In episode 1 of our Talking Real Estate with Peter and George video series, George Dube and Peter Cuttini discuss you should incorporate your real estate business. It’s the number one question they get from real estate investors. Watch now to learn the answer.
Cara:
Hello. Thanks for joining George and Peter, today on August the 20th, 2020. Where they will be discussing the topic, Should I Incorporate? Welcome, George and Peter.
George:
Thanks Cara. Thanks for having us, and looking forward to our first episode.
Peter:
Yes. Hello everyone. Should you incorporate? I would say that is the number one question that we get. I will say that usually our standard answer to that is, “It depends.” It depends on a number of factors. Today we’re going to go over a few choices, or a few factors that we ask about in terms of determining whether you should incorporate or not. But I will say each of them is different. Everyone has a different opinion. There’s no right or wrong. There’s no cookie cutter answer. We don’t give the cookie cutter answer, “yes or no”. It really depends on your facts situation. It’s not your fact situation today as much, its where do you want to be five, 10, 20 years from now. So George is going to talk about the five things that we look at when we make a recommendation on whether to incorporate or not. Go ahead, George.
George:
Yeah. So we start off with, again, this framework that we’ve developed. So the first item and the framework is what we call flexibility. Here we’re looking for what is the ability, if you will… I’ll contrast the corporate ownership just to keep this relatively straightforward in that, most people, when they’re coming to Peter and I are contrasting or comparing, “If I buy some property personally, as compared to should I set up that corporation?” So I’ll ignore other forms of ownership, which Peter and I will get into in a different episode.
But in terms of the personal versus the corporate, if we acquire a property personally… and lets for simplicity’s sake say there’s a husband and wife, they’re pretty much locked in if you will, in terms of what that ownership looks like. In other words, if they buy a property 50/50, or whatever percentages are allocated, they’re going to be dividing future expenses, revenues on that same basis. Whereas, with the corporation we have some more choices. So we have choices in the sense of when I was suggest properly set up, we can pay different levels, or different amounts of dividends to different owners. We are going to be able to, instead of just calling it rental income for example, and showing up on a personal tax return, it may be that we have flexibility with respect to, “Are we going to pay ourselves via a dividend, a wage, a bonus, a short-term loan?” There’s I don’t want to say a multitude, but certainly more choices available in using that corporation.
We have further choices with respect to when are we going to pair ourselves? So yes, the corporation is going to have to record some taxable transactions unquestionably when those are earned. But we may be taking funds out of the corporation in our personal hands, maybe that fiscal year, maybe that calendar year, maybe an alternative year. Again, we’ve got more flexibility, more choices. We have choices in terms of the ownership. So maybe it goes beyond husband and wife, and maybe it’s going to include the next generation, or siblings. Or somebody is going to say something to the effect of, “Hey, I think it would be great if George and Peter were partners with me, I am going to ask them to become shareholders.” Whereas changing the shares can be much easier as compared to, “Oh, by the way, now we’re going to change the deed of the property, the mortgage agreement, et cetera.”, and the opposite is true.
So more likely somebody is going to say, “Hey, I’ve been working with George or Peter for a bit, now I need to get rid of them.” So again, much more easy to remove them from a shareholder register, as compared to the deed and the mortgage. So all of these things in terms of that flexibility is ultimately in many cases, going to result in hopefully some future tax savings. Whereas again, if were acquiring the properties personally… Not that it’s horrible from a tax perspective, I don’t want to pretend that. But we are locking ourselves into a methodology, if you will, of ownership that cannot easily be changed if we’re retaining that personal ownership.
Peter:
Yeah. With personal ownership, all we’re really doing at the end of the year as accountants is keeping score. “How much money did you make? Pay your tax on that. We’re done.” It takes a lot of the tools out of our toolbox to help you save money.
George:
Next area we look at is from a legal perspective. To emphasize, Peter and I are definitely not lawyers, we don’t profess to be, we don’t provide legal advice, et cetera. We strongly encourage people to seek qualified legal advice from real estate lawyers as compared to just an average lawyer, if you will. But I think we can make some general comments and that’s to say, through our experience, there’s a… I don’t want to say the majority, but quite a number of people that may be setting up a corporation just for legal reasons, or that’s their primary motivation. In that they’re looking for additional creditor protection, legal protection.
