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Recent trends of a strong Canadian dollar and relatively low U.S. real estate prices have resulted in more Canadian residents investing in U.S. properties.
If these investments are made in a pooled structure for tax and legal purposes, such as a U.S. partnership, the Canadian investor will receive (typically in April) U.S. Schedule K-1 reporting his / her share of partnership income / loss, as well as Form 8805, reporting any tax withheld and remitted to the IRS (and any related State tax filings) for the prior year. It is important to note that the income / loss reported on the Schedule K-1 is prepared in accordance with U.S. income tax rules.
A Canadian investor is also required to report the income / loss on his or her Canadian tax return. However, there are key timing differences between U.S. and Canadian income tax rules that impact the calculation of taxable income / loss for a Canadian investor in foreign property. The following are some common income adjustments that may be required when comparing reporting requirements between the two tax regimes:
• Cash basis accounting: Cash basis accounting may be permitted under U.S. tax rules; however, accrual accounting is required for Canadian tax purposes.
• Depreciation: Under U.S. tax rules, a partnership must deduct allowable depreciation, which can result in a loss being reported. In contrast, Canadian tax rules often limit depreciation to an amount that will reduce taxable income to nil.
• Repairs and maintenance: Canada generally allows these expenditures to be deducted annually, however, U.S. tax rules may require some of the expenses to be capitalized and depreciated over a specified period of time.
• Prepaid rents: Under U.S. tax rules, prepaid rents are included in income upon receipt whereas for Canadian tax purposes, they are reported in income when earned.
• Debt repayments: Solely for Canadian tax purposes, the investor may be required to report additional income or gains from foreign currency transactions on debt repayments that the partnership makes during the year.
• Syndication costs: For U.S. tax purposes, these costs are not deductible, however, under Canadian rules they are deductible over a five-year period.
• Financing costs: These are deductible over the term of the loan in the U.S., but deductible in Canada over a five-year period.
As a result of these timing differences, a Canadian investor that simply converts U.S. income / loss (i.e. from a U.S. Schedule K-1) to the Canadian equivalent will likely be reporting incorrect taxable income / loss in their Canadian tax return. Unless the U.S. partnership provides appropriate Canadian tax schedules, an investor, without access to detailed records of the partnership, will be hard-pressed to determine their Canadian taxable income or loss for the year.
Although beyond the scope of this article, investors should also note they are required to separately track their Canadian at-risk amount and adjusted cost base of the partnership for tax purposes which may impact their ability to deduct losses in a particular year.
An alternative tax and legal structure used by Canadians investing in U.S. property is a Limited Liability Company (LLC). The use of LLCs is widespread in the U.S. because they allow investors a level of legal protection that is normally available for a corporation, however for tax purposes, the LLC is considered to be a partnership. Unfortunately for Canadian purposes, an LLC is treated as a corporation, which means a Canadian investor will report a foreign source dividend equal to the cash distributions received (including any tax withheld) as foreign investment income. However for U.S. tax purposes, they are required to report any income / loss from the U.S. ‘partnership’ and taxable at the applicable marginal tax rate. This may result in double taxation for the Canadian investor due to the mismatch of foreign income and tax credits in Canada during the years of ownership and cause additional double taxation when the underlying real estate assets are sold by the partnership for a gain.
Depending on the percentage of ownership of the U.S. entity and cash invested, a Canadian investor may face additional tax reporting of the U.S. investment on Form T1135, Foreign Income Verification Statement, Form T1134, Report on Foreign Affiliates and possibly Form T106, Report of Transactions with Foreign Related Parties. Failure to file these forms on a timely basis carry hefty penalties and care must be taken to address the filing thresholds and applicable due dates.
Related Topics:U.S. Tax; International Tax
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