Our most popular question when talking with real estate investors is “Should I incorporate?”
Our most popular answer as real estate accountants is “It depends!”
What factors influence the ultimate decision to incorporate your real estate business? We have reached back into our archives to walk though the five key decision points in making the choice to incorporate. With the new tax and financing rules from 2017 and 2018, we have updates!
Where Do Real Estate Investors Start?
Start with the end in mind.
When buying real estate today, think about what your situation will be in 10, 20 and more years. Will you have adequate resources available after taxes are paid? Discussing the appropriate ownership structure for your family, and how it will change over time, can save untold grief and taxes.
In the early stages, having the higher income spouse own properties and receive the deductions common to the early years of investment property ownership provides some tax advantages. As you earn additional income and sell properties, splitting properties between spouses may lower rates of tax within the family. However, changing property ownership can produce expensive tax consequences.
This is not a do-it-yourself project. For example, while splitting income between family members is generally a good thing from a tax perspective, the CRA restrains certain activities with, for example, the ‘attribution’ rules. In essence, in some situations the CRA believes that income earned by a family member truly belongs to another who contributed the funds for the investment, or previously owned the investment. Further, new rules from December 2017 introduced restrictions on income splitting with family members. We can still income split in many situations, but more care and planning is needed.
Considering alternative forms of ownership now, such as corporations and family trusts, is wise. While alternative ownership may be completely inappropriate now, from a tax perspective it may be far more effective to allow for the benefits of a structure to accrue over time. For example, creating a family trust for real estate ownership when your children are five years old may provide a vehicle to pay for post-secondary education while potentially protecting assets. The current federal government has restricted the traditional ways parents have financed their children’s education or youth entrepreneurship with their tax policies of 2017 and 2018, but possibilities still exist. The more time you have to plan and implement, the more benefits are available. Just don’t go overboard in setting up an elaborate structure that generates additional costs and complexity to operate.
5 Factors for Incorporation
We like to discuss structuring real estate investments within a framework of five major categories. Your priorities within the framework mean you can make the best decision for today, and tomorrow. Often, we provide completely different recommendations for very similar situations.
Generally, we consider our recommendations in the following order, although your priorities may differ.
Personally, we like having as many choices as possible, particularly with the new tax rules from 2017 and 2018. These choices include:
- How to remunerate owners
- How to structure investments with co-investors without negatively affecting the co-investors
- When to remunerate owners
- Who amongst the owners can be remunerated
- How much owners should be remunerated
- How properties within the portfolio may be disposed
- How to change the specific investors in a particular property (corporations with joint ventures tend to provide more choices as compared to personal ownership or partnerships, for example)
2. Legal Issues
From our perspective, we see differing opinions amongst the legal profession on whether real estate investments should be in a corporation. Well-respected lawyers fall on both sides of the “should I incorporate?” question. However, over the past few years, we are seeing more and more advocate for incorporation.
As well, using family trusts in the legal context is an option for investors, particularly when combined with financing and tax reasons. Advisors will also talk about limited partnerships in the context of attracting multiple investors.
Ultimately, this is the domain of lawyers and their advice is critical.
3. Tax Impact
From a tax perspective, there is no ONE right answer. A structure may be better or worse for you in different cases. For example, your timeline for investment, objectives of your investments, nature of your investments, other business and financial activities currently and in the future, plus family situation, all play a role. For someone unconcerned with flexibility and legal issues, who earns reasonable employment income, who is not interested in passing assets to the next generation in a tax efficient manner, and who is interested in a “buy and hold” strategy there is little tax incentive to incorporate. Alternatively someone who wants to flip or develop properties, has more family members interested in owning real estate or participating in the process, or who currently earns business income through a corporation, may be more inclined to incorporate. Further, someone wanting to attract multiple investors may prefer to remain more neutral from a tax perspective. This can be accomplished using the “flow-through” capabilities of a limited partnership because the investors can themselves decide how they prefer to own their partnership units (for example, personally or through a corporation).
With the guidance of your mortgage broker or financial institution representative, consider the impact of the potential structure on receiving financing for current and future properties. Various financing programs are often restricted to personal ownership, for example, while others insist on a corporation. Some institutions want specific shareholders on companies. We’ve encountered a wide range of opinions from financing professionals but wish to emphasize that many legal and ethical ways exist to attract financing. We do note that as of 2018, we are seeing more benefits to using a family trust as compared to a “parent company”.
5. Professionalism and Organizational Issues
We think a corporation often provides a more professional image. It also provides an ability to segregate personal from corporate activities.
However, some people find it much easier to understand and track their real estate portfolio when everything is in the same pot, or owned personally, as compared to having separate little “shelves” with one or more entities.
The Final Decision to Incorporate
This brief synopsis shows that many considerations and combinations are available for ownership. Avoid getting taken in by the sexiness of a fancy structure that you don’t understand and fails to meet your needs. You can grow into a structure when you’re ready. Changing your structure in the future may cost a little more, but you will have additional assets and cash flow to address these costs. You must address changing finance, tax, and legal rules with your advisors. For example, from a tax, finance and legal perspective, we are seeing a large increase in the use of family trusts, and advise you to consider the same for your particular situation.
Ultimately, you must decide what is best for you and your family. However, you need input from your advisors to appreciate the choices and ramifications. Your advisors may have different opinions. Get them to explain why they believe in one course of action over another. Ideally, your advisors can have a brief discussion with each other and with you to highlight areas of agreement and disagreement. Then you can weigh the choices.
George E. Dube, CPA, CA
Tax Partner, BDO Canada
Real estate accountant, real estate investor, speaker, author