Cherry Chan Your Real Estate Accountant

Save $1000s in Tax Liabilities with the Proper Share Structure in Your Real Estate Corporation

Hello fellow real estate investors,

The Year of the Goat, Chinese New Year 2015.

Happy Chinese New Year everyone! It is the year of Goat in 2015. Our family wishes everyone a happy and healthy and prosperous year of Goat.

Believe it or not, according to this Astrologer from Fortune.com, the real estate market and real estate investments are going to be stable and perform consistently.

Yay to all real estate investors!

As I mentioned previously in my blog, real estate corporations can be used to save you thousands of dollars of taxes when setup properly.

If you’re thinking, “A corporation is a corporation is a corporation, how can it be setup incorrectly?”

Standard corporation setup without the contribution from a professional accountant usually has standard one class of shares, owned 50/50 by a real estate investor and the spouse.

However, one of the strategies to use corporation to save you thousands of dollars is to split some of the income with a lower income spouse and/or your adult children.

If the corporation is setup properly, it should be allowed to offer multiple classes of shares. Each class of shares is owned individually by you, your spouse and/or your children.

Using an example to illustrate, in a standard corporation setup with only one class of shares, Mr. Investor and Mrs. Investor both own the same class of shares, 50/50.

When $50K dividend is declared, Mr. Investor and Mrs. Investor would each be required to report 50% of the $50K, i.e. $25K dividend income each, on their respective personal tax return.

Mr. Investor might have just decided to take a year off from work, but Mrs. Investor is still making 6 figure salary. Mr. Investor is likely able to receive this dividend without any tax liability, assuming he has no other income. But with this additional $25K dividend income, Mrs. Investor would still need to pay a significant amount of tax, roughly $10K.

On the other hand, if the corporation is setup properly, Mr. Investor owns class A shares, Mrs. Investor owns class B shares, and Junior Investor owns class C shares.

With this structure, the real estate corporation can declare the $50K dividend to Class A shareholder, Mr. Investor, who is on a year no pay leave, will report the entire $50K of income. He is then responsible for roughly $2,900 of tax liability. Mrs. Investor, who is the Class B shareholder, is not entitled to any dividend, and hence no dividend income is reported on her tax return.

With the proper shareholding structure, it can save you $7,100 tax liability.

And this is the power of owning properties in your corporation!

Of course, beyond the income tax splitting strategy, there are also other considerations an investor should take into account when structuring the corporation shareholding.

One of the most important factors is control of the company. Are you willing to give some control to your kids? If not, what can you do? You will definitely have to consult your professional advisor.

Until next time, stay warm and have a great year of Goat!

Cherry Chan, Your real Estate accountant

This site provides general information on various tax issues and other matters. The information is not intended to constitute professional advice and may not be appropriate for a specific individual or fact situation. It is written by the author solely in their personal capacity and cannot be attributed to the accounting firm with which they are affiliated. It is not intended to constitute professional advice, and neither the author nor the firm with which the author is associated shall accept any liability in respect of any reliance on the information contained herein. Readers should always consult with their professional advisors in respect of their particular situation.

/0 Comments/by Cherry

Other tax issues, Real estate investment, Real estate rant

How to Look at the ROI on Your Investment Property the Right Way

Recently, I had a few discussions with clients that complained about not getting sufficient cash flow from their investment.

Cash flow may be one measure to evaluate your investment return, but you also need to take into account 2 other components:

Mortgage paydown
Capital appreciation of the property.

Some investors also forgot about power of leverage. I feel compelled to share this calculation below with you.

Let’s use an example to properly illustrate the calculation of investment return.

