In the news | Espace | Vincent De Angelis | Navigating the Tax Maze – The Entrepreneur and Real Estate
Authored by Vincent De Angelis, CPA, CA, Partner, Richter
With contributions by Harvey Sands, CPA, CA, ICD, Consultant, Richter; Jenna Schwartz, LL. B., B.C.L., Vice-President, Richter; and Katherine Borsellino, LL. B, J.D., LL. M. Fisc., Senior Manager, Richter
As originally appearing in Espace Montreal, volume 30, #3, 2021.
Real estate is often an investment category that attracts successful business owners, irrespective of where and how they accumulated their wealth. Real estate properties, whether residential, commercial, or industrial, may be viewed by many successful business owners as great investments as well as great trophies. They are tangible assets and can be viewed as both annuities (in their ability to generate annual net operating profits) as well as wealth generators (as they tend to appreciate in value given the limited supply of lands). Certainly, these properties can be viewed as transferable from generation-to-generation if the proper asset and property manager are engaged in the life cycle of the real estate.
There are numerous income tax implications worth exploring in order to understand the potential real estate profits, after income taxes and cash flow realizations from after-tax net operating income. These depend on multiple factors being, whether that real estate is considered a passive investment, is more of a “business” or is connected with an existing operation as well as whether that investment has a long or short term holding horizon. These concepts are discussed in this article, throughout the life cycle of owning a property. With that in mind, we would like to emphasize that the exercise of evaluating these income tax implications is not a one-time event. As expectations around real estate properties change over time, whether as a consequence of changing market conditions or simply in an effort to repurpose an existing property, so does the income tax burden.
The impact of the pandemic on Canada’s federal and provincial economies and the looming accounting and fiscal management of record pandemic relief driven deficits will certainly further impact the taxation of investment income and capital gain realizations. Consequently, taxation and risk management must be considered in asset acquisition and portfolio management.
Real Estate Rentals
In sourcing funds for such investments, the entrepreneur may be able to use wealth that has accumulated in a corporation. At the time of acquiring real estate, legal structuring questions arise. Should real estate properties be accumulated in one single corporation, multiple corporations, in partnership or in joint venture, with other co-owners? Who and what property managers will be engaged to oversee the property, and will those managers be employed or contracted in a separate entity? As well, critical to these considerations is the benefits of income earned being qualified as business income or investment income and the consequential difference in the tax rates applicable to each.
Each decision taken will have an income tax impact. Understanding what issues influence the tax burden may help in maximizing profits, after income taxes. As there are a multiple of combinations of entities and legal structures, for the remainder of this article, we will assume a homegrown Canadian entrepreneur will set off in real estate acquisitions using a Canadian corporation to buy Quebec based real estate in 2021.
If the real estate acquired is there to generate rents, the Canadian corporation may be subject to a variety of income tax rates to be applied against its profits. In a base case where the company generates net operating income and that company has minimal employees, it will be subject to a high rate of corporate income taxes. This high rate is intended to mimic the rate of income tax as though the rents were being earned directly by the individual shareholder. As an example, an individual resident in Quebec that earns net operating income will be taxed at the highest marginal income tax rate of 53.31%. If a corporation earning certain rents is subject to the high rate of income tax corporately, its income tax rate will be 50.17%.
This higher corporate income tax rate of 50.17% includes in part a temporary corporate tax administered by the federal government. Once the corporation pays a taxable dividend to distribute its after-tax earnings to its shareholder, the corporation may be entitled to a tax refund. This has the effect of reducing the 50.17% income tax rate applied against the profits of the corporation to 19.5% once the refund is factored. Assuming the dividend is paid by the corporation to the individual entrepreneur, the personal income tax rate to apply on the dividend would be 48.07%. Working through the math, at the end, if the corporation earns $100 of net operating income, this would leave $41.84 in the pocket of the entrepreneur, after distribution by the corporation. In fact, this is less than what would remain with the entrepreneur if the net operating income were earned personally, absent the benefit of the deferral of income taxes. Overall, the difference represents a cost of earning passive income in a corporation in the medium term.
If the management of the corporation earning rents is such that the corporation employs more than five full time employees, there is a reduction of the corporate income tax rate. This “more than five full time employee” test appears to be the tax legislator’s view of when a rental property ceases to be a simple passive investment and moves to a “business” of sorts. The corporate income tax rate then moves from 50.17% to 26.5%. This material difference in corporate rates compounded year-to-year may provide the entrepreneur with the opportunity to hold on to more retained earnings and deploy those retained earnings in additional real estate acquisitions.
