Investing in Real Estate

Tax and Legal Issues

This is a brief overview of some of the tax and legal issues which a person should consider before acquiring a real estate investment. These comments relate to a real estate investment which generates rent or lease income and does not necessarily apply to real estate development or "flipping" real estate.

Ownership Issues

Before investing in a revenue property, you should consider how the revenue property will be owned and how it will be taxed and the legal consequences that flow from that.

The most common vehicles for owning a revenue property are individual ownership, ownership by a partnership or ownership by a corporation.

Ownership by an individual or partnership is taxed differently than ownership by a corporation. For example, a net rental loss (for income tax purposes) of an individual or a partnership is deductible from other sources of income and reduces your overall tax liability.

On the other hand, a net rental loss of a corporation must stay inside the corporation and cannot be used personally. A corporations net rental loss can only be offset against corporate income.

However, when it comes to losses, be aware that if your real estate investment does not have a reasonable expectation of earning a profit, Revenue Canada has the power to disallow the losses.

When the revenue property is ultimately sold, there may be a gain or there may be a loss on your investment. If the value of your investment has dropped and you have a capital loss, that capital loss can be used by you to offset any future capital gains you have. If the capital loss arises in a corporation, it can only be applied against other capital gains of the corporation.

By and large, the tax system is designed to eliminate the tax advantages of owning an investment property through a corporation. In fact in some cases a corporation will actually result in more tax being paid than if owned individually (or in a partnership).

The primary tax advantages of owning a revenue property through a corporation are for persons who are in the highest tax bracket. For such persons, there is a slight tax deferral advantage by using a corporation. A corporation can also be used to control income for the purposes of the tax "clawbacks" and can also be used to convert investment income into salary income eligible for R.R.S.P. contributions.

Corporations can also provide a greater measure of flexibility and creativity for estate planning purposes and can also be used for a certain amount of income splitting amongst adult family members.

Another possible advantage of corporate ownership is that a corporation enjoys limited liability which may protect your personal assets from liabilities which relate to the operations of the corporation.

To take advantage of a spouse or other family member who is in a low tax bracket, some people try to structure ownership so that the net rental income is earned by the person in the lowest tax bracket. This reduces the amount of tax owing.

However, the tax system has a number of "attribution" rules to limit how this is done. For example, if you purchase a revenue property in your spouse's name because your spouse is in a lower tax bracket than you, you must ensure that your spouse has a personal source of funds to purchase the property. To the extent that you pay (or guarantee a mortgage), Revenue Canada can attribute the net rental income back into your hands.

Similar rules apply for children and grandchildren under the age of 18.

If you have an adult child who is in a low tax bracket, it may be possible to avoid the attribution rules described above but you should also consider the legal consequences. If you give or loan funds to an adult child so that they can purchase a revenue property, the investment will be at risk in the event of a marital breakdown of that adult child or financial difficulty of that adult child. These risks can be minimized by way of mortgage security.

If you acquire a revenue property with another relative (such as a brother or sister) or with a friend or business associate, consider what will happen if you have a falling out. For example, what if one of you wants to keep the property and one of you wants to sell. How will the buy out occur and at what price. What happens if the other person dies? Will their estate require the cash right away? What happens if you cannot agree to renovations or repairs? What if there is a loss?

All of these matters should be addressed in a comprehensive Ownership Agreement. A good Ownership Agreement should minimize the problems that arise on a disagreement.

Lastly, before you make an offer to purchase a revenue property, consider the allocation of the purchase price between the different assets for income tax purposes. A revenue property typically consists of land (which is not depreciable) and building (which is depreciable but at a low rate) and equipment and possibly furniture and appliances (which is depreciable at a higher rate). Generally speaking, a purchaser will prefer to have a high allocation to depreciable assets because depreciation can be claimed as an expense each year (but cannot create a loss). Revenue Canada will accept an allocation agreed to between a vendor and a purchaser as long as it is not unreasonable.

Summary
Before you purchase revenue property, consider the following questions:

1. Who will be the owner or owners of the property?

2. If more than one owner, what percentage will each owner own?

3. If a corporation is the owner, who will be the shareholders and directors of the corporation?

4. How much cash will each owner contribute?

5. How much of the purchase price will be financed?

6. Who will provide the financing and will any guarantees be required?

7. What is the expected net rental income (loss) for the next three years?

8. What will be the tax consequences of the net rental income (loss)?

9. If there are net rental losses, is there a reasonable expectation of profit?

10. What will be the tax consequences on resale of the property?

11. Will all of the rental expenses be deductible for income tax purposes (in particular mortgage or loan interest and capital cost allowance)?

12. What should the allocation between land, building and equipment and other assets be for income tax purposes?

This column is not legal advice and a lawyer should be consulted on any specific case.

By Tom Fellhauer