Purchase price of the property: $250,000

Downpayment: $50,000 (20% downpayment)

Closing cost: $5,000 (including legal fees and land transfer tax)

Renovation cost: $10,000 (including HST)

Annual mortgage paydown: $3,500

Monthly cash flow: $100

Annual appreciation: 5% in the neighborhood

Year 1:

You just purchased a rental property, located in a great location, close to public transit and malls. You even manage to rent it out before closing. Now closing time comes, you did your calculation, you have invested a total of $65,000 (Downpayment $50,000 + closing cost $5,000 + renovation cost $10,000).

At the end of year 1, as you are preparing your tax return, you would like to know how much return you have made. Here is the calculation –

Initial investment : $65,000

Mortgage paydown : $3,500

Annual mortgage payment including interest : $10,200

Annual cash flow (assuming rented out for 12 months) : $1,200

Total return in dollar value : $3,500 + $1,200 = $4,700

Cash on cash return : $4,700 ÷ $65,000 = 7.23%

Appreciation : ($250,000 + $10,000) × 5% = $13,000 (assuming the renovation you did only brought the value up by the cost of renovation conservatively)

Total return in $ value = $4,700 + $13,000 = $17,700

Return on investment if you were to sell it at end of year 1 : $17,700 ÷ $65,000 = 27.23%

Note that calculation above did not take into account the cost of selling the property.

What kind of investment products would allow you to make this type of return other than real estate? $100 monthly cash flow may seem like a small amount, but cash on cash return alone (just by collecting rent and paying down the mortgage) would allow you to earn 7.23% on your investment. Appreciation can bring up your return all the way up to 27.23%! Property investment can be a tricky business for those who are interested in taking it up, luckily there is information out there for those who are interested in taking up this type of investment. If you are interested in finding out more about property investment, you might want to check out somewhere similar to DST Properties to find for more.

Isn’t real estate amazing?!

Of course, I have to caution everyone that this calculation has not taken into account the tax cost. You do have to pay tax in this 27.23% return on investment.

Year 2:

It is year 2. Everything went on smoothly. At the end of year 2, it is time to your real estate investment again! We are using the same amount for mortgage paydown and the annual cash flow to keep things simple. So for year 2, the cash on cash return is 7.23% as well. (See cash on cash return calculation above).

But cumulatively, your cash on cash return for both years now become 14.46% (($4,700 + $4,700) ÷ $65,000).

Value of property at the end of year 2: $260,000 × 1.05 (Year 1 appreciation) × 1.05 (Year 2 appreciation) = $286,650

Total appreciation in 2 years: $286,650 – $260,000 = $26,650 (Year 1: $13,000, Year 2: $13,650)

Return on investment for 2 years combined: ($26,650 + ($4,700 + $4,700)) ÷ $65,000 = 55.46% (average per year 27.73%)

Of course, you can use the same way for calculation for Year 3 all the way to the year you decide to sell your property!

This calculation just goes on to show that you $100 cash flow may seem small, but it is not as small as you think!

If you weren’t able to borrow and choose to purchase the property all in cash, your initial investment would have been $265,000. Year 1 Cash on Cash return is 4.30% (($10,200 (No mortgage payment to pay) + $1,200) ÷ $265,000). Year 1 return on investment would have been 9.21% (($13,000 + $10,200 + $1,200) ÷ $265,000). Still not bad, just slightly lower than 27% if you were to borrow 80%.

The example above shows you the power of leverage. Because you are able to borrow to purchase the property but capitalize on the full appreciation on the property, your return is significantly higher.

And of course, the more leveraged you are, the more risk is involved, also the less your cash flow would be!

Until next time, stay warm and happy investing!

Cherry Chan, Your Real Estate Accountant

This site provides general information on various tax issues and other matters. The information is not intended to constitute professional advice and may not be appropriate for a specific individual or fact situation. It is written by the author solely in their personal capacity and cannot be attributed to the accounting firm with which they are affiliated. It is not intended to constitute professional advice, and neither the author nor the firm with which the author is associated shall accept any liability in respect of any reliance on the information contained herein. Readers should always consult with their professional advisors in respect of their particular situation.

