Investing in rental properties can be a lucrative venture, providing a steady stream of income and potential long-term wealth. A common question that often arises with clients is how best to structure their real estate investments. Though there are a few different structures available to hold your real estate investment, but for the purposes of this article, we will focus on holding real estate personally or through a corporation.
Within a corporation, the real estate properties can be held either in an existing operating company, a holding company, or a property company. Ultimately, which structure is best for you depends on your individual situation and long-term goals for your real estate investments. Most investors prefer using a holding company to buy real estate in Canada; the reasons of which will become apparent below.
In this article, we will explore the advantages and potential drawbacks of holding real estate personally and through a corporation via a holding or operating company. In addition, we will also discuss other important considerations that need to be taken into account before making a decision on which structure is best for you.
Holding real estate personally can be quite beneficial for those who are looking to keep their investments simple.
If your objective is to own a few real estate properties, the simplest structure for you would be hold the property personally. In this situation, you would purchase the property in your name or in joint ownership with your spouse and obtain financing personally. You would report the gross rental income on your personal tax return and claim the corresponding eligible rental expenses to arrive at your net profit from the rental property. To get a full list of eligible expenses that can be claimed against your rental income, see our article, Tax on Rental Income in Canada: A Comprehensive Guide.
In addition, when you own the rental property personally, the other tax obligation you need to be aware of is the capital gain tax in the year you dispose of the property, which would get taxed based on your personal marginal tax rate.
The main advantage of holding real estate personally is that it allows you to keep costs low as you won't have to pay for the setup, filing, and maintenance costs associated with a corporation. Additionally, you will have more control over your investment decisions and can manage it yourself or hire a property manager if desired. Furthermore, if you are looking to quickly liquidate your investment and move on to another opportunity, then holding real estate personally may be the best option for you. Finally, holding real estate personally can provide you with more flexibility in obtaining financing and in certain cases may be more tax advantageous as rental losses can be used to offset your other taxable income.
On the other hand, there are some potential drawbacks to consider. For instance, holding real estate personally exposes you to a greater risk of liability if any legal issues arise. This means that your personal assets are at risk in the event of a lawsuit or other legal issue. Additionally, if you have multiple properties, then the income from each property will be reported on your personal tax return and can result in a higher overall tax burden than if they were held through an entity.
Overall, there are both advantages and disadvantages to holding real estate personally so it is important to carefully consider all of your options before making a decision. It is always best to consult with a qualified tax professional who can help you determine the best structure for your specific situation.
If you plan to be in the business of real estate investing by purchasing multiple properties in the future, you’ll want to consider holding the properties within a corporation. The most important benefit of holding real estate within a corporation is liability protection. Furthermore, as your investment portfolio grows, having a corporation allows for greater flexibility when it comes to tax planning and tax savings, helping you maximize your profits. Below we will compare the advantages and disadvantages of holding real estate through an investment holding company vs an operating company.
A holding company is a separate legal entity that does not carry on any business activities. It does not participate in the selling of goods or the provision of services. Instead, its main function is to maintain investments, which can include real estate properties or shares in both public and private companies. In the context of private companies, a holding company is usually introduced to hold shares in an operating company for tax planning purposes.
An operating company is an active company used to run the day-to-day business operations of a business. If an operating company is under the control of a holding company, it is classified as a subsidiary. The main advantage of such a structure, where the holding company owns the operating company, is that it allows you to shift residual income from the operating company up into the holding company on a tax-deferred basis via dividends. This provides the holding company with enough cash to acquire passive assets or flow the funds to the individual shareholder(s).
Though this type of structure can provide many tax benefits but the most important is that it allows you to defer personal liability until you withdraw the funds for personal use from the holding company. For the purpose of this article, we will be analyzing the advantages and disadvantages of a holding company that owns only investment property such as real estate, shares of publicly traded shares etc, rather than shares of an operating company.
One of the key advantages of holding a rental property through an investment holding company is the limited liability protection it provides. When you hold property in a holding company, your personal assets are safeguarded in the event of a lawsuit or other legal issues. This means that in the case of a legal dispute such as a tenant suffering an injury on your property, your personal possessions like your house, car, and other belongings would be safe from any potential risk in the lawsuit. However, it is essential to note that severe negligence or illegal activities may still expose you to personal liability.
