Business and Real Estate - Tax Considerations Los impuestos de los negocios y inmuebles Les impôts sur les entreprises et l'immobilier

Business Entity Planning

This is a vast topic, but for now, I will only touch upon the topics of incorporating as a worker/independent contractor, as many IT workers in Canada do when they take on contract jobs, as well as setting up a business entity for rental real estate.

Business Entities - For Workers/Independent Contractors

Forming a Canadian corporation

Many advise IT and other contractors and other small business owners in Canada to incorporate for tax savings, because small business tax rates are often lower than individual rates due to a small business tax deduction. There are opportunities to keep the earnings in the corporation to defer payment of tax, or to pay shareholders a salary or dividends or a combination of both. There are also opportunities for income splitting with family members to spread out the income to take advantage of lower tax brackets among family members.

US persons (i.e., US citizens and permanent residents), however, would often be excluded from most if not all of these benefits due to US CFC and GILTI rules. A Controlled Foreign Corporation (CFC) is a foreign corporation that is more than 50% owned by US persons and has been subjected to special unfavorable tax rules for a long time. Trump's tax reform legislation (the Tax Cuts and Jobs Act of 2017) created a new Global Intangible Low-taxed Income (GILTI) provision that applies to all US persons who own 10% or more of a CFC.

Here are two possible scenarios for US persons performing professional services who form a Canadian corporation that is more than 50% owned by US persons:

1. By default, US persons owning a CFC would need to pay the GILTI tax on all earnings of the corporation at their marginal tax rate, whether the earnings are distributed to the owner or not. When the earnings are distributed as dividends, the dividends are not taxed. So in this situation, you don't the benefit of deferring tax due to the need to pay US income tax on current earnings. Furthermore, any foreign taxes paid by your foreign corporation paid to Canada cannot be taken as a foreign tax credit on your individual US tax return, so you would be subject to double taxation.


2. If you choose to make a Section 962 election to be taxed as a corporation, you would pay the GILTI tax at the 21% corporate rate, which could be lower than your individual marginal rate, and a foreign tax credit of up to 80% of the foreign corporate tax paid to Canada can also be taken on the US tax return, which could reduce or eliminate double taxation. However, when you take dividend distributions from the corporation, the dividends would be taxable on your US personal income tax return, so you would be subject to double taxation under GILTI and as a dividend. Canada will also tax you on your personal return on dividends received, which you can use as a foreign tax credit on your US tax return. So to avoid double taxation, you would need to distribute all income earned each year and therefore wouldn't benefit from income deferral.

Thus forming a Canadian corporation could net a lower tax rate, between the 21% US corporate tax rate and 80% foreign tax credit, and the lower Canadian small business tax rates, but you would need to distribute all income every year.

To avoid being classified as a CFC and therefore avoid the GILTI tax, one should have at least one co-owner of the corporation who is not a US person. Of course, there are other non-tax considerations that might make this impossible. Note, however, that

Note: if you already have a corporation set up in Canada, you will likely be subject to the deemed transition tax, which was also created by Trump's tax reform legislation. This involves a one-time repatriation of the overseas profits of certain foreign companies known as controlled foreign corporations (“CFC”) at the rate of 15.5 percent on cash and cash-equivalent assets, and 8 percent on non-cash assets. The Deemed Transition tax becomes applicable for the last taxable year which begins before January 1, 2018. This means that for taxpayers with a December 31 year end, the transition tax is applicable for the 2017 tax year. For fiscal year filers, the tax becomes applicable for the 2018 tax year.

The LLC is not available as an entity type in Canada. A US LLC, which is preferred by many, especially in real estate (to be discussed later), for its flow-through tax treatment while providing the liability protection of a corporation, is treated as a foreign corporation in Canada and therefore subject to double taxation in Canada.

For business entities in many countries, there is an option to file IRS Form 8832 to have the US treat it as a foreign disregarded entity, but unfortunately Canadian corporations are "per se" corporations that do not qualify for this election; they can only be treated as corporations by the US.