/2 Comments/by Cherry

Other tax issues, Real estate investment, Real estate rant

Earn Money by Preserving the Principal Residence Exemption Status of Your Home!

As real estate investors, I would assume the majority of us have read the book Rich Dad Poor Dad written by Robert Kiyosaki. It was the book that changed my life and my perspective on money.

Being a Chartered Accountant, I was blessed to make a decent living right out of university. From my early days as a co-op student to a full time position, I had never needed to worry about getting a job with decent pay.

Thanks to my parents, I was debt free since I graduated. Being able to make a decent living with limited expense early on helped me with the purchase of my first residence – a condo in Richmond Hill. From there on, as I progressed through the corporate ladder, I made more money. I got a nicer car and a bigger home. I was the classic ‘middle class’ described in Rich Dad Poor Dad. This was when the problem came in. I started noticing that I had no money in my bank account. I lived pay cheque to pay cheque.

Wealth is really measured by how long you could live without getting a paycheck. It was zero for me at the time.

Robert Kiyosaki said that, “assets produce income whether you work or not.” It was then I realized, my nice car was a liability, my executive Toronto townhouse was also a liability!

None of these assets are producing ANY income for me.

It took me a while to make changes in life. We refinanced the townhouse to purchase our first student rental. We have also rented out the townhouse for a great rental return. And, we live in a detached home with a walkout basement, which is currently rented out to a tenant.

We turned the majority of these liabilities into money producing assets.

Many investors, who are like us, have rented out their basement to generate extra income.

That got the accountant in me to start thinking, “Would that affect the status of principal residence exemption in Canada Revenue Agency’s eyes?”

For a property to qualify as principal residence (and hence the gain on disposition is tax exempt), the taxpayer or taxpayer’s family (spouse or child) must “ordinarily inhabit” in this particular property. A family unit can only claim one property as the principal residence in any given year generally speaking.

If you live in the house and you rent out your basement, this is considered a partial change in use in CRA’s eyes. If you have undergone a structural change to section off the space for income producing purpose, the Income Tax Act provides for a deemed disposition of this converted portion of the house. The gain on the deemed disposition is being sheltered by the principal residence exemption. No tax would need to be paid on it.

You are allowed to deduct capital cost allowance (CCA) on the capital cost of that portion of the house, and any cost involved in altering the house against the rental income.

At the same time, you are also required to pay tax on the capital gain you earned on this converted portion, so NO principal residence exemption!

What’s considered “structural change” is more substantial and permanent in nature. Examples include conversion on front half of the house into a store, conversion of a house into a self-contained domestic establishment for earning rental income (a duplex or triplex).

However, CRA’s policy is not to apply this deemed disposition rule provided that the following criteria is met:

The income producing use is ancillary to the main use of the property as a residence
There is no structural change to the property; and
No CCA is claimed on the property

In our case, we did not do any alteration structurally (we bought the house that has a secondary suite) and hence no structural change was made. Although it was producing good income on a monthly basis, it is only sufficient to cover our monthly maintenance cost and we, as a family, are still occupying the major section of the house. The income producing use is therefore considered ancillary to our residence use. And of course, we will not claim any CCA at all, just so that we can preserve the principal residence status on this house!

Luckily, in our case, the deemed disposition rule does not apply to us.

Converting liability into income producing asset is great, but make sure you do it in the most tax efficient manner. Until next time,

Cherry Chan, Your real estate accountant.

This site provides general information on various tax issues and other matters. The information is not intended to constitute professional advice and may not be appropriate for a specific individual or fact situation. It is written by the author solely in their personal capacity and cannot be attributed to the accounting firm with which they are affiliated. It is not intended to constitute professional advice, and neither the author nor the firm with which the author is associated shall accept any liability in respect of any reliance on the information contained herein. Readers should always consult with their professional advisors in respect of their particular situation.

