Incorporate: Unlocking Tax Advantages for You and Your Family

Coming across an investor who is unsure whether they should incorporate to hold their rental properties or not is more common than you may first think. I’ve met many and I’ve always offered the same advice-

It all depends on your personal situation and your Big Why.

In my last blog post, I shared with you that my daughter, Robin, is my Big Why. I may invest in real estate, but I’m really investing in Robin and her future.

The Canadian tax system is designed so that you pay the same amount of tax whether you earn your income personally or through a corporation.

Say your job pays you roughly $120K a year, your marginal tax rate on rental income is about 46% if you own the property in your personal name.

If you own the property in your corporation, because rental income is considered passive income, it is being taxed at 46%. The same as if you owned it personally.

So why would I, or anyone else, incorporate then?

Well, out of the 46% tax the corporation is required to pay, 26.67% is refundable when a taxable dividend is declared. The refund is calculated based on 33% of the taxable dividend the corporation declared.

Let’s use an example to illustrate, if your rental property generates $10,000 in rental income this current year, the corporation is required to pay $4,600 in tax.

Out of the $4,600 tax, $2,667 is recorded in a notional account called Refundable Dividend Tax On Hand (RDTOH). It can be refundable to you when a taxable dividend is declared to the shareholders (this would be yourself).

Let’s say you want to declare a dividend of $3,000 from the corporation to yourself. The corporation is entitled to a tax refund for $1,000, up to the maximum of the RDTOH account balance. After the tax refund, the RDTOH account balance becomes $1,667. It will be available for refund when a taxable dividend is declared.

Essentially, the corporation is only paying roughly 20% tax on this rental income.

When a taxable dividend is declared and paid to the shareholder (you), there is tax impact on your personal tax return. Meaning… I will have to pay tax on the $3,000 I receive from the corporation!

Here is the key to owning the properties in the corporation – timing is everything.

If you want the after-tax rental income immediately declared as a dividend and distributed to you in your personal name, and you are already earning $120,000 from your job on an annual basis, there is absolutely no tax advantage despite a portion of the tax is refundable in the corporation. This is tax integration.

When someone is making $120,000 from their job, chances are, they don’t really need this income to maintain their lifestyle. Hence, you don’t necessarily need the dividend declared immediately.

However, one day you might decide to take a one-year leave of absence and travel to experience the world, this would be the year you want to declare dividends to yourself. You can declare close to $50K paying close to nothing in tax.

Combining the 20% tax the corporation pays and the 0% you pay in your personal tax return, the total tax payable is still $2,000.

But if I own the property in my personal name, I am paying 46%, the $4,600. None of which is refundable.

Let’s take this one step further. What if Robin, or perhaps your own child, owns shares once they turn 18?

I would be able to pay the dividend directly to Robin. She’ll likely have very little income when she’s 18. Hence, I can maximize the amount of dividend I issue to her with very minimal tax payable. If she’s a student in post-secondary education, she will also have tuition credit and other educational benefits to further tax savings. I can even declare more dividends to her and pay very little tax.

And don’t forget that the corporation provides limited liability too!

Many investors are hesitant to incorporate because of the cost to setup and maintain the corporation. Yes, there are costs involved, but that’s when I remind myself of my Big Why. Make your decision based on your ultimate goal in mind.

With that being said, a corporation does allow you more flexibility in life if you use it right. It is like have a savings account where you can reap the benefits when you and your loved ones are ready!

If you need help deciding how to apply this tax strategy, setup a one-on-one consultation with me and I can walk you through your own situation in detail.