Again, best to talk to the lawyer in terms of how that can be done. I would certainly highly suggest that the corporation’s not going to be something that provides perfect protection, but it’s certainly a barrier that assists in that regard. So it is something where I think people need to kind of factor in what’s that almost cost of insurance to help protect some of those assets, help protect some personal assets. Again, best to discuss with their legal team exactly what that may look like in their particular situation.
Third area we look at, which may sound a little bit odd coming from accountants, but the third area we look at is tax. Although, we’re probably cheating on that first flexibility area was largely tax oriented. But on the tax side, again, a corporation may be good or bad for someone. What we frequently find however, is people are looking at the tax situation and they’re analyzing, “What’s the tax situation today?” As compared to, and Peter referenced earlier, “What’s the situation going to look like five, 10, 20 years from now, inter-generationally?” Because that corporation can be good or bad, it’s important to, in my mind understand some of the tax implications, some of the tax rates associated with the corporation. Many people have heard that if you are buying properties, you should not have a corporation because the tax rates so high.
Again, I’m just going to use average tax rates, appreciating that there’ll be slightly different for the various provinces. However, they’re all going to be in a relatively speaking tight bandwidth. So if somebody with a corporation is going to be initially paying tax at 50%, yes that’s a high tax rate, no question. However, if we compare that with the tax rate for someone who’s personally earning property income, if they are in a good tax bracket… Of course, they don’t even have to be in the maximum tax bracket, but they’re probably getting into the low 40%, and over 50% certainly possible in terms of their tax rates. A big contrast if we’re talking long-term whole rental income, or second mortgage income for example, is that as an individual if I pay my 50-ish percent tax, that money was gone forever. I’ll never see it again. Whereas, in the corporation of that 50%, roughly 30% is a refundable tax. So that my net corporate tax over time… and it could be immediate, but it may be more so over time, is going to be 20%.
I have an ability to pay out a dividend to one of the shareholders, that may be good or bad. But if I have a scenario where that individual is allowed to receive a dividends and they have no other source of income, it’s possible that they’re going to pay less than $2,000 in taxes on that $40,000 dividend. Or if I’ve got multiple shareholders again, we have to make certain assumptions in terms of qualifying for those dividends, but it can be a great and inexpensive way of receiving income. Such that, yes, it sounds bad at first 50%, but it can be a whole lot lower than that. it may not even be something where we’ll be looking to pay out a dividend to receive that refundable tax upfront. It may be, “I’m waiting for semi-retirement.” Or one of the parents, for example, to begin working for themselves or work full-time in real estate, or full retirement. Or ultimately as I’m accumulating my refundable taxes, we’re watching over that number on an annual basis, it’s accumulating.
Perhaps at some point in time, I’m going to sell my corporation and say to the purchaser, “Hey, there’s $5 million in refundable taxes in there. Why don’t we split that?” At least then from a tax perspective, the owners have gotten something out of it. A lost in time value of money, but if they did things personally, they lost it all in the first place. They never had a chance for that. So again, on the tax side for inactive income, not so bad. Peter, have a quick comment there?
Peter:
Yeah. Never look at the tax rates on a one year basis. What’s the overall tax you’re going to pay for holding the property for its entire life. That’s what you should be looking at. If one is better than the other, go with the one that’s better.
George:
Yeah. So that’s kind of part of it. So if we’re talking long-term real estate and now let’s talk active income. Which more traditionally we’ll see with respect to at least a component of a rent-to-own arrangement, flipping properties, development of sale properties. So here, we’re going to be taxed a little bit differently. Initially again, depending on the province you’re going to be tasked kind of in that 10% to 15% area, assuming that the profits are less than a half million dollars a year. It’s possible there’s a higher tax rate depending on the amount of investment income that’s earned. So once somebody starts earning more than $50,000 of investment income… there’s certain exceptions here… and gets over the $150,000 limit, yes, they’re going to be paying a little bit of a higher tax rate. Again, depending on the province that’s going to vary, and there’s a fair bit of variance there actually.
