Structuring Your Stocks and Real Estate Investments: Some Considerations, Part I

Posted by on May 8, 2007 in Real Estate, Taxes

Re Money and the Money Diva have recently commented and posted respectively on the tax aspects of investments. Specifically, there have been comments or posts about tax issues with investing in dividend stocks, the tax characterization of certain income trusts and possibly the tax aspects of real estate investments. Since taxes on investment income is not taken at source, like a paycheck, it is quite important to understand the tax consequences of every investment and, just as importantly, to put aside certain money to pay taxes on it. I am not an accountant but I have done some structuring work in connection with saving taxes and the following are some of the tax efficient structures I have come across (as usual, please do not take this accounting advice; please see your own accountant for qualified assistance).

As a starting point, I would read the Million Dollar Journey’s posts on this subject. It is an extremely good summary on taxes (please note it only applies to Canadians though). The one thing to understand about the Canadian tax system is that it punishes the generation of passive income relative to active income in a corporation. Active income is income you make from your job or business. Passive income is made from investing, rental income and royalties. Outside of the corporation, the tax treatment is neutral in the respect that, removing the dividend tax credit and capital gains from the equation, you are generally taxed at your personal income tax rate.

In a corporation though, passive income is taxed at the highest marginal tax rate (in plain English, the highest tax rate possible). If you mingle passive and active income in a corporation, your active income may become subject to passive income tax rates. This is one reason why a manufacturers owns its building in one corporation and the actual manufacturing business in another corporation. So keeping that in mind, here are some structuring options (assume owners are resident Canadians):

Real estate properties/rental income:

  • If you are being taxed at a high personal tax rate, you may want to have a corporation own the investment property; rental income outside of a corporation is taxed as income (i.e. 100 cents on the dollar is subject to taxation at your personal income tax rate).
  • To use the tax jargon, you can keep the taxes “flat” on investment properties (inside or outside of a corporation) by racketing up the mortgage payments so that the cash flow coming in is almost equal to the mortgage payment (in order words, your taxable income is quite low because you are using all of your profit to pay off the mortgage). The short amortization rate on your mortgage will increase the equity in the investment property quickly allowing you leverage to buy other properties (this is the most tax efficient way to build a mini real estate empire relatively quickly but it does have its risks).
  • The above point assumes you are buying the real estate investment properties for capital appreciation and not cash flow though. If you are buying it for cash flow, open up a high interest bank account and put your projected tax bill pro-rated on a monthly basis into that account- at the very least, your taxes are covered at the end of the year and you haven’t spent it (plus you make some interest).
  • If you want to keep real estate in the corporation and derive tax efficient cash flow, consider incorporating a corporation which provides landlord/property management services to your real estate holdings. This corporation is making active income and the income derived is being taxed at a lower tax rate. You can take the money out of the landlord/property management corporation on a tax-friendly basis by dividending out money to yourself. You should only consider this if you have a lot of property or are profitable out of a few properties and you are being taxed at a high personal income tax rate and/or the rental income would push you into another tax bracket.
  • The primary advantage of holding investment property in a corporation is that you can sell the shares of the corporation rather than the house/building itself or structure the corporation in such a way to transfer the shares inter-generationally on a tax efficient basis. In Canada, you cannot generally use the capital gains exemption on the sale of this type of corporation for reasons listed below. In the United States, I understand this method for selling the shares rather than the house is done regularly by sophisticated investors of real estate.

In my next post, I’ll post about structuring and stocks/dividends and other income.

7 Comments on Structuring Your Stocks and Real Estate Investments: Some Considerations, Part I

By QCLandlord on May 9, 2007 at 11:32 pm

Regarding your comment:

“you can keep the taxes “flat” on investment properties (inside or outside of a corporation) by racketing up the mortgage payments so that the cash flow coming in is almost equal to the mortgage payment (in order words, your taxable income is quite low because you are using all of your profit to pay off the mortgage).”

Actually, this isn’t totally correct. In Canada, even if you increase your mortgage payment, you cannot use payment on the principal to reduce your taxable rental income, since only the interest is deductible. Have I misunderstood your strategy?

By admin on May 10, 2007 at 11:33 am

Generally speaking, taxable income is (income) – (deductible expenses). Your interest payments on the mortgage is deductible but the principal is not (remember also that deductibility is also voluntary, you can not claim the interest, although I don’t know why, if you don’t want to).

If the principal on your mortgage is greater than your rental income, you generally have a business loss (this is a very simple analysis; CRA may take the position that the loss is not allowable for a variety of reasons). If your rental income is the same as your principal, you have no taxable income or a tax loss if you deduct the interest. If the profit is minimal (either because you cannot receive that much rent or your principal is quite high), you have kept your taxes quite “flat” but you are building equity without incurring any operating losses.

That is my understanding (remember I am not an accounting); if you have any thoughts on this matter, please share. Thanks.

By QCLandlord on May 11, 2007 at 12:25 am

As you are saying, mortgage principal is not deductible, so when you fill your tax forms, you simply cannot create a business loss by increasing your principal.

e.g.:

rental income: 20K
interest on mortgage: 10K
principal on mortgage: 4K
maintenance expenses: 2K
utilities: 1K
insurance: 1K
property taxes: 3K

In this case, even though your expenses are greater than what you earn, you’ll still have a taxable income of 3K (20-10-2-1-1-3).

Hey, I’d like to do it myself, but the rules are really clear and simple. Any accountant in here with more info on this subject?

By Weekend Reading - May 12, 2007 - Million Dollar Journey on May 12, 2007 at 8:06 am

[...] ThickenMyWallet has a great article explaining tax considerations when structuring your real estate and stock assets. [...]

By admin on May 14, 2007 at 5:56 pm

QC Landlord:

Ok- I think I see what you are driving at. In the tax form for previous years, you cannot redistribute your expenses to non-deductible items.

However, most mortgages allow you to increase your bi-weekly/monthly payments which means that you are paying more towards principal than interest. It is this increase in the mortgage payments that I am speaking about. So in your example, you increase your mortgage payments (which is usually applied in greater portion to principal than interest) and increase the non-deductible expense.

Is that clear?

By PC on April 12, 2008 at 2:38 pm

Hello,

When you move your real estate holdings into a corporation, do you have to pay the appropriate land transfer tax in Ontario, Or can you make an application for an exemption? It does make sense that you pay yourself a tax on this type of transaction.

Thank You.

By admin on April 15, 2008 at 8:28 pm

It depends on the situation but I can’t find an exemption which would allow a deferral of LTT in the situation you described.

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