The U.S. property market can present incredible value to those who are willing to take the plunge, but buying across the border is not without its risks. Sarah Megginson reports.
It almost seems too good to be true. "For sale: three-bedroom, one-bathroom house in Indianapolis. Renovated and already rented out, market value of $66,000. Asking price: $44,000."
You don't need to be a math whiz to work out that a deal like this guarantees a highly positively geared investment.
Let's assume that the monthly rental return for this property sits conservatively at $500, after property management fees and other maintenance expenses. On a purchase price of $44,000 (with a 25% deposit of $11,000), the mortgage repayments at 6.5% amount to around $220 per week - less if you opt for an interest-only loan.
Based on these figures, this investment will generate several hundred dollars in positive cash flow each month. With a yield of around 13.5% based on the purchase price, it's the sort of deal that investors dream about.
So why isn't every Canadian rushing across the border to snap up these bargain deals?
It's because there is usually more to these types of investments than meets the eye, according to Vernon Martin, MSRE, CFE, a certified general appraiser and principal of American Property Research.
"Those who invest here for financial gain are sometimes misled or swindled," warns Martin.
"Rental home investments are being marketed outside the U.S. in cities that have serious housing oversupply. They are advertised as being leased and having a positive cash flow, but they are often located in areas of high vacancy, so once the tenant leaves, finding another tenant is problematic - particularly for foreign owners."
How can you minimize the risks?
1. Apply the google test
Martin recommends that when you find a deal that seems worth pursuing, you run the company advertising the property through the google test. "Always google the name of the management company promising guaranteed return-on-investment and quick replacement of tenants, as the search will often lead to consumer complaints against these management companies," he says.
2. Ask for referrals
If you're looking at buying a U.S. property through a particular developer or management company, ask for referrals from previous happy customers. A written testimonial is fine, but it pays to ask for the email address or phone number of previous clients too, so you can verify that their experience has been positive and profitable.
3. Visit the property
"With rental homes, tenant quality is important, too, so every Canadian investor should physically visit his or her intended investment beforehand," Martin advises.
You can't rely solely on the images the selling agent provides you, as a property might present well in photos, when the reality could be a much smaller, more run down home - or one that is located on a less desirable street, or in a dodgy neighbourhood.
4. Do your research
This goes without saying, but it's vital that would-be investors conduct extreme due diligence when researching a potential U.S. investment. Don't just rely on the research your net browsing uncovers, either: pick up the phone and call property managers and local authorities to ask questions about the neighbourhood and local tenant demand.
Where should you buy?
If you're keen to invest in the U.S. but you don't know where to start, your first step is a simple one: you need to identify your goals.
That's because the best place to park your investment dollars stateside really depends on your investment objectives.
"It all goes back to risk versus reward, and it depends on your risk tolerance," explains Brendan Keating, principal owner of The Equity Group, a commercial real estate company based in Las Vegas, Nevada.
"If you're looking for a 7-9% return, you can invest your money in relatively safe assets, but the upside is limited. If you're looking for a 15%-plus return, those assets have more risks and larger vacancies, but the upside is much greater. So we look at it in two classes: wealth preservation or wealth accumulation."
As a general rule, for those buyers seeking a relatively "safe" investment with the greatest potential for appreciation and continued rental income, Martin believes the best places in the U.S. to invest are located close to where the jobs are, including expected new jobs.
"In these areas, demand for property is reasonably secure," Martin explains. "One only needs to drive a short distance south of the border to find job opportunities in places like North Dakota and Wyoming."
Alternatively, for those who are looking to invest in a property they can personally enjoy, he says there are many overbuilt vacation destinations which are offering big discounts.
"The DisneyWorld area in Florida, for instance, offers huge discounts on newly built condominiums. Kissimmee, Davenport and Orlando are just a few of the nearby communities," Martin says. "Just make sure that the condo project is mostly sold out."
Cheap and cheerful...
As our earlier example demonstrates, it's possible to pick up a property in the U.S. for about the same price as a new car. Whether this type of low-cost property will be profitable in the long run remains to be seen, but if your primary objective is to secure positive cash flow in the short term, a cheap and cheerful investment could be your golden ticket.
"We like the distressed regions in the Southwest U.S. because they have fallen the furthest in values, for example, Las Vegas and Phoenix," Keating points out.