Sole Proprietor

A sole proprietor is not subject to double taxation by either country and is not subject to GILTI, but all income is reported and taxed in the year received, so no US tax deferral is available. Self employment income above $400 for the year is also subject to self employment tax in the US and can't be avoided in countries that do not have totalization agreements with the US, but in Canada, through the totalization agreement between the US and Canada, the sole proprietor can claim an exemption from US social security taxes by attaching a statement and a Certificate of Coverage to the US tax return each year. The sole proprietor does need to pay Canadian CPP premiums. Or you could work for a Canadian corporation - either form your own with a non-US person business partner who owns at least 50% of the corporation so that your corporation does not become a CFC, or work for one of the staffing companies that are paid by the client and pay you a portion in wages with all applicable taxes withheld; in either case, the corporation would pay for half of the CPP premiums and deduct the other half from the employee's wages, similar to how US employers pay for half of the FICA taxes and deduct the other half from the employee's wages.

Information for Canadian Small Businesses

Real Estate Planning

This section is geared especially toward real estate investors who have rental real estate, as well as those who own a primary home.

Entity/Ownership Structure

Unfortunately the LLC, one of the most recommended forms of ownership of investment real estate in the US due to it ability to limit liability like a corporation while being taxed as a sole proprietorship (i.e., all income flows to the owner on Schedule E), is unavailable in Canada.

3-tier Corporate Structure

A number of experts in Canada recommend a 3-tier corporate structure, mainly for minimizing liability. The idea is to own each property through its own corporation, have a management corporation that manages the properties, and have a holding corporation have 100% ownership of all these corporations. One or more individual investors would own the holding company. The corporations owning the properties would hire the management company, which would collect rents and pays for repairs, maintenance, etc., take out a property management commission, give the rest to the corporations holding the real estate, and pay dividends to the holding corporation as needed. The management corporation could qualify for the 15.5% rate for active businesses, although it would need to register for HST if it makes at least $30k in a quarter.

Advantages: liability protection, tax options only for non-US persons or non-CFCs

I think this structure is very good, from a liability protection standpoint, for a non-US person who owns a number of properties, and it also allows for different tax strategies regarding deferral of income and timing of dividends.

Disadvantages: administrative overhead, double taxation day to day and on sale

• This 3-tier structure is a lot of work to set up and a fair amount of work to maintain day to day, and I think it is overkill for people who have only one or two properties.

• As with any corporation setup, there is double taxation at the corporate level when the income is earned and to the owners when dividend distributions are made. The double taxation could be especially severe when the properties are sold; the corporation would pay tax on the capital gains, and then the owners would pay tax on the proceeds that the corporation distributes as dividends. 
• The tax paid by the corporation to Canada would also not be usable as a foreign tax credit on the individual's US tax return, during operations as a rental property and when the property is sold.
• I have also read about structuring the sales as a sale of the stock of the real estate company to avoid the double taxation and inability to use the foreign tax credit, but it might be difficult to find a buyer who would be willing to buy corporate stock of a corporation owning the property rather than buying the property itself.

CFC and Subpart F issues for US persons

As with all corporation structures in Canada, US persons would likely run into issues with CFCs and Subpart F. Subpart F income is passive income earned by CFCs and is taxable the same year to US shareholders (more precisely, limited to current E&P (IRC Sec. 952(c)(1)(A))) , even if the CFC does not distribute earnings to the US shareholders; in other words, no US tax deferral is available. Generally rental income is considered to be Subpart F income, unless it qualifies for active rents and royalties exception, which requires that the income is received from a party unrelated to the CFC and earned from an active trade or business, which requires meeting either the "active development test" (Treasury Regs. Sec. 1.954-2(d)(1)(i)) or "active marketing test" (Regs. Sec. 1.954-2(d)(1)(ii)) - basically that the CFC's officers and employees are actively managing the property, including repairs and improvements, or marketing the property.

So, what ownership structure can a US person without non-US person partners use?

