Allan Madan – Savvy Tax Tips for Real Estate Investors

Debt Partner◦ A partner who provides a loan to the other

partners within a joint venture. Depending on the terms of the loan, the debt partner would receive the principal back in full when the project is closed and would receive periodic interest payments

Difference between a Debt or Equity Partner in a Joint Venture? (Real Estate)

Equity Partner◦ A partnership structure in which the partner

shares in the appreciation and profits made while holding the property and after selling it.

◦ The higher the equity percentage within the partnership, the higher their share of the profit

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The agreement may establish:◦ Business purpose◦ Governance structure◦ Operational rules◦ Initial capital contribution◦ Decision-making◦ Exit strategy◦ Voting rights◦ Profit sharing formula◦ Other legal considerations

Joint Venture/Partnership Agreement

Generally debt partnerships are more safeguarded because on the dissolution of the partnership, the debt partner receives priority over the equity partner.

For greater security, the debt partner can ask for collateral which can safeguard their principal

What is Safer? Debt? Or Equity Partnership?

General Partnership◦ A structure in which the partners have unlimited

liability, meaning that their personal assets are liable to the partnership’s obligations. They share equally in profits, liability, and solvency of the partnership

Limited Partnership◦ A structure in which one or more of the partners is

liable only to the extent of the amount of money that they have invested. Their personal assets are not at risk. The limited partner cannot take part in the management of the partnership nor can they act on behalf of it

General Partnership vs Limited Partnership

As a limited partner in a limited partnership, you are only liable for the amount that you actually invest. You are simply a passive investor who is not involved in the day to day operations of the business

In a general partnership, you are equally responsible for the liabilities and are involved in its overall operations

What’s the Primary Difference?

In Joint Ventures (JV), each participant is responsible for the profits, losses, and expenses that are associated with it

Each participant is responsible for their share of the pro rata tax

Participants of real estate joint ventures, can report their profits, losses and expenses on their T1 return by using form T776 (Statement of Real Estate Rentals). They can also choose to claim CCA

Joint Venture – Tax

Partner 1 Partner 2 Partner 3 TotalIncome $500,000 $500,000 $500,000 $1,500,000

Expenses

Equipment Rent $20,000 $20,000 $20,000 $60,000

Office Rent $18,000 $18,000 $18,000 $54,000

Depreciation $4,000 $4,000 $4,000 $12,000

Office Supplies $3,000 $3,000 $3,000 $9,000

Professional Fees $2,000 $2,000 $2,000 $2,000

Advertising $8,000 $8,000 $8,000 $8,000

Phone $3000 $3000 $3000 $3000

Meals and Entertainment

$1000 $1000 $1000 $3000

Bank Charges $400 $400 $400 $1200

Total Expenses $59,400 $59,400 $59,400 $178,200

Example of a Joint Venture Income Statement

A limited partnership is classified as a flow-through entity, so all profits and losses flow directly to each limited partner

The limited partnership does not pay tax on its income, but rather each limited partner is subject to tax on a personal level based on their share of the income

For tax purposes, the income received may be treated as ordinary income or as capital gains

Limited Partnership - Tax

Each limited partner will be provided with a T5013 Slip (Statement of Partnership Income)

See next page

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t5013-14b.pdf

T5013 Slip (Statement of Partnership Income

Limited Liability Corporations are treated as foreign corporations by the CRA. Therefore, any tax paid on the income by the LLC will not be credited to you on your Canadian personal tax return

Profits distributed from the LLC will be subjected to dividend tax in Canada, thus resulting in double taxation

Numbers may vary, but Canadian residents operating an LLC on rental properties may have to pay upwards of 70-80% on taxes

Why LPs Crush LLCs when Canadians Invest in the United States

Capital Expenditures – are home improvements that add value to your home. Examples include windows, upgrade heating and ventilation etc. You can deduct these costs when you sell the property

Claim Capital Cost Allowance – you can deduct a portion of the depreciable cost of your rental property

Other things you can deduct◦ Insurance on the property◦ Advertising ◦ Fees from lawyers and mortgage brokers◦ Office supplies ◦ Bookkeeping/accounting/tax preparation fees◦ Salary/wages to property manager and other property staff

Can Smart Tax Planning upfront Save You Over $100k in unnecessary income taxes?

Scenario◦ A couple owns a property worth $100,000 which

generates $11,000 in income. The higher income spouse has a marginal tax rate of 50% and the lower income spouse has a rate of 0%. If the higher income spouse were to own the property, they would be subjected to $5,500 in tax on that $11,000 of income. If the lower income spouse were to own the property, the tax faced would be $0

‘Spousal Loan Method’

First glance seems to suggest it would be better off for the lower earning spouse to own the property

Attribution Rules have to be taken into consideration in this situation◦ The CRA’s attribution rules forces the higher

earning spouse to include the income on their return

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Consider making a spousal loan at the CRA’s prescribed rate of interest (1 percent)◦ In this situation the higher earning spouse would

lend the lower earning spouse $100,000 to purchase the property. The 1% interest ($1000) would be reported on the higher earning spouse’s return and the lower earning income spouse would report the $1000 as a deduction. In this case, the $11,000 could be reported on the lower earning spouse’s return without attribution rules

How to Avoid Attribution Rules?

Pro Con

Leave property to surviving spouse

Least costly Generally, surviving spouse must be US citizen

Purchase life insurance to cover US estate tax

Cost efficient Life insurance may not cover the entire estate tax

Own through a Canadian corporation

Absolute protection from US estate tax

Maintenance cost, high investment tax rate in Canada

Own through Canadian Trust

Can defer estate tax until the death of second spouse

Can only defer estate tax and not eliminate it. Very complicated to

Hold Limited partnership interest through Canadian partnership

Protection from US estate tax with fair about of certainty

IRS has yet made ruling on whether they will impose estate tax on this structure. Also, costly

How to Mitigate Against Estate Tax in the United States?

Each Canadian resident can apply a credit amount of $2,081,800 (in 2014) in estate tax. This effectively shelters $5.34M of taxable estate.

Estate tax rate is 40% of the estate This exemption is prorated based on the

value of the Canadian deceased’s US estate over the value of the deceased’s worldwide estate

How is US estate tax calculated?

Example:John had US estate of $2M and total

worldwide estate worth $4.5M. Is John subject to estate tax?

Amount of exemption available: $2M / $4.5M * $5.34M Exemption = $2.37M

of US estate is exempt from Estate tax. Since John’s US estate is worth $2M, all of this is exempt from estate tax.

How is US estate tax calculated?

Example:John had US estate of $2M and total

worldwide estate worth $10M. Is John subject to estate tax?

Amount of exemption available: $2M / $10M * $5.34M Exemption = $1.068M

of US estate is exempt from Estate tax. Since John’s US estate is worth $2M, $932,000 is subject to estate tax

How is US estate tax calculated?