Wednesday, January 7, 2015

Top tax tips for real estate investors

Incorporating your property business makes sense when...

Just because you can incorporate, doesn’t mean you should — and vice-versa. Weigh the advice of several professionals – a lawyer, an insurance agent, a lender and an accountant. But be forewarned: they will have different opinions and you will have to sort through that advice to make the decision that’s right for you and your business.

Overall, income from passive sources, including rental income, is initially taxed at the highest rate; about 46 per cent depending on the relevant province. This can be reduced to approximately 20 per cent where dividends are paid to shareholders. Due to the tax-favoured treatment of dividends, these dividends may generate little or no personal income tax, but may be subjected to taxes at the rate of approximately 30 per cent, depending on your income and province of residence. This potentially creates double taxation.

Active income is income from businesses such as retail, restaurants, professional practices, developers and rental income in a corporation with more than five full-time employees amongst associated companies. The first $500,000 of taxable income from these businesses is taxed at the low rate of corporate tax (about 16 per cent, depending on your province, although some provincial limits increase at $400,000).

Beyond the general tax rates, a wide assortment of other tax issues will be revealed during your conversations about incorporation with your accountant. The most important thing to remember here is that your situation is unique and demands a unique approach.

There may be tax implications to refinancing an investment property
When you refinance a property you own personally, the interest you paid on the loan may or may not be deductible. It depends on what you used the funds for. If they were used for personal use, the interest is not deductible. On the other hand, if you used the money for qualified investment purposes, the interest will be deductible. The funds received on refinancing will not, however, be taxable.

In a corporation, these mechanics change. Here, if you take funds out of a corporation, they may be taxable regardless of how you use them. Here is an example of how this works, using a property purchased at $1 million as an example.
  •     Purchase price: $1 million
  •     A partner pays a down payment of $200,000, plus an extra $50,000 for renovations
  •     The original mortgage amount: $800,000
  •     Your investment: $ 0

Once renovations are complete, you have the property appraised and your numbers look like this
  •     Property value $ 1.5 million
  •     New mortgage $ 1.2 million
  •     Pay out old mortgage $800,000
  •     Cash left: $400,000

Let’s say at this point you meet with your partner and decide you will pay back your partner’s original investment of $250,000, with the balance of $150,000 split between you ($75,000 to each). The original $250,000 being paid to the partner is not an issue. It is paid back on a tax-free basis as that was his original shareholder’s loan. The $75,000 becomes a dividend to each of you. Normally, you would pay tax on this amount.
You may be able to get some corporate taxes refunded as a result of paying these dividends, but talk to your accountant first. It is much easier to make adjustments to business decisions before a transaction takes place.
  •     Figure out how to make the mortgage on your home tax deductible

You can make the mortgage on your home tax deductible. Sometimes called the Smith Manoeuvre, the strategy actually takes several forms.

In the basic version of a typical plan, you may have, for example, a house with a value of $200,000. Say the outstanding mortgage on the residence is $120,000. In many situations, it will be relatively easy for you to obtain a mortgage of at least $150,000 on this property (75 per cent loan to value). You could also obtain a mortgage product from various institutions, which allows you to effectively place a mortgage and /or line of credit on the property for $150,000. That would be tracked in at least two segments. In one segment, the bad/non-deductible mortgage would equal $120,000. The good/investment line of credit would be available for the difference between $150,000 and the outstanding “bad” debt, initially $30,000 in this example. As you make payments on the “bad” debt, the amount you have available to borrow and invest with increases — although the total is never more than $150,000.

This means you could invest in real estate, mutual funds, your corporation or other qualified investments and receive a tax deduction for the interest related to the “good” debt. These tax deductions then provide you with more cash flow, which, in turn, can be used to pay off more “bad” debt and increase the “good” debt.
  •     Documentation is key to deducting interest

The rules related to interest deductibles can be confusing, but a recent Supreme Court of Canada decision offers some clarification. In January 2009, the Supreme Court confirmed in the Lipson case instances where the interest charges on mortgages for a rental property itself are deductible, as is the interest from other loans, provided certain conditions are met.

One of these conditions relates to maintaining the ability to trace the source of the borrowed funds to an eligible investment. Structuring your financial affairs correctly may allow you to deduct more of your interest costs, thus saving more money.

More specifically, Canadians are allowed to deduct interest charges where they use a line of credit, second mortgage, or separate loan to pay for a portion of a property’s deposit or various operating expenses related to the property. These expenses can include repairs, utilities and property taxes. The key is being able to trace the payments from the line of credit to the property. Ideally, a separate line of credit is used wholly for investment purposes. Where you require a line of credit for personal use, this should be done with a separate account. This ensures you do not mix amounts spent on your vacation or big-screen TV with those related to your investments.

A variety of financial institutions have debt products which allow you a total amount of debt and then divide this total into multiple accounts you have created. Over time, it may also be possible to restructure your debt so that even otherwise non-deductible interest can be converted into fully deductible interest. To make sure you can take advantage of deductible interest, talk to your tax adviser about what you can do to deduct as much of your interest as possible — and in a method that is acceptable to the CRA.

Don R. Campbell is a bestselling author, investor, researcher, and founding partner of the Real Estate Investment Network. This column is an excerpt from his book, 81 Financial and Tax Tips for the Canadian Real Estate Investor: Expert Money-Saving Advice on Accounting and Tax Planning.

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