For some investors, limited liability protection alone would be the guiding factor of whether they should incorporate a holding company to hold their real estate investments. For example, for commercial real estate investors, having limited liability protection on commercial property that is rented out is even more important as they have a higher risk liability compared to a residential rental property.
Another advantage of incorporating an investment holding company is the ability to do an estate freeze as part of a tax planning strategy. This strategy allows you to “freeze” a company’s value at a point in time for the original shareholders while ensuring that any future appreciation on the assets held in the holding company are passed to the next generation or desired family members. If your goal is to expand a substantial investment portfolio and would like to reduce your estate taxes while transferring property to your family, utilizing an investment holding company structure can provide maximum flexibility.
Holding companies are simply expensive to set up and have ongoing administrative responsibilities. This includes the initial setup of a corporation, such as incorporation fees, name search fees, and professional fees. Once the holding company is established, there are ongoing annual fees for maintaining corporate records and filing corporate tax returns. These costs can vary depending on the complexity of your rental property and the specific services required.
Regardless of whether you choose to incorporate or not, it is essential to maintain accurate financial records and properly report rental property income and expenses on your tax return. While accounting for a corporation can be more complex, consulting with a corporate tax accountant can ensure compliance and optimize tax strategies.
When it comes to tax implications, owning a rental property in a corporation does not always provide significant tax benefits. Unlike personal taxes, there are no graduated tax rates or brackets applied to an investment holding company. In Canada, passive income earned by corporations is subject to a single high tax rate. For example, in Ontario, the corporate tax rate on passive income such as rents, interest, and dividends is 50.2%. This tax rate often aligns with the personal marginal tax rate for individuals in the highest bracket.
However, when the holding company distributes taxable dividends to its shareholders, a portion of the taxes paid can be refunded through a mechanism called Refundable Dividend Tax On Hand (RDTOH). Once the dividend is declared, it reduces the corporate tax rate (to the extent of the dividend) to 20% which is relatively low. Therefore, it is advisable for an investment holding company to distribute its income to shareholders in the same fiscal year it was earned in order to minimize the overall amount of corporate taxes paid for that year. Let's look at an example to see how taxable income is taxed in an investment holding corporation.
Example
Assume the corporation is a Canadian Controlled Private Corporation (CCPC) and earned $10,000 of rental profit in the year. The corporate tax rate for a CCPC on passive income is 50.2% in Ontario compared to only 12.2% on active business income.
Taxation of investment income (rental) within an investment holding company
| Taxable income | $10,000 |
| Corporate Tax payable (50.2%) - A | $5,020 |
| After-tax cash available | $4,980 |
Calculation of RDTOH
| Taxable income | $10,000 |
| RDTOH (30.67% of taxable income) | $3,067 |
In order for the corporation to receive part of the corporate tax paid back through the RDTOH, the corporation has to pay the shareholder a dividend. To get the full $3,067 back, the total dividends paid must be $8,001 based on the refundable dividend tax rate of 38.33% for CCPC's.
| Dividends paid to shareholder | $8,001 |
| Refundable Tax ($8,001 *38.33%) - B | $3,067 |
| Net tax at the corporate level (A-B) | $1,953 |
Personal tax paid on dividends flowed out to the shareholder
Assuming that the shareholder is in the highest personal tax bracket, the non-eligible dividend rate for Ontario is 47.74%.
| Taxable dividend | $8,001 |
| Personal tax payable (47.74%) (C) | $3,820 |
| After-tax cash available to shareholder | $4,181 |
| TOTAL PERSONAL AND CORPORATE TAX – 57.73% (A-B+C) | $5,773 |
As the example above shows, you will generally pay a higher tax on passive income earned through an investment holding company than if you earn such income personally. Therefore, owning a rental property personally rather than corporately is a better option for many people. This approach allows them to pay lower taxes while avoiding the complexities and expenses associated with managing a corporate structure.
