Canadians are purchasing U.S. property while prices remain affordable. Chances are they need advice on the best ownership structure, which should address issues such as probate, incapacity and U.S. estate tax. Those who own rental properties have two additional concerns: creditor protection and maximizing profits through tax planning. Partnerships are a good way to protect owners of U.S. rental properties. Since partnerships must have a profit motive, they’re not the right choice for personal-use property.
The most common partnership structures for owning U.S. real estate are:
- Limited Partnerships (LPs);
- Limited Liability Partnerships (LLPs); and
- Limited Liability Limited Partnership (LLLPs).
LPs have two types of partners:
- General Partners: Unlimited liability for partnership debts
- Limited Partners: Liable only for partnership debts up to the amount of their capital investment in the partnership
If an LP’s used to hold U.S. real estate, it’s best to create a corporation as the general partner. Clients can act as limited partners. The general partner typically invests a small amount in the partnership, while the limited partners invest the remaining amount. Here are some of the benefits of holding U.S. rental property in an LP.
1 U.S. probate
Partnership interests are intangible assets, so they pass to a limited partner’s heirs upon death without probate.
2 Incapacity and guardianship
Guardianship proceedings are held when someone becomes incapacitated. The court determines if a person is incapacitated and appoints a guardian to take over decision-making. Legal representation is necessary and can be costly. Properly drafted, LPs can avoid guardianship proceedings if a limited partner becomes incapacitated; the limited partner acts by way of the general partner, which is a corporation, and corporations can’t become incapacitated.
3 U.S. estate tax
Canadians with U.S. assets worth more than $60,000 and a worldwide estate greater than $5.34 million are exposed to U.S. estate tax. The tax is based on the fair market value of all U.S. assets owned at the time of death, and can reach 40%, depending on the value of the U.S. asset and the worldwide estate. (The $5.34-million exemption is current for 2014 and will rise with inflation in coming years.)
LPs may avoid U.S. estate tax upon the death of a limited partner. It’s not yet clear whether the IRS has the authority to tax Canadian residents on partnership interests as if they’re U.S.-situated assets for U.S. estate tax purposes. Thanks to its look-through rule, the IRS may levy estate tax on a limited partner upon death.
4 Creditor protection
As limited partners, clients receive creditor protection. If a third party or tenant successfully sues the LP, then only the general partner will be liable for the partnership’s debts.
5 Tax treatment of rental income
LPs are classified as flow-through entities in both the U.S. and Canada. Net rental income flows through the LP and into the hands of the limited partners, who pay tax at their graduated personal rates in both Canada and the U.S. Limited partners receive full tax credits in Canada for income tax paid in the U.S., avoiding double taxation.
U.S. tax rules require partnerships to withhold tax on income to foreign partners at the highest marginal rate. Since that rate’s applied regardless of the partners’ actual tax bracket, it’s likely too much tax will be withheld. So, partners can request a refund when they file annual tax returns.
6 Capital gains tax treatment
When the property’s sold in the U.S., clients get a lower capital gains tax rate as limited partners compared to owning the property in a corporation, for example.
In LLPs, each partner has limited personal liability for the partnership’s debts. This feature of LLPs eliminates the need to incorporate a company that acts as the general partner. LLPs are, therefore, less expensive to implement and maintain than LPs.
LLPs also provide creditor protection if the partners are non-residents of the U.S. (i.e., two spouses who are Canadian citizens and residents).
But when one partner spouse passes away, the structure ends. Moreover, upon the first partner spouse’s death, state regulators may implement probate proceedings to pass the partnership interest to the deceased spouse’s heirs. Finally, LLPs don’t protect clients from U.S. estate tax.
For these reasons, the LLP isn’t ideal for holding U.S. rental property.
The LLLP is a fairly new structure and is only recognized in certain states. There is no Canadian equivalent.
An LLLP is similar to an LP: it has general and limited partners. But, if the LLLP chooses, its general partners’ liability for partnership debts will be limited instead of unlimited.
For Americans, the LLLP is great for holding rental properties. The structure provides creditor protection by limiting the liability of its general partners while also acting as a flow-through entity, allowing partners to be taxed at their low personal income tax rates.
However, CRA hasn’t yet classified LLLPs under Canadian rules. So, it’s still unclear what the tax consequences are for Canadian clients who hold U.S. rental properties in LLLPs.
The key question is whether CRA would view LLLPs as corporations or partnerships.
CRA may classify LLLPs as foreign corporations because of the general partners’ limited liability. In that case, rental income partners get from the LLLP would be characterized as dividends in Canada. Income tax paid to the IRS would not, therefore, get the same tax treatment from CRA: in the U.S., income would be taxed in the hands of the partners at their low personal rate, but the income would be taxed in Canada as dividends, at a high marginal rate. The result? Partners would only receive partial foreign tax credits in Canada for tax paid in the U.S.
If partners choose to defer tax in Canada by leaving rental income in the LLLP, the partners will lose any foreign tax credits the CRA would have provided in previous years for U.S. income tax already paid when that income’s eventually distributed. Additionally, the high marginal rate would still apply.
The potential for double taxation of rental income earned from U.S. property held in an LLLP is clearly problematic for Canadian residents. Given the uncertainty surrounding the classification of LLLPs in Canada, it’s best for Canadian residents to refrain from investing in U.S. rental property using LLLPs.
An LP is a sound solution for Canadian clients who own U.S. rental properties. Structured properly, an LP can avoid U.S. probate and incapacity proceedings, as well as U.S. estate tax.
When the general partner is a corporation, the LP also protects creditors. Because the LP is classified as a flow-through entity on both sides of the border, clients, as limited partners, enjoy low capital gains and income tax rates, and they receive full foreign tax credits in Canada on all U.S. income tax paid.
Clients with a large number of U.S. real estate holdings may even wish to create a two-tiered limited partnership, or Cross Border Limited Partnership, which combines Canadian and U.S. limited partnerships and Canadian and U.S. corporate general partners to attain low tax rates, limited liability and minimal U.S. estate tax.
by David A. Altro, a Florida attorney, Canadian legal advisor and the managing partner at Altro Levy. He can be reached at 416-477-8155 or firstname.lastname@example.org.