/0 Comments/by Cherry

Real estate corporations, Real estate investment, Small business and real estate

Tax Tip from a Retired Accounting Firm Partner About Setting Up Corporations

Hello fellow real estate investors,

Just before the holidays, I had the opportunity to meet up with my long-time mentor, a retired partner at the biggest accounting firm in Canada. His practice is built primarily around small business. A lot of his clients were investors, some are mutual funds investors and some are real estate investors. Many of them have seen significant growth in their wealth using real estate as their investment vehicle.

We chatted about work, our children and vacation. He is now living the life of his dream.

He goes to Florida frequently, golfs all the time, and does tai chi on a daily basis. (For those of you who don’t know what Tai Chi is, here’s the wiki link. Being Chinese, I still have to look up the definition for it myself!)

He built his accounting practice from zero to over a million of gross billings.

For those of you that do not know much about how professional firms work, $200K gross billing is a decent number, $500K is considered quite successful, above and beyond $1 million solely focus on small business clients is extremely successful.

Of course, being a good student, I had to ask him for a few tips and how he achieved his success.

I also shared my stories on building my accounting practice, my market and my competition. I even specifically asked him for his view on holding real estate investment in a corporation.

The number 1 factor to determine whether you should invest through a corporation is whether the investor needs the money NOW!

Many investors are under the impression that corporations can provide you limited liability. If you want to protect your personal residence or other assets that are in your own name, you should incorporate to hold your assets.

That’s true – only to a certain extent.

Always remember that the financial institutions do not like lending money to a corporation (especially a brand new one) without business income. They don’t consider rental income as business income.

More often than not, they would require personal guarantees from you. Meaning, you are personally liable for the mortgage if the corporation defaults in payments.

Say if you have a fully paid off home worth $500,000, and you also owe about $500,000 worth of mortgage within your corporation that you personally guarantee for, protection against your personal residence is limited in this limited liability structure.

Can it limit some of your other liabilities exposure? Absolutely! I am not a professional lawyer; consult your lawyer on what it can protect you from.

On the flip side, there is tax advantages that you may overlook.

If you don’t need the cash flow from the rental properties, like my previous boss, leave them in the corporation. He uses a tax free roll over election rolling real estate investments into the corporation. He got special shares back. (The tax free roll over election allows you to defer the capital gain tax you would otherwise need to pay if you were to sell the property into the corporation.)

These special shares have no controlling right of the corporation. They are preferred shares.

The preferred shares are worth the same amount of money as the properties were worth when he “rolls over” the properties, minus any loan he got in the deal. Nothing more.

His wife and his sons own the common shares, also known as the growth shares of the company. This means that that the family owns the future capital gain on the properties. We also call this in the accounting world, estate freeze. Freezing your estate at the current value, passing on the future growth to your families and kids.

The preferred shares entitle my boss to receive dividend – when he chooses to.

The common shares also entitle the wife and the sons to receive dividend – when he chooses to declare dividends.

His sons went to post secondary schools. Great! Declare dividends and pay no personal income tax.

If his wife doesn’t have any other income, declare dividends so she doesn’t pay personal income tax.

Corporation pays 20% tax roughly (after refundable dividend tax). Combined tax rate = 20%.

If you make more than $40K salary income, your marginal tax rate on your rental income is more than 20%.

Next time when you decide whether you should incorporate, ask yourself if you need the cash now!

Have a great weekend!

Until next time, happy real estate investing.

Cherry Chan, your real estate accountant

This site provides general information on various tax issues and other matters. The information is not intended to constitute professional advice and may not be appropriate for a specific individual or fact situation. It is written by the author solely in their personal capacity and cannot be attributed to the accounting firm with which they are affiliated. It is not intended to constitute professional advice, and neither the author nor the firm with which the author is associated shall accept any liability in respect of any reliance on the information contained herein. Readers should always consult with their professional advisors in respect of their particular situation.

/2 Comments/by Cherry