However, certain strategies can help minimize the tax burden associated with owning rental properties in a corporation. One such strategy is depreciation, also referred to as capital cost allowance. This allows for a deduction of a percentage of the building's cost annually, which helps defer the tax consequences associated with rental income. By carefully calculating and claiming capital cost allowance, it is possible to lower yearly income tax until the property is eventually sold. To learn more about how capital cost allowance works in the context of rental properties, read our blog article, Tax on Rental Income in Canada: A Comprehensive Guide.
The Lifetime Capital Gains Exemption (“LCGE”) allows every eligible individual to claim a capital gains deduction of up to $971,190 realized on the disposition of their qualified small business corporation shares (“QSBCS”). In order to qualify for this deduction, the small business corporation must meet certain criteria. It must be considered a Canadian-controlled private company and generate its income primarily through active business activities within Canada.
An investment holding company that is only used to hold passive assets will not qualify for the enhanced capital gains deduction when its shares are sold. Unfortunately, this is a common misconception among real estate investors that they can take advantage of the lifetime capital gains exemption on the disposition of the investment holding company’s shares.
The main advantage of owning real estate within an operating company is the potential cost savings that come from not having to establish and maintain a second separate entity. This could be particularly significant for smaller, less complex businesses. However, if a business has substantial size or growth prospects, it may be worthwhile to consider this investment.
Owning real estate in an operating company may seem like a convenient option, but it actually comes with some risks. Unlike holding companies, operating companies are exposed to various risks through their everyday business activities. This means that if something unfortunate happens to the operating company, the assets, including the real estate, could be vulnerable to creditors.
By transferring some of the assets from the operating company to a holding company, you can create a protective layer for those assets. This means that even if your operating entity gets sued, the real estate assets will remain separate and protected from any legal proceedings. Hence from the perspective of limited liability protection, owning real estate in an operating company carries far more liability.
Generally, when you go to sell your business, buyers are more interested in the primary operating portion of your business than its investments. However, complications may arise if both are housed within the same company and a potential buyer expresses interest in only the operating portion. In such cases, transferring the real estate or passive assets to another entity becomes necessary, which requires tax planning and takes considerable time.
Also, it is important to note that having passive assets in an operating company could make you ineligible in meeting the criteria for the capital gains exemption on the sale of the operating company’s shares. Hence proper tax planning and the right structure is imperative to ensure you can utilize the capital gains exemption and other benefits when you're ready to exit the business.
Before incorporating your rental property, it is crucial to verify the criteria for financing properties owned by corporations. It may be more difficult to secure mortgage financing for a corporation compared to buying a property personally. Additionally, when applying for a mortgage as a corporation, banks may require personal guarantees from the property owners, particularly if the business is not well-established. This negates the purpose of setting up a holding company for limited liability protection. Understanding these restrictions and requirements is vital to ensure a smooth purchasing process.
One of the primary considerations when deciding whether to incorporate your rental property is the potential impact on the principal residence exemption. This exemption allows individuals to sell their primary residence without incurring capital gains tax. If your rental property is part of your principal residence, incorporating may jeopardize your eligibility for this exemption. Unless you have sophisticated tax planning strategies in place, it is generally not advisable to incorporate a rental property that is part of your existing home.
In conclusion, deciding whether using a holding company to buy real estate or investing in real estate personally will ultimately depend on your long-term investing goals. It is important to understand the implications of each structure and how it affects your overall tax liability. Understanding the specific circumstances of your rental property and seeking professional advice from accountants and lawyers specializing in real estate tax planning is crucial in making an informed decision.
With proper research and careful consideration, you can make an informed decision that best fits your financial goals. If you have additional questions on how best to structure your real estate investments and are looking for an accountant in Hamilton for professional guidance, contact us today. We are here to help!
If you want to learn more about other tax and accounting topics, explore the rest of our blog!
Disclaimer
The information provided on this page is intended to provide general information. The information does not take into account your personal situation and is not intended to be used without consultation from accounting/tax professionals. NBG Chartered Professional Accountant Professional Corporation will not be held liable for any problems that arise from the usage of the information provided on this page.
