-ownership, a leasehold, an option to purchase or lease property, a time-sharing interest, a life estate, remainder, or reversionary interest, and any other direct or indirect right to share in the appreciation in value or proceeds from the sale or real property.
A U.S. property interest also includes any interest (other than an interest solely as a creditor) in a domestic corporation that was a U.S. real property holding corporation at any time during the five-year period ending on the date of the disposition of such interest or, if shorter, the period the investor held the interest. This provision prevents foreign persons from avoiding FIRPTA tax by incorporating their U.S. real estate investments and then realizing the resulting gains through stock sales, which ordinarily are exempt from U.S. taxation. A domestic corporation is a U.S. real property holding corporation if the fair market value of its U.S. real property equals 50% or more of the net fair market value of the sum of the corporation’s following interests:
1) U.S. real property interests (including any interests in another U.S. real property holding corporation);
2) Interests in foreign real property; and
3) Any other property of the corporation which is used or held for use in a trade or business.
To ensure collection of the FIRPTA tax, any transferred acquiring a U.S. real property interest must deduct and withhold a tax equal to 15 percent of the amount realized on the disposition. A transferee is any person, foreign or domestic, that acquires a U.S. real property interest by purchase, exchange, gift, or any other type of transfer. The amount realized is the sum of the cash paid or to be paid (excluding interest), the market value of other property transferred or to be transferred, the amount of liabilities assumed by the transferred, and the amount of liabilities to which the transferred property was subject. FIRPTA would likely apply to a disposition of U.S. real estate by a Canadian investor.
There is one significant advantage for both U.S. and Canadian tax purposes of direct ownership of U.S. real estate. Personal ownership allows a Canadian investor the ability to increase the mortgage on U.S. real property without triggering a gain or an income inclusion in both Canada and the United States. If the U.S. real estate increases in value, it is possible to place a new mortgage on the property, in an amount exceeding the original cost, without there being any deemed disposition of the property for either Canadian or U.S. tax purposes. Assuming the individual reinvests the funds in another income-producing investment, the related interest expense would be deductible in Canada, but not necessarily in the U.S.
Holding U.S. Real Property Through a Trust
Now since we discussed the consequences of personal ownership of U.S. property, we will discuss the various entities that may be used to hold U.S. real property. Anytime a foreign investor holds U.S. investment real estate through any type of entity, he or she must consider the Section 884(a) of the Internal Revenue Code. Section 884(a) imposes a branch profits tax on effectively connected income of a U.S. branch of a foreign corporation when those earnings are repatriated, or deemed repatriated, to the home office of the branch. Unless reduced or exempted by a tax treaty, a 30 percent branch profits tax is imposed on after-tax effectively connected earnings and income. The branch profits tax can be imposed on U.S. corporations or LLCs owned by a Canadian investor holding U.S. real property through a corporation (domestic or foreign) or a limited liability company (“LLC”). A rather unique planning opportunity to avoid the branch profits tax exists through operating in the U.S. through a complex trust.
Canadian irrevocable discretionary trust may be classified for U.S. tax purposes as a complex trust and it may own the U.S. real estate investment. If the trust is regarded as such for U.S. tax purposes, notwithstanding the fact that the real estate is involved in an active trade or business, the trust would not be subject to branch tax. However, avoiding the branch profits tax comes at a cost. For U.S. tax purposes, any effectively connected rental income will be subject to the highest marginal rate of 37 percent on income that exceeds $12,750. For Canadian income tax purposes, A Canadian trust would pay tax in Canada. Currently, the top personal marginal tax rate is 53.53 percent in Ontario and 48 percent in Alberta. However, the trust would be entitled to a foreign tax credit for any U.S. tax paid.