On the maximum side, they’re looking at paying somewhere in the neighborhood of say 26.5%. That can be thought of as either they’re passed that $150,000 investment income, or they’re past $500,000 in taxable income. But still at 26.5%-ish, that was a heck of a lot better than paying tax around 50% on the personal side. So you’ve probably still cut your taxes in half as a worst case scenario, if you were in a good size personal tax bracket.
So to suggest that someone is going to be worse off using a corporation from a tax perspective, I would suggest… I don’t know the exact numbers, but 80%-ish of the time, if there’s enough meat and potatoes there to justify the use of a corporation, we’re going to have an ability to save quite a bit. Let alone some of the ability to deduct some of the other costs often associated with investing. Whether that’s travel expenses, home office, professional development, things of that nature. That while in theory should be able to be deducted on the personal side, it’s just easier in a corporation ,receives less attention. At the end of the day, there’s less complications with Revenue Canada.
Peter:
I think what George highlighted in the last part there is if you are doing rent-to-owns or flips, and that is going to be a significant part of your income, I think I would say 99% of the time we’d recommend incorporating. That might be low at 99% of the time. Those are the two that I think there’s almost it doesn’t depend, you’re pretty much always going to do that. If it’s going to be a significant portion. If you’re doing a one-off, that’s a different story but it’s definitely something-
George:
Sorry. Maybe comment Peter, too just if they’ve got another business, for example, or a medical practice.
Peter:
Sure. Absolutely. If you’ve got an existing business like George said, medical practice, engineering firm, whatever the case may be, and that’s going to fund the real estate purchase… even if it’s not, we can still work around that. But if you’re going to buy real estate and you’ve got this, your business income… I would say again, 100% of the time you’re going to incorporate your real estate business. A, from a legal perspective, but B, from the tax savings. Basically, the way the tax savings are going to work, so if you buy it personally, you’d have to take money out of your corporation to fund the down payment, pay the 50% tax.
As opposed to a proper structure, we can lend money across to a new real estate company from your business company. You’re only paying that 12.5% tax or approximately 12.5% tax here in Ontario. So your down payment instead of on 50 cent dollars, you’re using 87 and a half cent dollars. That goes a lot further and it makes total sense. So if you have an existing business, I’d say it’s also probably 100% that we’d recommend incorporating.
George:
Fourth theory, we’ll look at is from a finance perspective. Again, Peter and I don’t want to try and pretend that we’re mortgage brokers, or bank professionals, et cetera. But it’s not like we haven’t bought a property before. We’ll have quite a number of people come to us and say, “Well, it’s impossible to get financing through a corporation.” Or alternatively, “The terms are so much more challenging.” Whether that’s kind of the interest rate itself, the conditions, the amount of leverage that you’re allowed to obtain. I guess the quick comment to that is to say one, I don’t believe it. I acknowledge that it’s more challenging, no question, but there are certainly solutions available. Certainly, there are solutions that don’t cost an arm and a leg.
Then let’s go back to, okay, maybe there is a bit of a premium that’s involved here. Let’s start contrasting that then with the tax savings as an example that are available. So now we can make a business decision with respect to do we want the tax savings, or do we want perhaps a slightly lower interest rate. More frequently? I would suggest Peter and I are in scenarios where someone has acquired four or five properties personally, and they’re really struggling to get those next properties. Again, they’re practically speaking, being forced to use corporations.
So somebody that’s going to go out there and they’re going to acquire two or three very small properties, that’s it for the rest of their lives, maybe you don’t need a corporation. Maybe that’s perfectly fine. But if you’re going to be acquiring a number of properties, and you are looking to have over time an expanded portfolio, I think it would be inappropriate not to be exploring the corporate use rate at the beginning. And checking out, “Maybe I need to be talking with somebody else on the financing side”, talking to George and Peter. “Okay. Maybe I’m struggling with who I should talk to. Who can help me out?” Talk with some of the fellow investors. This is not something that is unique to a particular area. Peter and I experiences again very, very frequently, and one of our biggest complaints I would suggest. Is that fair, Peter?
