Like starting a company, for some people, owning rental properties is a dream come true. But if you are fortunate enough to turn your dream into reality, you may soon realize that your vision is a little blurrier than you initially thought. This is especially true when you’re trying to decide where to hold that real estate.
A common question brought forth both by existing landlords and individuals with an interest in rental properties is: “should I incorporate?” The answer: it depends.
To incorporate or not to incorporate
As an individual taxpayer, you pay taxes based on the taxable income you earn during the year. Similarly, as a business owner, you pay corporate tax based on the taxable income earned by the business throughout the year. Personal taxes only apply on that income once you take it out from the business, but what you leave behind makes all the difference.
A significant advantage to being incorporated is the potential to defer taxation – that is, to pay personal tax later as a result of leaving the income you earn in your company undistributed. The beauty of this advantage is that those deferred taxes can be invested, or reinvested in the business, and are now able to earn income. The cycle of life continues, and the income you generated on those deferred taxes can continue to be invested or reinvested, leading to compounding returns. Like many have said before, money makes money.
Unfortunately, when it comes to rental properties, this advantage only applies to ‘active’ income.
Generally, rental income generated in a corporation would be considered passive, and the deferral advantage is almost non-existent. In essence, the dollars you are left with inside of your company are marginal at best, in contrast to the dollars you would be left with outside of your company.
In fact, although the company has a slight (almost non-existent) deferral advantage to when taxes are paid, once they are paid (i.e., taken out personally), the combination of corporate and personal taxes paid ends up being higher than if you had just held the property personally to begin with.
Add the compliance costs associated with setting up a company, operating as a company, and among other things, the new Underused Housing Tax (UHT) rules that require corporations with rental properties to file a return (with a hefty non-compliance fee if missed) and you might rephrase the original question to: “Why would I incorporate?”
Well, here are a few reasons why you might want to incorporate:
You are looking out for those around you and want to prepare for the tax liability on death
Two things in life are certain – death and taxes (harsh, we know). Most people don’t want to have that conversation, but when it comes to your assets and what you intend to leave behind, the tax authorities may have different plans in mind.
When you pass away, a triggering event takes place that results in any accumulated gains (e.g., rental property, etc.) becoming taxable – it’s treated as if you sold everything you own personally at the time of your death. The outcome being that your family may need to liquidate some of those assets in order to pay the resulting taxes.
One mechanism for planning ahead for this event (as it relates to rental property) may be to transfer your existing property, or properties, to a corporation on a tax deferred basis. You then undertake a series of transactions that result in any future growth in property value being attributable to someone else – frequently your adult children – helping to kick some of those taxes down the road.
You are an existing business owner and have accumulated funds inside of an operating corporation
As mentioned above, the potential to defer taxes on income may exist for certain business owners.
The most significant deferral opportunity exists for businesses that are considered to generate active income. This is due to the fact that the first $500,000 of active income is generally taxed at the low small business deduction rate (in Ontario that rate is 12.2%). This means that in an active business generating net income of $100,000, there will be $87,800 of after-tax income available to invest.
As an operating business owner with accumulated capital inside the business, you may want to explore the opportunity of investing those pre-tax earnings into rental property, leveraging the deferral advantage by providing you with a higher down payment and reducing the amount of debt to take on.
Your vision is bigger than yourself… about six times the size
There are situations where a tax deferral opportunity exists for rental property investors.
Like flipping on a light switch, if you can demonstrate that your passive holdings represent an active business, you may suddenly be able to access the resulting small business deduction rate described above.
The catch? You need more than five full-time employees involved with running that business.
It’s worth noting that holding rental property personally can be beneficial to the taxpayer. If losses are incurred, a taxpayer may deduct those losses against other sources of income. If losses are generated in a corporation, they can be used to offset future taxable income of that corporation, but cannot be used by the individual.
There may be other considerations that bring you to conclude that incorporating is the right choice for you, but if you haven’t answered the “should I incorporate?” question yet, the team at Armstrong Jones LLP can help guide you in the right direction.
Speak to one of our expert advisors by calling (613) 695-9087 or contact us online and we will get back to you promptly.