Ownership by a Canadian Company
A Canadian company may directly own U.S. real property. If it does, it would be required to file income tax returns in Canada and the United States, and a foreign tax credit would be available in Canada for U.S. business or non-business taxes. If a Canadian company carries on a U.S. trade or business or has effectively connected income, it must file U.S. corporate tax returns and pay U.S. corporate tax. Also, it must pay U.S. branch profits tax at the rate of 5 percent on net income exceeding 500,00 Canadian. If a Canadian company is not carrying on a U.S. trade or business, it is subject to U.S. withholding tax at 30 percent of its income that is sourced in the United States, unless it makes a net election under the Internal Revenue Code to be taxed on net rental income as if the company were carrying on a trade or business or had effectively connected income.
A major decision in structuring a U.S. real estate investment concerns the manner in which the investment is financed. In general, interest on funds borrowed to acquire U.S. income-producing property is deductible in Canada. Under 20(1)(c) of the Canadian Tax Code provides that interest is deductible if it relates to the purchase of an interest in U.S. rental property, the acquisition of common stock in a U.S. company, or an investment in a U.S. partnership.Canadian corporations must allocate interest payments for U.S. purposes not on a tracing basis, but rather on a fungible basis. As for the deductibility of interest payments for U.S. purposes, the Internal Revenue Code has intricate interest allocation rules and limitations on interest deductions. Internal Revenue Code Section 163(j) operates to prevent U.S. and foreign owned companies from eroding the U.S. federal income tax base through tax deductible interest payments. Historically, Section 163(j) applied when a debtor’s debt-to-equity exceeded 1.5 to 1 and its total “net interest expense” exceeded 50 percent of its “adjusted taxable income,” that would result in the disallowance of a portion of its “related party tax-exempt interest.” Disallowed interest could be carried forward.
The 2017 Tax Cuts and Jobs Act modified the Section 163(j) interest expense provisions in several key ways, most notably eliminating the 1.5 to 1 ratio requirement. The new interest limitation rules under Section 163(j) provides that the deduction allowed for business interest rules under Section 163(j) provides that the deduction allowed for business interest expense in any taxable year generally cannot exceed the sum of 1) the investor’s “business interest income” for the taxable year, plus 2) 30 percent of the investor’s adjusted taxable income for the taxable year. To illustrate, suppose an investor has $500 of adjusted taxable income and $100 of business interest income. Under Section 163(j), the investor could deduct up to $250 interest expenses [$100 business interest income, plus 30% of $500 adjusted taxable income].
The term “business interest income” is defined to mean the amount of interest includible in gross income that is allocable to a trade or business, which does not include investment income. The term “adjusted taxable income” means the taxpayer’s taxable income, but for tax years beginning before January 1, 2022, computed without regard to any deduction allowable for depreciation, amortization, or depletion (“EIBITA”). For tax years beginning after January 1, 2022, reduced by depreciation, amortization, or depletion. (“EBIT”).
Certain carryforward rules apply. Business interest expense that is not deductible because of this limitation may be carried forward indefinitely. Several special rules apply. First, any disallowed business interest expense is carried forward indefinitely, potentially subject to limitation if the corporation with such carryforwards experiences an ownership change. Second, special rules apply to partnerships whereby non deductible interest is not carried forward, but rather is treated as excess business interest expense that is allocable to each partner in the same manner as the partnership’s non-separately stated taxable income. The new interest expense limitation provisions provide a notable carve-out for certain investors. The interest expense limitation does not apply to investors with an average gross income of less than $25 million for the last three years. The differences on how Canada and the United States treat deductible interest income may result in the amount of interest that is deductible in the United States being different from the amount deductible in Canada.
A Canadian corporation will be subject to U.S. and Canadian on gains realized on the sale of the U.S. real estate. Article XII of the United States-Canada Income Tax Treaty confirms the United States’ right to tax gains derived from the sale of U.S. real estate. As noted above, FIRTA imposes withholding tax on the sale of the real estate. Any gain on the sale of the real estate is subject to tax in Canada with a foreign tax credit available for the U.S. tax. If a Canadian company acquires replacement property in the United States, the exchange may qualify as a tax-deferred transaction under the U.S. like-kind exchange rules. However, this transaction would not qualify for the Canadian replacement property rules because the former property was not located in Canada.