One option I considered was to form a US LLC of which I would be sole owner, in a tax-friendly state like Delaware, register it as a foreign LLC in Ontario (although since Canada does not have ), and own and operate my rental real estate in Ottawa through this LLC. I have not heard of anyone doing this, but since the LLC is the entity of choice for many rental real estate investors in the US, and I previously owned real estate in the US through an LLC of which I was sole owner, this idea came to mind. However, I would want some definitive answers to some questions I have, such as: would a US LLC provide as much liability protection that a Canadian corporation would in Canada? Would it encounter issues operating in Canada? When purchasing real estate, as a US LLC, would it be considered a foreign buyer and subject to the foreign buyer tax in certain jurisdictions and unable to obtain financing?

Canada does not recognize the LLC entity and treats LLCs as corporations. So a US LLC would be treated by Canada as a foreign corporation. For Canada tax, the LLC would distribute earnings as dividends each year to generate the individual Canadian tax for use as a foreign tax credit on the US tax return. There would also be the double taxation on the Canada side inherent in any corporation setup.

In the US, there would be no double taxation because the LLC is treated as a disregarded entity. The rental income would also need to be calculated using US tax accounting rules for the US tax return (see the "Special Tax Considerations for US Expats" section below).

When it comes time to sell the property, the best one could do tax-wise in Canada would be to structure the sale as a sale of stock by the individual to the buyer, as discussed above, although it might be too difficult to find a buyer who would be willing to buy the stock of a US LLC  rather than the property itself. In the US, gain on the sale would flow to the owner because the LLC is treated as a disregarded entity.

For now, I personally decided just to own my Canadian real estate as a sole proprietor. I only have one duplex, of which one is entirely a rental and the other is my primary home in which I rent out 2 rooms (more details on renting rooms out of your primary home below). Considering my personal situation, the tax consequences of holding real estate in a US LLC or a Canadian corporation are too unfavorable and other potential consequences too complicated and uncertain for the potential benefits to be worth it for me at this time.

Special Tax Considerations for US Expats

This section will discuss some of the differences between tax accounting methods of the US and Canada that are particularly relevant to real estate. You will need to calculate taxable income using the US tax rules for not only real estate that you hold in your name, such as rental property you operate as a sole proprietor or a primary home (for which only the primary residence exemption is applicable if there is no rental activity), but also that held in a CFC that is subject to Subpart F; the US rules regarding calculating foreign earnings and profits (E&P) require adjusting foreign income to conform to US tax accounting standards. However, foreign corporations that are not CFCs or subject to Subpart F do not need to worry about recomputing taxable income based on US tax accounting standards.

Depreciation differences

Depreciation (called Capital Cost Allowance or CCA in Canada) is optional in Canada, unlike in the US, where you must reduce your basis in all assets by the depreciation allowed or allowable, so you might as well take the depreciation. The CCA rates differ from US depreciation rate. If you choose to take CCA in Canada, you can take as little or as much as you want, up to the maximum allowable for the year.

Depreciation Methods

On the US tax return, all property located outside the US must be depreciated under ADS using straight line.

Here are some common depreciable assets used in rental real estate and their depreciation methods in Canada and the US:

Asset Type	Canada CCA class	US depreciation method
Computers and their peripheral equipment	Class 50 (55%) or Class 46 (30%)	ADS - SL - 5 years
Automobiles	Class 10 (30%) or Class 10.1 (30%)	ADS - SL - 5 years
Light trucks	Class 10 (30%)	ADS - SL - 5 years
Appliances, Furniture used in rental property, Carpeting	Class 8 (20%)	ADS - SL - 9 years
Office furniture and equipment, such as: desks files	Class 8 (20%)	ADS - SL - 10 years
Any property that doesn’t have a class life and that hasn’t been designated by law as being in any other class	Class 8 (20%)	ADS - SL - 12 years
Roads	Class 17 (8%)	ADS - SL - 20 years
Fences	Class 6 (10%)	ADS - SL - 20 years
Building and components - residential rental real estate	Class 1 (4%)	ADS - SL - 30 years (40 years for property placed into service before 2018)

Depreciation Convention

While the US uses 3 different conventions - half-year, mid-month, and mid-quarter conventions -Canada effectively follows only the half year convention with the Half-year rule, which allows you to claim only half of the CCA available for an asset in the year of its purchase.

