Invest in U.S. real estate tax-efficiently

Canadians looking to invest in U.S. real estate funds should be aware of two things: market trends and opportunities, and the tax implications of cross-border investing.

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One type of U.S. real estate people should consider investing in is self-storage properties, says Chip McKinley, senior vice-president and portfolio manager with Cohen & Steers in New York. Among other real estate funds, he manages the Renaissance Global Real Estate Fund.

“Traditional self-storage facilities are something everyone uses, and they’re a growing property type. Over the last few years, the publicly traded companies [in this space], of which there are four, have been doing an exceptionally effective job [of] consolidating the sector,” which has traditionally been fragmented. (The four public companies are CubeSmart, Extra Space Storage, Public Storage and Sovran Self Storage.)

Read: U.S. real estate still attractive

Until now, says McKinley, self-storage facilities have been “owned by thousands of mom-and-pop individual investors across the country who aren’t that sophisticated,” so the public companies have been taking market share.

Meanwhile, he adds, the public companies “have done a fantastic job of using [tools like] revenue management software to get in front of those looking to rent storage space, and to adjust their prices and respond to changes in demand.”

Read: Find undervalued small-cap gems

As a result, he finds publicly traded self-storage companies are growing their earnings well into the double digits year-over-year. These gains are “real cash flow earnings, which translate into dividend earnings and growth.”

McKinley notes their outperformance is underappreciated — he calls self-storage real estate “the most boring sector in the U.S.” and, as such, it doesn’t attract a lot of attention.

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The tax impact

Before investing in a U.S. real estate fund, clients should understand what they would own and how they would be taxed, says Jamie Golombek, managing director of tax and estate planning at CIBC Wealth Advisory Services.

“When you own a U.S. real estate fund that’s domiciled in Canada,” he explains, “what you’re essentially owning is a mutual fund that invests in various investments that have exposure to the U.S. real estate market.”

Read: How to own U.S. rental property

Regarding taxation, tell clients they’ll be taxed on “distributions [they’d] receive from the mutual fund, just like with any other mutual fund that receives regular income, and any capital gains or losses [incurred] when selling units or shares of the fund.”

Further, clients could receive two main types of distributions: income distributions and capital gains distributions.

“An income distribution would typically be from U.S. rental income that’s been flowed out, and normally there would be a withholding tax.” Due to recent changes, he adds, “the rate of withholding on these [distributions] is generally 15%, but you then get to claim a foreign tax credit. So you essentially report the gross foreign income coming from the mutual fund, and then you claim the foreign tax credit for the 15% withholding tax.”

As a result, says Golombek, “the only tax paid would be on the difference not paid to the U.S.”

Read: Consider closed-end funds to generate income

For capital gains distributions, there’s no withholding, so clients “would just report [that distribution] and pay tax at 50% of their marginal rate.”

And, make sure clients understand that when they sell mutual fund units, they receive capital gains or losses–just like with a normal mutual fund. Those gains or losses are “calculated by taking the proceeds, less the adjusted cost base (which is what you paid for the fund), plus the cost of any reinvested distributions.”

Overall, “the taxation of a U.S. real estate fund is no different than any other mutual fund, other than the fact that the income you’re receiving could be subject to withholding tax.”

But, he points out that if Canadian clients are collecting foreign income in a registered account, they can’t claim the foreign tax credit.

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