Using A U.S. Corporation to Hold Real Property
A Canadian company may form a wholly owned U.S. corporate subsidiary to acquire U.S. real estate. Such a structure may be subject to Canada’s Foreign Accrual Property Income or FAPI. The FAPI regime is intended to prevent Canadian residents from avoiding Canadian income tax on passive investment income earned through a controlled foreign affiliate. The FAPI rules only apply to passive income held in a corporation (which is a controlled foreign corporation). Thus, an initial determination would have to be made whether the U.S. company would be regarded as carrying on an active, or an investment, business for Canadian tax purposes.
If the U.S. company earns active business income, its Canadian parent would not be taxed in Canada on the dividends it receives from the U.S. company from active business earnings. Nevertheless, U.S. withholding tax at the rate of 5 percent would apply to dividends, and no foreign tax credit would be available in Canada. If the U.S. company is liquidated after the U.S. real estate is sold and U.S. taxes have been paid, no U.S. withholding tax would arise on the disposition. If the U.S. corporation is carrying on an active business, the corporation may participate in a like-kind exchange transaction in the U.S. without triggering Canadian tax.
Direct ownership of a U.S. corporation by a Canadian individual is not recommended because of the individual’s exposure to U.S. estate tax and because a dividend from a U.S. company would be taxable as ordinary income. By interposing a Canadian company, the Canadian individual who is a shareholder of the Canadian company might benefit from the favorable tax treatment afforded Canadian dividends.
A major advantage of having a U.S. corporation carrying on an active business hold U.S. real estate is that it will likely file only a U.S. income tax return, which is simpler, and the tax differences between Canada and the U.S. would not result in any mismatching. Furthermore, under Article VII of the United States-Canada Income Tax Treaty, management fees generally are not subject to U.S. tax, assuming the Canadian shareholder receiving the fees does not maintain a permanent establishment in the United States. The disadvantage of using a U.S. company to own the real property is that losses arising from the property will be locked into the U.S. company and thus forfeit the option of being deducted in Canada. This is because Canada does not allow losses in a U.S. company to be applied against Canadian based taxable profits.
Some Canadian investors may be tempted to form an LLC to hold U.S. investment property. LLCs are popular investment vehicles for U.S. tax purposes. However, they are not appropriate vehicles for Canadian investors to own U.S. real property. If a Canadian company forms a U.S. LLC to engage in an active business in the U.S., the Canadian company will be regarded as carrying on business in the U.S. through a branch, as the LLC is disregarded (unless it elects to be treated as a U.S. corporation). U.S. corporate tax and the 30 percent branch profits tax (without the treaty reduction in Article X of the U.S.-Canada Income Tax Treaty) will apply. The reason is that the LLC is fiscally transparent for U.S. tax but a foreign company for Canadian tax.
Use of U.S. Limited Partnership
A partnership will be a Canadian partnership for Canadian income tax purposes if all the members of the partnership are Canadian residents. The advantage of having a Canadian partnership is that such a structure can be used for tax-deferred rollover. Non-Canadian partnerships do not qualify for rollovers. On the other hand, a U.S. partnership with a Canadian company as the general partner and Canadian individuals or corporations as limited partners may qualify for a tax-deferred rollover. In this scenario, the Canadian partners would need to file Canadian and U.S. income tax returns. However, the returns would differ in terms of depreciation, whether interest may be deducted or capitalized, the tax treatment of soft costs, foreign exchange rules, and the utilization of losses. If the U.S. partnership is carrying on a trade or business, each general and limited partner is deemed to be carrying on a trade or business and is taxable in the United States on effectively connected income. The amount of deductible losses is restricted by the at-risk rules in Canada and the U.S. (the passive loss rules also reduce the loss-flow through for U.S. tax purposes).