Should you take depreciation on the Canada side, and how much?

On the US side, depreciation is effectively mandatory, because whether you take the allowable depreciation or not, you will need to reduce your basis by the allowable depreciation and pay tax on it when you sell the property, so you might as well take the depreciation and get the tax benefit now.

Depreciation (CCA) is optional on the Canada side, and not taking CCA would allow you to pay less tax when you sell the property, since you would not need to reduce your basis. But if you don't take depreciation on the Canada side, 1) you would not get the current benefit of taking depreciation on the US side, because you would be taxed on the pre-depreciation amount in Canada, and 2) when you sell the property, you won't pay less tax, because you will need to pay tax on depreciation recapture on the US side.

So, it would seem to be a good idea to take depreciation on the Canada side as well, approximately up to the amount required by the US if it does not exceed the maximum allowed CCA percentage. Keep in mind the depreciation convention. If you put rental real estate into service in January, you get almost a full year of depreciation in the first year via the mid-month convention on the US side, but on the Canada side, you still get only half a year's depreciation in the first year, so it is still necessary to keep two different depreciation schedules, one for Canada and one for the US.

1031 exchanges

Canada does not have an equivalent to the US §1031 exchange, which allows you to defer recognizing gain on the sale of real estate if you satisfy all the requirements listed in Section 1031 of the Internal Revenue Code. Foreign property is not like-kind with US property, so you can't do a 1031 exchange of US property for foreign property or vice versa. However, foreign property for other foreign property is like kind, even if they are in different countries. So for example, you can sell your Canadian rental real property and replace it with another one in Canada or Mexico or France, or any country other than the US.

See this article for some basic information on offshore 1031 exchange, including whether to do one and how to find a qualified intermediary outside the US. However, one important factor to consider, when deciding whether to do a 1031 exchange for your foreign property, that is not mentioned in the article, is the effect of exchange rate fluctuations between the purchase and sale of the property. A property in Canada with modest capital gains could still have a large capital gain for US tax purposes after taking into account the change in exchange rate, in which case doing a 1031 exchange could make sense.

So if you would like to minimize the amount you pay when you sell the property, you could consider doing a 1031 exchange to defer US taxes, and not take CCA on the Canada side in order not to have to pay for depreciation recapture on the Canada side. However, note that you generally cannot avoid paying tax on 50% of capital gains on the Canada side if you sell the property at a gain, unless you qualify for one of two exceptions:

1. Change in use of property - options to defer and partially exclude gain under Section 45 of the Income Tax Act

   When there is a change in use of the property from personal use to income producing use or vice versa, the owner of the property is deemed to have sold the property and have immediately repurchased it at fair market value, thereby recognizing applicable capital gains.
   • When changing from principal residence to income-producing use, there is the option to make a subsection 45(2) election to defer capital gains tax for up to 4 years and lengthen the time by 4 years that the property is considered to have been used as a principal residence in the calculation of any eventual gain. The owner must not claim CCA on the property and must remain a resident of Canada during those 4 years.
   • When changing from income-producing to principal residence, there is the option to make a subsection 45(3) election to defer capital gains.

2. Business property (NOT rental real estate) that was stolen, destroyed, or expropriated (section 44 of the Income Tax Act)

   • The property must have been stolen, destroyed, or expropriated ("involuntary disposition")
   • Rental real estate is specifically excluded from the definition of "business property", which is specifically defined as a "former business property" under subsection 248(1) of the Income Tax Act.
   • See this article for a good explanation and comparison to US 1031 exchanges.

Read this article for more details and an example.

This article makes some interesting arguments that I agree with for why Canada ought to have the equivalent to the US 1031 exchange.

Taxation of Capital Gains

Canada taxes capital gains at 50% of your marginal rate, with no difference in the treatment of long and short term gains are taxed the same way, unlike the US, which taxes short term capital gains at your marginal tax rate and long capital gains at 15% for most taxpayers but with a range of 0 to 28%; part of the capital gain could also be subject to the 3.8% Net Investment Income Tax.