Although the “more than five full time employee” test may appear to be a bright red line test, several court cases matching the tax authorities against taxpayers have transpired. For example, questions that have been addressed by the courts include if a property is held in a co-ownership, can each owner claim its respective portion of the employee in its count? How many working hours makes an employee a full-time employee?
Likewise, other carve outs apply to the “more than five full time employee” test. For example, if a company is charged a fee from a company within the same corporate group and it is “reasonable to consider” that that fee is equivalent to having more than five employees, the company may still achieve the lower corporate tax rate. In addition, if rents are charged by one company to another company in the same corporate group and that company carries on an “active business”, the company may achieve the lower corporate tax rate on that income.
Finally, varying the shareholders of a corporation may impact the income tax rates applicable to the company. This may be the case where a co-shareholder of a company is a non-resident of Canada. This issue is a consideration during the structuring of property ownership that requires attention.
Managing the corporate tax rate is an important task, as lower income taxes equate to quicker corporate wealth accumulation. Managing year to year the corporate rates is a fundamental component in generating wealth for the entrepreneur real estate investor.
Change of Purpose
The global Covid-19 pandemic is an example of an event that shifts the purpose of real estate. It is not extraordinary to consider properties moving from commercial rental to residential condominiums. This will impact intuitively the rents earned as the commercial leases are wound down or are bought out to prepare for a repurpose of the properties, but also the taxability of any appreciation in value of the real estate properties itself.
As most people are aware, the income tax rate on capital gains is favorable in Canada. To expand on this, a capital gain is determined by simply taking the fair value of the property less the tax cost of the property and all costs to dispose of the property. Capital gains attract a 50% inclusion rate to a taxpayer’s income. In terms of Canadian corporations, that equates to an effective tax rate of 25.1%. In the context of a Canadian corporation, it may also contribute to a company’s “capital dividend account”. This account is increased by 50% of any capital gain realized by a corporation. It allows a shareholder to extract corporate funds without incurring personal income taxes up to the balance in this account. Given the tax advantages, capital gains are a treatment sought after in managing the ownership of a real estate property.
If an appreciation of value of a property does not qualify for capital gain treatment, it will be taxable at a corporation’s normal active rate of 26.5% (if revenues exceed $500,000). This tax on profits does not generate a balance in a company’s capital dividend account.
Whether an ultimate sale of real estate assets is a capital gain, or alternatively, simply ordinary profits, is a question of fact. There is clearly no bright line test in making this determination and it is essential to look at the history of the property to make this determination. What was the buyer’s intent in acquiring the property, to generate income from it, such as rents, or to generate income with it, such as on a quick sale of the property itself? What was the holding period of the of the property? What is the expertise of the entrepreneur? Certainly, some cases are clearer than others, as is the case where a rental property held for decades is simply sold right out to a buyer. Other cases are more complex and require a review of the countless court cases that have passed before the courts.
Changing the purpose of the real estate property during its ownership may impact how the appreciation in value will be taxed on the ultimate exit. It is important to safeguard capital gain treatment given its preferential tax treatment. To continue with the example above, if a property moves from rental to development with the ultimate objective being condominium sales as the end game, accumulated appreciation to that point may be placed in jeopardy. The Canada Revenue Agency administratively does provide some relief to safeguard the capital treatment up to the change of purpose. This relief must be understood and applied with caution.
Sale of Real Estate
Whether to upscale or realize on a great opportunity, the sale of real estate can attract a material tax liability, whether the exit generates a capital gain or ordinally corporate profits. If the real estate property was purchased for rental income, there undoubtedly was a year-to-year claim for the cost of the building in the form of tax amortization. This amortization may be subject to a “recapture” and therefore subject to income tax. If the company had historically been subject to the higher passive tax rates on its annual income, this recapture of tax depreciation will now be subject to tax at the same rate (being the 50.17% mentioned above). The alternative is also true; that is, the active rates on the recapture will apply if the property was historically subject to active corporate rates (being the 26.5% mentioned above).
As shown throughout this article, there are immediate and long-term benefits for properly managing the income tax implications of owning real estate. This means careful attention must be continuously paid to structuring and monitoring the activity of the entrepreneur and their real estate portfolio to allow for the maximization of after-tax net operating income and the accumulation of wealth.