Section 1446 imposes a U.S. withholding tax rate of 35 percent on partnership income allocable to a nonresident individual and 35 percent on a partnership’s effectively connected net taxable income allocable to a non-U.S. corporation. Withholding would be at lower long-term capital gain rates. If the partnership is not carrying on a trade or business, U.S. withholding tax applies at the rate of 30 percent on gross rental income, unless an election is made under the Internal Revenue Code to withhold tax on the effectively connected income.
The disadvantage of using a partnership to own the U.S. real property interest is that the partnership will be subject to Canadian income tax if it increases the property’s mortgage above the property’s original cost and distributes the excess mortgage proceeds to its partners. Another disadvantage is that Canadians who invest through a partnership will not benefit in Canada from the tax deferral available in the United States under the like-kind exchange in Section 1031 of the Internal Revenue Code.
U.S. and Canadian tax consequences will arise on the disposition of partnership interest. There would also be FIRPTA withholding tax and a foreign tax credit would be available in Canada.
A Canadian investor may want to consider utilizing tiered partnership to hold U.S. real property. The Canadian partnership can elect to be treated as a corporation for U.S. tax purposes, which should eliminate Canadian individual partners’ exposure to U.S. estate tax. This arrangement would also allow the Canadian partnership to file a U.S. tax return as a corporation, avoiding multiple filings by its Canadian partners. Also, the Canadian partnership may receive a credit against U.S. tax for any U.S. withholding tax paid by the U.S. partnership under Section 1446 of the Internal Revenue Code.
Investment in a U.S. Real Property through a REIT
Finally, a Canadian investor may consider utilizing a real estate investment trust (“REIT”) to hold U.S. rental investment property. In general, REITs have fully transferable interests and are widely held, having a minimum of 100 investors. REITs make current distributions out of income derived from U.S. real estate investments. The distributions are taxed in the United States as corporate distributions but there is no U.S. corporate-level tax. Under Article VII(c) of the United States-Canada Income Tax Treaty, however, the REIT must withhold U.S. tax at 5 percent on dividends paid by U.S. REIT: 1) to a Canadian resident individual owning 10 percent or less of the REIT; 2) if the dividends are paid regarding a class that is publicly traded and the beneficial owner is a person owning not more than 5 percent of any class of stocks; or 3) if the REIT is diversified, the owner owns 10 percent or less of the interest in the REIT. In all other cases, the U.S. withholding tax rate is 30 percent.
Distributions in excess of the REIT’s earnings and profits are treated as nontaxable returns of capital or, if the distributions exceed basis, as taxable gains; in either case, the distribution is subject to a 10 percent withholding tax, unless the FIRPTA exceptions for domestically controlled REITs or publicly traded companies apply. If a REIT distributes gains relating to the disposition of U.S. real property interest, shareholders are subject to FIRPTA tax, and the distributions are subject to a 35 percent withholding tax, unless the REIT’s stock is publicly traded and the Canadian shareholders do not own more than 5 percent of its stock. In the case of a domestically controlled REIT, any gain on the disposition of a REIT interest is not subject to U.S. tax. This may also be the case for any gains from a disposition of publicly traded stock if the seller has not owned more than 5 percent of the REIT’s stock.
Conclusion
The differences in the Canadian and U.S. tax systems naturally leads to unfortunate structuring by practitioners and clients not well versed in the cross-border issues. Canadians considering investing in U.S. real property must retain competent tax counsel on both sides of the border.
Anthony Diosdi is one of several tax attorneys and international tax attorneys at Diosdi Ching & Liu, LLP. As a domestic tax attorney and international tax attorney, Anthony Diosdi provides international tax advice to individuals, closely held entities, and publicly traded corporations. Diosdi Ching & Liu, LLP has offices in San Francisco, California, Pleasanton, California and Fort Lauderdale, Florida. Anthony Diosdi advises clients in international tax matters throughout the United States. Anthony Diosdi may be reached at (415) 318-3990 or by email: adiosdi@sftaxcounsel.com.
This article is not legal or tax advice. If you are in need of legal or tax advice, you should immediately consult a licensed attorney.