Across much of the United States, the residential real estate market is red hot. On the flip side, the COVID-19 pandemic has left tens of thousands of commercial properties empty and many multi-family properties underperforming. With the expectation that we are on the back end of the pandemic, with vaccinations on the rise and a return to “normal” on the horizon, many investors are seeing the down commercial real estate market as the perfect time to be a buyer. That includes Canadian investors looking to invest in American properties.
Although Canadian clients may have some familiarity with respect to certain aspects of U.S. commercial real estate investments, there remain a number of differences and special considerations we discuss with our Canadian clients. For Canadian investors, the trend of investing in U.S. real estate is especially pronounced in Western New York, where Ontario-based investors have sought comparatively lower priced U.S. investments to escape the high prices of the Toronto market. Some clients north of the border may not be fully prepared for the tax consequences and pitfalls associated with cross-border investing. In addition, recent changes made by the Canadian Revenue Agency may mean that even the most experienced Canadian investors need to re-evaluate the structure of their U.S. investments going forward.
Do your homework
Initially, and especially for clients new to investing in the US real estate market, we advise all of our clients to undertake as much initial due diligence as possible prior to entering into an agreement to invest in U.S. property. A Canadian client investing in U.S. property faces a complicated taxation landscape. The client will be subject to both U.S. tax law and Canadian tax law. Moreover, the general rules for both taxing jurisdictions may be modified by virtue of the Canada-United States Income Tax Convention, a/k/a the Treaty. Engaging in additional due diligence may prevent our client from entering into an arrangement that will lead to higher taxes or transaction fees that will lower their returns.
LLC vs. LLP
Real estate practitioners can be creatures of habit and tend to prefer the use of limited liability companies (“LLCs”) to hold investments in real property. For a U.S. based investor, LLCs, which have elected to be taxed as a partnership, provide a unique mix of liability protection and tax benefits that makes them ideal for the majority of real property investments. This is not, however, the case when dealing with Canadian clients. In fact, in most cases, LLCs should be avoided by Canadian investors, as a second layer of taxation will be triggered. This results from the Canadian Revenue Agency’s position that LLCs are not entitled to pass-through taxation, but rather are treated as corporations for the purposes of Canadian tax law. This subjects LLCs to the same corporate tax imposed upon any other corporation in Canada, thus eliminating one of the LLC’s most attractive features.
To complicate matters, in 2016 the Canadian Revenue Agency announced that limited liability partnerships (“LLPs”), a vehicle that had been popular with Canadian investors (and not to be confused with limited partnerships which are discussed below), would also be treated as corporations for taxation purposes. LLPs (usually domiciled in Delaware) had been used by many legal professionals to obtain similar benefits to that of an LLC, without the negative consequence of double taxation. The Canadian Revenue Agency’s announcement not only affects the choice of entity for prospective investments going forward, but will also require many existing investments to be restructured into a form recognized by the Canadian government as eligible for pass-through treatment.
The potential for two layers of taxation may lead some practitioners to suggest holding an investment personally, while attempting to limit liability risks through the purchase of additional insurance. Here too, differences between U.S. and Canadian law lead to a significant negative result for the Canadian investor. Under Canadian tax law, Canadian citizens are not entitled to the typical deductions that make investments in real property attractive to many U.S. investors. These deductions, like those available on the payment of mortgage interest and insurance premiums, cannot be claimed by an individual, and thus do not “lower” the investor’s return for tax purposes. Without these deductions, the returns a Canadian investor would enjoy are likely less than those of comparable investments.
For large investments in commercial properties, we recommend our Canadian clients consider using a limited partnership (not to be confused with the now disfavored limited liability partnerships discussed above) to hold their investments. From a taxation standpoint, a limited partnership will receive partnership treatment from the Canadian Revenue Agency, and thus will not be subject to the second layer of taxation that would result from the use of an LLC or LLP. In addition, limited partnerships are entitled to take the traditional deductions for real estate investments that a Canadian citizen cannot claim individually.
From a liability standpoint, the limited partnership should be structured in a fashion in which the individual is the limited partner. The general partner is most often a corporation or LLC formed solely for that purpose. It is important to remember that the individual investor should not consider stepping into the general partner role, as the same will defeat the liability protection that is afforded to the limited partner. Using a limited partnership is not, however, without drawbacks.
The chief drawback to using a limited partnership is that the structure is more expensive to set up and maintain. Specifically, the investor will need to create and maintain the general partner entity. In addition, the general partner must also share in some allocation of ownership in the limited partnership. This will likely result in double taxation of any income resulting from the general partner’s ownership. However, the ownership allocated to the general partner can be limited to a nominal 1% to minimize that tax consequence.
Finally, Canadian investors also need to be aware of special U.S. tax consequences that are triggered upon the sale of the investment property. At the time of sale, the gross proceeds may be subject to the provisions of the Foreign Investment in Real Property Tax Act (FIRPTA). While FIRPTA does not apply to sales of property less than $300,000 and where the purchaser intends to use the property as its principal residence, if FIRPTA does apply, up to 15% of the gross sales price will be required to be withheld at the closing to offset U.S. taxes that may be due. It is important to remember FIRPTA was amended in 2016 to increase the withholding rate on many transactions.
Even with the sometimes onerous interactions between U.S. tax law and Canadian tax law, many Canadian investors still believe the time is right to invest in U.S. properties. Our commercial real estate team and our cross-border attorneys work closely together to assist our clients with these type of complex purchases to make sure they are best positioned to minimize tax liabilities and maximize the return on their investment.
Trevor M. Torcello is a shareholder of Gross Shuman P.C. who focuses his practice in the areas of commercial real estate, business transactions, agribusiness and working with emerging businesses. He has extensive experience representing various parties in complex business transactions. He can be reached at 716.854.4300 ext. 227 or firstname.lastname@example.org.