In my last post, I summarized that for Canadians looking to purchase California real estate which they could then rent out, but who were worried about potential lawsuits from their tenants (as they should be), utilizing the limited partnership form was probably the best method of ownership currently available. Let’s take a closer look at to why…
Why Can’t I Just Purchase My New California Rental Property as an Individual, as Joint Tenants or Tenants in Common?
Because owning property in an individual capacity provides you no liability protection. If your tenant gets hurt on your property, he or she can sue you personally for all you have in a California court. And keep in mind, it is quite possible that a Canadian court would enforce the judgment of a California court.
I’ve Heard So Much About LLC’s, why Can’t I use a California Limited Liability Company to Purchase My Rental Property?
It’s a shame, because the LLC really would be a terrific structure for Canadians who wanted to purchase California real property which they would then rent out. The LLC offers the great combination of liability protection (which is critical in case of a law suit by your tenant), plus the LLC members may elect to be taxed a partners (and not corporate shareholders). This tax treatment is critical. Corporations pay corporate taxes (at a rate of 35%) on income earned by the corporation, and then when the shareholders receive a distribution (a dividend), the shareholder must pay a dividend tax (i.e., shareholders of a corporation can effectively pay a second tax on the same income). Not good. Partners, however, are taxed just like individuals. The partnership is disregarded, and there is only one tax on the partner. And by the way, on rental income that should be a very low amount of tax, if any, because the partnership can take significant deductions on the rental property.
But the problem is we understand that LLC’s are not currently treated as partnerships for tax purposes in Canada. It’s our understanding from our Canadian colleagues that this may change in the future. For now, the Canadian owners of an LLC electing to be taxed as a partnership (of course you would make this election) will not receive a credit on the US income as a partner (from renting or selling the property) in Canada. Canada would give the Canadian LLC member a dividend credit (presumably) as if the LLC were a corporation, but the Canadian LLC member with rental property in the US doesn’t have a dividend. They were taxed as partners (individuals) in the US. So this means the LLC owner could end up paying tax TWICE on the same income: once in the US (as a partner of a deemed partnership) and once in Canada (as shareholder of a deemed corporation). This is a result that any Canadian investing in US real estate cannot let happen: double tax. Until further notice from the CRA, US LLC’s are off the table for Canadians.
I Already Have a Canadian Corporation, Why Don’t I Just Buy My California Rental Property With That?
First of all, you would get the limited liability you seek with your Canadian corporation only if you register it to do business in California. That will cost a minimum of $800 to the state of California each year (the same as if you were forming a California corporation). If you fail to do that, and your tenant has an accident and sues the owner of the property (the Canadian corporation), the California courts will treat the corporation’s shareholder as individual owners (i.e., the California courts will not respect the liability protection of a foreign corporation which does not register to do business in California). That’s the price of liability protection in California- a minimum of $800 a year.
But standard (C) corporations (whether US or Canadian) owning US rental properties are probably a bad idea anyway. If your corporation buys a rental property in the US today for $150,000, and then the corporation sells it five years later for $350,000 (we’ll think optimistically), the corporation owes a tax to the US of $200,000 (the appreciation) x 35%(today’s corporate tax rate)= $70,000. That’s too much. If you owned the property as a partnership, under same scenario the partners would owe a tax to the US of $200,000 x 15% (today’s individual capital gains rate)=$30,000. That’s less than half-quite a difference.
Finally, note both for purposes of the CRA and the IRS, generally if the corporation’s shareholders don’t pay rent to the corporation to use the property personally in the US (if they ever do), that’s taxable income in both Canada and the US on the “imputed” value of the fair market rent. You don’t own the property, your corporation does. Got to pay rent if you go use the property.
For now, I think limited partnerships are the preferred entity for those renting out the California property. More detail on those soon, in Part 3 of this series.