This is the third (and last) part in this series. We see a lot of Canadians here in the Palm Springs/ Palm Desert area/ Coachella Valley area who are interested in not just vacationing here, but in purchasing property which they will then rent out. This series has been about the best way to own California property which will be rented out, with the goal of minimizing any damage from a tenant who likes to sue landlords. While this series has been directed towards Canadians purchasing local property, everything we’ve written in this series (with the exception of the discussion about LLCs and why they don’t currently work for Canadians) applies to people from any country, and for that matter much of it applies to Americans wanting to purchase and rent out California property as well.
We’ve concluded that the limited partnership is likely the best structure (for now) for the Canadian looking to purchase and then rent out Palm Springs/ Palm Desert area/ Coachella Valley property. Let’s look at a few more questions and answers on this topic.
Why Don’t I Just Use a Corporation to Buy the Property, But Instead of My Corporation Selling the Property with the High Tax Rate, I’ll Sell My Corporation’ Stock (with the Property in it) at the Low Tax Rate?
This is an interesting way to get around the problem of the high corporate tax rate (35% rate), (and then the tax on the dividend back to the shareholder (if it’s a US corporation with Canadian shareholders, the dividend is subject to withholding to boot- maximum rate of 15%)). Why not just sell the stock of the corporation instead of the property in the corporation (we will steer clear of the US real property holding company issues for this discussion)? Corporate stock sold by an individual shareholder will likely be taxed at the good individual capital gains rate of 15%. So maybe I can have the great individual great tax rate (15% rate) and have my limited liability in a neat corporate structure too? The biggest problem I see with this concept is marketability. It may not be so easy to find a buyer of your corporation, when all the buyer really wants to buy is the real estate in the corporation (particularly, by the way, if it’s a Canadian corporation which holds the property….is an American really going to want to buy a Canadian corporation?). The buyer wants real estate, not a corporation with real estate in it.
Are There Negative Tax Elements to the Limited Partnership Structure?
The biggest negative is that a partnership with foreign (Canadian) partners must withhold tax annually on income, regardless whether that income is distributed to the partners (at the highest individual rate…today that’s 35% on the annual income of the partnership). I view this required withholding as more problematic on paper than in realty. What income is the partnership going to have every year? Well, if you’re renting out the property, clearly that will be rents. But as we’ve discussed (and will again), if the partnership is taking deductions on the expenses that go into the property, there should not be much rental income (if any) on an annual basis. And if the partnership sells property for a gain, yes, this withholding tax rule will kick in. But remember, the withholding tax isn’t the real tax, it’s just a security deposit for the IRS. Your accountant will do your taxes in the year after the sale, and the 35% tax will turn into a 15% (i.e, more than half the tax withheld should be returned).
How Many Limited Partnerships Should I Form to Own My California Properties?
So this is a question we get a lot. I’d like to buy several US properties to rent out, how many limited partnerships do I need? Each limited partnership you own is going to cost money. It will cost some to set each one up, and then each limited partnership will require an annual fee to the state (that fee in California is $800 a year, but some states are much less expensive). But you don’t want to skimp here. Remember that in a worst case scenario, if your tenant has a really bad accident and sues the owner of the rental property- limited partnership, you (as the 99% limited partner in the lim. partnership…and again, we think the general partner should probably be a 1% regular (c) corporation) can end up losing every asset in the limited partnership. So the more properties you stuff into one limited partnership, the more than you stand to lose in a worst case scenario. The most careful strategy would be to just put only one property into each limited partnership. Maybe if they’re relatively low value properties you could live with a couple stuffed into a single partnership, but you probably wouldn’t want to go much beyond that, if at all. The safest play: each rental property to go in its own limited partnership.