Primary residence exemption

Canada's principal residence exemption exempts all gain from the sale of your primary residence from tax, while the US's Section 121 exclusion exempts only $250,000 ($500,000 if married filing jointly) of gain from tax.

Rental Income Timing Differences

Rents received are reported on the cash method for US tax, while rental income and expenses are reported on the accrual method for Canada tax, with cash method allowed only if your net rental income or loss would be almost the same if you were using the accrual method. In particular, it is common practice for Canadian landlords to ask for first and last month's rent at the beginning of a tenancy, at least in Ontario. For US tax, the last month's rent would be recognized in the year it was received, but for Canada tax, last month's rent would not be recognized until it is earned, that is, in the last month of tenancy, which could be in a year or more.

Renting Out Part of your Personal Residence

There are some important differences between Canadian and US tax rules to keep in mind if you rent out some rooms in your residence. In both countries, you take deductions for expenses specific to the room(s) being rented out (for example, making repairs to the room) and pro-rate between rental and personal deductions for expenses relating to the entire house (for example, real estate taxes, insurance, mortgage interest).

Primary residence exemption

In addition to differences in the allowable amount of primary residence exemption discussed above, there are differences in how the primary residence exemption works when you rent out part of your home.

• In the US, you must depreciate the portion of the residence being rented out, because when you sell the property, you will be taxed on the depreciation allowable on the rental portion of the house, up to the amount of gain from the sale; this depreciation recapture cannot be excluded via the section 121 exclusion, which will apply only to the personal portion of the property.


• The rules are a bit more complicated in Canada.
• You can designate part of your property as a rental and get the same tax treatment as the default US tax treatment described above.
• Or, if your rental or business use of the property is relatively small in relation to its use as your principal residence, and you do not depreciate the rental part of the property or make any structural changes to the property to make it more suitable for rental or business purposes, you can take the principal residence exemption for the entire property when you sell it.

How to rent out part of your primary residence and have the entire property qualify for the exemption in Canada

You must satisfy all of these 3 conditions:

1. Your rental or business use of the property is relatively small in relation to its use as your principal residence. What exactly does "relatively small" mean? There is no standard definition, but try to rent out less than 50% of the home, and use that rental percentage to divide up common expenses (real estate taxes, insurance, mortgage interest, utilities that can't be directly traced to the rooms being rented out).


2. You do not make any structural changes to the property to make it more suitable for rental or business purposes. If you make any structural changes, such as adding another bathroom or a separate entrance, you will need to prove that your intent is was not to enable you to rent out one or more rooms but for your own personal convenience. I did add a bathroom to my basement, which is a risk, but I really wanted to have my own bathroom for my personal convenience. Even if I were not renting out any rooms, I would have wanted to have a second bathroom as a backup in case of a plumbing emergency in the other bathroom, and also a bathroom for guests to use. The house, which has a main floor, a second floor, and a basement, came with only one bathroom on the second floor. It is also nice to have a bathroom nearby if I am working in the basement, rather than having to climb up two floors to use the upstairs bathroom.


3. You do not deduct any CCA on the part you are using for rental or business purposes. Since you must take depreciation for US tax purposes, unfortunately this will be a timing difference resulting in some double taxation. While holding the property and renting part of it out, you would pay Canadian tax on a higher rental income (without depreciation). This additional tax over the US tax paid on rental income would not be usable as a foreign tax credit on the US return when you sell the property and need to recapture depreciation if not also pay tax on additional capital gains on the US side, because on the Canada side, you would not be paying tax on any of the gain. To avoid paying US tax when selling the property, you could consider including the property in a 1031 exchange, if you will buy another property outside the US soon enough after the sale.
   
   Depending on the exchange rates when you buy and sell the property, you could also end up with an additional gain (or little or no gain) to pay US taxes on; for example, if you bought your property for $150,000 CAD when the CAD/USD exchange rate was 1.5, your basis for US tax would be $100,000 USD. Now if, when you sell the property. the exchange rate moves to 1 CAD/USD, as it was for most of 2009-2014, and you sell the property for $150,000 CAD, you would have no gain or loss on the Canadian side, but you would have a $50,000 gain on the US side, because the $150,000 CAD would convert to $150,000 USD due to the exchange rate change, in which case, a 1031 exchange would be even more appealing.
   