Peter:
Yeah, absolutely. I would also say, if you’re looking to buy multifamily, if you’re looking to buy apartment buildings, six, eight, 10 plexes, and above banks are going to say, “Put it in a corporation.” I think they want it in a corporate structure. I don’t think they want it, personally. Most bankers that we talk to recommend putting it in a corporation for multi-families. Would you agree with that, George?
George:
Absolutely. The couple of the, what I would suggest are better mortgage brokers are going to stay the same. They steer their clients they’re right at the beginning. I acknowledge again, if I’m going to go buy that white picket fence house for my own personal use? Sure. The corporation probably has no business being anywhere near the discussion points. Or again, if I’m acquiring one or two properties, it’s hard to imagine many scenarios where the corporation’s worthwhile. But if I’m a serious investor looking to acquire, I don’t need to acquire a whole lot at the beginning, but certainly nicer to start off that way. It makes it easier for me down the road.
The last area that Peter and I look at towards trying to help advise somebody whether to create that corporation or not, is more of what I’ll call the organizational business perspective. It’s a bit more loosey goosey admittedly, in terms of how we’ve phrased this, but just from what I’ll call general perspective. If someone is going to be presenting themselves to other investors, vendors, whomever, I would suggest that their image looks slightly different, whether they have a corporation or not. That can be good or bad. I think people also can find it easier to organize themselves in using a corporate structure. In the sense of, they may for example have their rent-to-owns in Company A, their properties in Ontario, in Corporation B, the properties in Nova Scotia, Company C, some flips and Company D. They don’t necessarily need to start off that way and have all of these companies, but they can kind of grow into something.
Whereas admittedly, other people will kind of like to see the whole picture in front of them, and having personal ownership where they can’t compartmentalize. That may suit their preferences at the end of the day. I think with any of these one through five areas that we’ve talked about, again, as Peter alluded to at the beginning, it’s not that one is right or wrong. It’s more that different people will place different weightings or importance on one of those factors versus another. So in my own case, yes, I admittedly placed a little bit more importance on the legal and the finance side. The tax savings that I obtained, it’s icing on the cake. Don’t get me wrong I don’t want to ignore it, it’s important in my planning. But it may not be what drives me. So everybody’s going to have something separate that drives them.
Maybe, Peter, you can talk a little bit about moving past this three-tier structure now. Sorry, I meant moving past the corporates situation in terms of, we hear a lot about this three-tier structure and have a number of clients, as you know, that are potential clients that are coming to us, talking about a three-tier structure. So maybe what is the three-tier structure, and what are we doing with that?
Peter:
Sure. Thanks, George. So I would say, the three-tier structure used to be our bread and butter, cookie-cutter… Not cookie-cutter solution, but our bread and butter solution for a majority of our clients up until 2017, 2018. We probably used those 90% of the time. What I will say is we don’t use those anymore, from a number of reasons. One, tax rules that were implemented in 2018 have changed the effectiveness of the three-tier structure.
Two, and we hear this from a lot of different financial institutions, they just don’t like it. They don’t like the three-tier structures. And if you don’t know what the three-tier structure is, it’s basically you have real estate co, or a parent company that owns real estate company and a management company. And the management is the property manager for the real estate. And it charges a property management fee. I would say, we recommended it a couple of times in the last year. Would you agree with that, George?
George:
Yeah. Maybe a touch more, just in the sense of it can work in some isolated case where, for example, we have some other business activity that’s perhaps non real estate oriented, or they’re just flipping properties.
Peter:
Yeah. Or they’re doing property management to outside investors, not just their own property. We see that. So we’re just not recommending it. You lose the GST/HST, because if you’ve got $30,000 of property management fee, you do have to charge HST/GST, and you don’t recover the ITC, the input tax credit on the real estate side. Yeah, you can get a tax deduction, but it doesn’t work perfectly. And so we’re not recommending that. What we’re recommending a lot more is a real estate company owned by a family trust. And George will get into a quick high level discussion of what the benefits are of using a family trust.
