Corporations provide a lot of flexibility in tax planning but the immediate cost to setup and maintain can sometimes be difficult to bear, especially for new investors who barely make any cash flow from the properties.
Whether you should incorporate seems to be the most asked questions among real estate investors. Unfortunately there is no one size fits all answer.
Here are the 7 questions I’ve come up with to help you prepare when making this difficult decision (PART 1).
- Do you have a small business?
If you own a small business like I do and you don’t need all the cash flow generated from the business to survive, you definitely should incorporate.Say a small business owner makes $150,000 net profit from his business before paying himself. If he pays himself full amount in salary, he nets about $103,000 in his pocket.Now say he only really needs $60K after tax for his personal expense, he has $43K ($103K – $60K) left to be invested in his own personal name.
What if he doesn’t take all the profit from the corporation?
He only needs to pay himself roughly $77K salary before tax to get to $60K after tax money for his personal expense.
This means that he has $73K profit ($150K – $77K) left in the corporation.
He needs to pay 15% tax on this $73K profit. And that is $11K.
After tax profit to invest in the corporation is $62,000.
So investing in a corporate structure means you have an extra $19K to invest! And this is only from one year!
If you own a small business and you do not need every dime from the business to live, you definitely should consider incorporating to invest faster.
- Do you need the cash flow now? Most accountants would argue that there are no benefits to owning the properties in the corporation.This is a very true statement.There is something called tax integration in Canada.Our tax system is designed in a way that you should end up with the same amount of money despite the ownership structure.
This means, you should be net more or less the same amount if you were to earn the rental income in your name vs earning it in a corporation and taking them out immediately.
If you need the cash flow from the properties immediately and declare the dividend to yourself the same year, chances are you are paying the same amount of taxes.
The accountants make the money by filing your taxes. Tax payers end up having less in their pocket.
Before you make the decision not to incorporate, you have to also consider other factors – such as the one after this.
- Do you have someone to split income with? Real estate investing is considered a specified investment business in the eyes of Income Tax Act. What this means is that the net rental income you get from deducting all the eligible expenses are considered passive income.Passive income in a corporation is taxed at 50%.That’s a lot!But out of this 50%, 30% is refundable when a taxable dividend is declared to the shareholder.
So you really only pay 20% (50% – 30%) over the long run in the corporation.
The key here is that you are declaring a taxable dividend to a shareholder.
So the shareholder has to report the income in his/her own name.
If this shareholder does not have any other income, you can pay minimal tax with the first $40,000 dividend.
Between the shareholder’s personal tax rate at close to 0% and the 20% in the corporation, the combined tax rate is 20%.
When structure properly, corporation can lower your tax rate to as low as 20%! Isn’t that amazing?
- Are you concerned with legal liability protection? Admittedly I am not a lawyer and I am not the expert to discuss the legal liability protection that you get from a corporation.A corporation is a separate legal entity in the eyes of the law. This means that it can be sued as a separate entity.
For any legal wrongdoing that the corporation may be a part of, it can stand in court by itself (to a certain extent).Say you get sued by a tenant, the corporation can stand alone in court.
As an investor, I can tell you that the corporation can provide you a certain kind of legal protection.
But it’s not everything.
For example, when we purchase the properties in the corporation’s name, the bank often still requires the shareholders to guarantee the loan personally.
This means that if the corporation cannot afford to make the mortgage payment, the bank can still come after our personal assets.
Let’s keep this blog post short and sweet. We will discuss more about the next three factors in our next week’s blog post. Stay tuned.
Until next time, happy Canadian Real Estate Investing.
Cherry Chan, CPA, CA
Your real estate accountant