   Note, however, that you should be able to take CCA on furniture in the rented rooms (that are used only by the renters); you should also list the furniture in the rental agreement.
   
   Direct repairs to the rental rooms are fully deductible as a rental expense in both countries, but the initial cost of repairing the rental rooms to put them in suitable condition to rent out is considered a capital expense in both countries, even though in other circumstances it would be treated as a current operating expense. So the initial expenses in preparing the rental rooms for rent would need to be capitalized and depreciated for US tax but not depreciated and only added to basis for Canadian tax if you want to keep the entire property eligible for the primary residence exemption.

Exchange Rate Risk

On your US tax return, you must convert all amounts to US dollars. The Internal Revenue Service has no official exchange rate. Generally, it accepts any posted exchange rate that is used consistently. I use the Bank of Canada exchange rate when I need a daily rate and have a spreadsheet with formulas to look up the Bank of Canada rate from the CSV download for a given day.

The CRA also has stated that for any day after February 28, 2017, the relevant spot rate is the rate published by the Bank of Canada for that day or the closest preceding day, if no rate is published for that day (Income Tax Folio S5-F4-C1, Income Tax Reporting Currency).

As illustrated above, changes in the exchange rate due to fluctuating exchange rates can result in unexpected capital gains or losses on the US side when selling your property (note that capital losses are not deductible for personal property such as a primary home that is not rented out).

Furthermore, it is possible to have a capital loss from the sale of real estate but a IRC Section 988 exchange rate gain from paying off a mortgage denominated in a foreign currency if, at the time of the sale, the foreign currency depreciates against the US dollar from the exchange rate at purchase. Section 988 gains and losses are taxable as ordinary income at your marginal US tax rate.

• Assume the reverse of the example above happened, and you bought your property for $150,000 CAD when the CAD/USD exchange rate was 1. Then your basis for US tax would be $150,000 USD. Suppose also that you took out a mortgage for $100,000 CAD and USD (i.e., you paid $50,000 cash and financed $100,000) and did not make any principal payments while you owned the property. Now if, when you sell the property. the exchange rate moves to 1.5 CAD/USD, and you sell the property for $150,000 CAD, so no gain or loss on the Canada side, you would have a $50,000 capital loss on the US side, because the $150,000 CAD would convert to $100,000 USD. The sale also paid off your $100,000 CAD mortgage, which is now $66,666.67 USD. Since, in US dollars, you took out a loan for $100,000 but were relieved of it for $66,666.67, you now have a 988 ordinary income gain of the difference of $33,333.33 USD that you would need to pay US tax on. And if this was just a primary home, the capital loss would be a personal, non-deductible loss.

Exchange Rates to Use on Different Forms

In addition to the general rules above, certain forms require the use of specific rates as follows:

• FBAR (FinCEN Form 114, Report of Foreign Bank and Financial Accounts) and Form 8938, Statement of Specified Foreign Financial Assets - use the currency exchange rate on the last day of the tax year according to the US Treasury Bureau of the Fiscal Service to figure the maximum value of a specified foreign financial asset
• Form 1116 - credit for taxes accrued - IRS's Yearly Average Exchange Rates for Converting Foreign Currencies into U.S. Dollars
• T1135 Foreign Income Verification Statement
• Maximum funds held during the year or Maximum fair market value during the year - the average exchange rate for the year.
• Funds held at year end or Fair market value at year end - the exchange rate at the end of the year.

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Important warning! I do not provide tax, legal or accounting advice. I am writing this guide only for informational purposes, and based heavily on my own unique personal facts and circumstances. And I am a unique individual with a unique background and my unique set of personal facts and circumstances, so what is applicable to me might not be applicable to you. This guide, like all other content in this blog, is not intended to provide, and cannot be relied on for, tax, legal or accounting advice. You are responsible for consulting your own tax, legal and accounting advisors to obtain advice on your personal situation.