"In general, in Las Vegas we are seeing properties trade at 60-90% off of 2005-06 values, depending on the asset class and the level of distress. We recently closed a transaction for $1 million on a property that had sold for $6 million in 2005."
In purchasing highly distressed properties, you need to be prepared for what you're up against, including potential prolonged periods of vacancy. But Keating says those who have patience - and who hire local experts in leasing and management - will enjoy a profitable investment.
"Personally I would rather take the risk of not having cash flow on day one, and having a lower basis, rather than purchasing a more stabilized asset with higher occupancy that will provide positive cash flow at the time of purchase," he says. "The reason being that you can lose a tenant the next day, but you have already paid for that tenant in the higher purchase price."
... or prime properties?
Prime properties are homes that are located in good neighbourhoods, and that attract an ongoing stream of quality tenants.
Property sectors with the lowest vacancies are bringing in the highest price per square foot, as they have the highest level of buyer demand and thus competition is heating up.
Although these properties offer a safer alternative to the more volatile opportunities available in cheaper, distressed areas, Martin cautions buyers against believing everything they read or hear.
"It is difficult for foreigners to know as much as the locals, and prime properties are often overpriced," he says. He reinforces that it is vital to do extensive research so you can "make sure the property can be readily rented at an acceptable rate of return."
Martin also recommends that buyers focus on the returns on offer as a first priority, as genuine capital growth opportunities are few and far between.
"I don't see much capital growth nowadays, despite plenty of blue-sky promises from real estate developers. Aim to assure a positive cash flow first, as a cash-flowing property is more likely to retain its value or appreciate in value," he says.
"Multi-family properties seem to have the strongest prospects at the moment, but it's best to buy a larger property and have it professionally managed, than to buy a small property and be an absentee landlord."
Tax implications of buying in the U.S.
Residents are taxed in Canada based on worldwide income, which means you are required to report the net rental income you receive from your U.S. property investment when filing your personal tax return.
"The rental income is subject to tax, in the same way that rental income earned on property situated in Canada would be," explains Silvia Jacinto, senior tax manager, Soberman LLP.
She adds that where the rental property costs more than $100,000, you will also need to file a special information form (T1135) with your personal tax return to disclose ownership and income earned from the property.
In the U.S., local government levies property tax on real estate, based on fair market value, and as a foreign owner, you will be liable to pay. Rates vary depending on the jurisdiction the property is located in. The amount of tax payable is determined annually on a set date, and generally amounts to between 0.2% and 4%.
Unfortunately, this property tax "does not create foreign tax credits within Canada", Jacinto confirms. "Rather, it is considered to be an ordinary expense in connection with owning the foreign property," Jacinto says.
"However if the real estate is a rental property, you can deduct the property taxes as well as any utilities you pay in respect of the property when computing the net rental income, for purposes of calculating your Canadian taxable income."
Jacinto also notes that a Canadian resident can choose to own a foreign property through a Canadian corporation, partnership or trust. Under each ownership structure, the taxation of the income and the gain on sale differs, so specialist taxation advice is recommended.
What about capital gains tax (CGT)?
If you decide to sell your U.S. property, you will generally be required to pay CGT in Canada. According to Jacinto, the taxable portion of the gain (50%) will be included in income in the year of disposition, and will be subject to Canadian income tax at your individual marginal tax rate.
"You should also consider whether your principle residence exemption is available on the sale of the foreign real estate. For Canadian tax purposes, a principle residence is exempt from CGT and the taxpayer can elect any residence that they own as their principle residence - with some restrictions, but including a foreign owned dwelling," she says.
"If the exemption is utilized on the sale of your U.S. property, then the capital gain is sheltered from Canadian tax. However, the gain may still be subject to tax in the foreign country, in which case it may not be wise to utilize the exemption on the sale."
While foreigners are usually not taxed on capital gains within the States, U.S. tax law requires that all persons, whether foreign or domestic, must pay income tax on dispositions of interests in U.S. real estate.
To ensure tax collection from foreign taxpayers, FIRPTA (Foreign Investment in Real Property Tax Act of 1980) requires buyers of U.S. real property interests to withhold 10% of the sale price. You can apply to the Internal Revenue Service (IRS) to reduce this percentage to the amount of tax estimated to be due.
SILVIA JACINTO
Silvia is a senior manager with the firm's Tax Group. She has insight into a wide range of subjects, and is specifically knowledgeable of tax issues relating to real estate.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.