George:
Yeah. And just to clarify with the GST/HST, of course, Peter’s referring to where we’ve got used residential property, and we’re renting that out on a, what I’ll call a normal or longer-term basis.
Peter:
Thank you, George.
George:
But in terms of the family trust. Again, we’re going to have this as a separate episode as well, in terms of exactly what it is. But in a very, very loose definition, I’ll describe it as in a traditional sense, an opportunity for mom and dad to be able to control assets, control income, but not to own the assets themselves. Technically, it’s not mom and dad, but it’d be the trustees of this trust, which is going to hold assets, often shares of other corporations, which are set aside for the beneficiaries, which often will be basically mom and dad, kids, grandkids. And these relationships, the grandkids, or even flat out the kids may not even be born yet, but we’re identifying who, down the road, may receive assets.
And so there’s a host of legal and tax reasons why we like using the family trust. And as Peter said, it’s largely replacing the three-tier structure, and there’s a few different versions of that three-tier structure. But replacing those three-tier structures, such that I think that over the next five-ish years, we’ll have the majority of our clients using family trusts. And as Peter alluded to, or stated outright, back in 2018, my family trust was created for the same reason, as a result of prior tax changes and the finance changes that came into play. And we’re just seeing more and more of that with our clients and prospective clients as well. But stay tuned for a future, more involved description there about family trust.
And I guess, one of the last things we should touch on too, is we’ll frequently get the question of when should I set up the corporation? And so there’ll be some common advice out there in terms of, well, wait until you have a few properties, then you’ll have enough meat and potatoes to get it set up. But the problem, quickly, people find out is if that’s the strategy that was chosen, they come to Peter and I. And all of a sudden, they’ve got their three properties. We decide that the corporation is best, and we should transfer the existing properties to the corporation. Well, there’s a lot of costs and aggravation, if you will, associated with that transfer.
So basically, we’ve sold those properties for fair market value to the corporation. We’re either going to pay tax on to that. Or alternatively, there’s a methodology that’s usually available in most cases, for us to do a tax deferred transfer to the corporation. But the lawyer’s involved, the accountant’s involved, Revenue Canada’s involved, and everybody’s filling out paperwork, and guess who’s paid for that paperwork?
Plus, depending on the province we’re speaking of, we may have land transfer tax. We may have to deal with the financial institution, if there’s a mortgage on the property. We’ve got a lot of balls in the air, where if we would have just purchased the property using the corporation on day one, even if it was slightly under-utilized for a couple of years, that was far cheaper than paying the transfer costs after the fact.
Again, it’s more important, as Peter started off with, where are we going to be down the road, not where are we today, in terms of defining when we should be using the corporation. Let alone, if we should be using the corporation. So I think both are serious considerations. And it’s not to say if we’ve already acquired a handful of properties personally, that we should be nervous about going to have the discussion with Peter and I. It’s to say, the sooner you have that discussion, ultimately, the more effective your dollars are going to be.
Any further comments, just in terms of overall there, Peter?
Peter:
One last thing, just also remember, a corporation is a separate legal entity. It will have to file its own corporate tax returns and financial statements every year. It is a little bit more expensive to run a corporation than personal return every year. There’s no question to that. But remember, it is a separate legal entity and you do need to file separate tax returns for that corporation.
George:
Excellent. Yeah. So there’s some costs to doing that, and Peter and I can certainly describe those in pretty good detail, and make that a relatively obvious part of the discussion when we’re going through analyzing for yourselves, should you or should you not incorporate?
With that, we should also reference, Peter, we’re going to have an episode that specifically goes through a handful of case studies, in terms of applying these five rules or areas of consideration, so that people can get something a little bit more tangible out of that. So again, feel free to link into that discussion, and we look forward to talking to you again. Thank you, everybody.
Peter:
Take care, and have a great day.
To contact Peter or George you can email pcuttini@bdo.ca or gdube@bdo.ca.
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