Little Known Tax Impact of Refinancing Your Properties

“Some people dream of success while others wake up and work hard at it” ~ Napolean Hill.

Although I didn’t grow up in a wealthy family, my parents worked extremely hard to provide everything we wanted in our lives for us.

As a kid growing up, if I felt that I needed a tutor to help me excel at my school, my parents would not think twice to hire one for me immediately. I rarely needed it but they were always available. Academic success came relatively easy for me.

I am a bit ashamed to share this but in my university days, I would skip almost all classes and stayed up all night before the exam to study. I passed and did relatively well. It was still a lot of hardwork, but it wasn’t a sustainable long term solution to pass my Chartered Accountancy final exam.

So when I teamed up with my study partners, Jason & Irene, they made the entire process a lot easier. We planned at the beginning of the year and we started working on cases weekly from February onwards. It’s all about discipline, day in an day out.

We all passed with the first try! Then I read 4 Hour Work Week written by Tim Ferris. I dreamed of having a business of my own and traveling around the world while still making thousands and thousands of dollars with only 4 hours of work dedicated to it.

And you see all this news about people writing blogs about anything you can dream of – and it seems, at least from the surface, that they are living a great life. I wondered why I can’t just “create a business and just write a couple of blogs a week” to make a living. Oh man, how I was wrong!

Last year I did a presentation about incorporation to a concierge company’s audience. The founder, also the organizer, of the company is the son of a retired Big Four accounting firms’ partner. He came up to me and said “so what’s about that real estate niche that you have? Isn’t it just about compliance?”

For those of you who don’t know what compliance is, that means filing your tax returns and required forms for the government. His comment basically downgraded me from being a “specialist” to a general compliance person. To be a real estate accountant means that virtually all my clients are real estate investors. 

To be a real estate accountant means that I have an immediate tax answer to all your real estate investing questions, from flipping, rent to own to long term buy and hold. And yes, these answers actually need to be backed up with real work, real compliance work, that we all have to file. No tax planning can be carried out without having the “compliance part” finished.

To be a real estate accountant means that every week I have to write up a blog post sharing the tax tips I learned during the week with my followers. And I started writing this blog post at 5am in the morning.

To be a real estate accountant also means that I have skin in the game. I, too, also have some investment properties. Like all real estate investors, I have my day job of running my own accounting practice and being a mom and just a few properties to take care of. Many people think that I run a successful business. Few people notice the struggle we have behind the scenes. Even fewer people understand the amount of work we put in, day in and day out.

Over the family weekend, one of the family members, who loves to bake once in a while, made a yummy orange chocolate cake with the best quality chocolate you can find. Erwin casually suggested that she should become a baker and have her own baker shop one day. Another family member agreed and complemented how much better her baking skill is in comparison to another family member who currently has a bakery business.

Baking definitely requires some skills, operating a business requires commitment and dedication. The family member who’s got a business running already is fully dedicated. She hustles and she goes to baking school to improve her skills. She operates her website and updates her Facebook account with new products that are coming out. It’s sad how few people actually understand the amount of work involved behind running your own business and achieving success, especially in today’s microwave age that everyone thinks everything can be done in a second.

Now on to this week’s topic: Many real estate investors ask me about the tax impact on refinancing a property. Say you purchase a property 2 years ago for $300,000, the market has been doing really well and your neighbor just sold for $500,000. Assuming you can qualify for financing, refinancing the property to 80% loan to value can give you an additional $160K for your next investment. SWEET! And that’s the power of real estate.

Refinancing the property when owning personally

If you own the property personally, one thing you would need to pay attention to is how you use the funds from refinancing. In Canada, you are only allowed to deduct the interest on money borrowed for investment. 

So, instead of using the funds for your next investment property, the fund is used to pay down the mortgage, the interest related to this $160K is not deductible. The general advice is that you would use other investments available to pay off your property, not the principal residence mortgage.

After years of appreciation and refinancing, you may have taken a lot more out than what you have put in. Say in our example, over the years, you’re able to extract a total of $400K and the mortgage outstanding at the time of sale is $500K. And you can sell the property for $700K. Your capital gain is $400K ($700K selling price minus purchase price of $300K).

Assuming you pay the highest marginal tax rate, the tax liability is approximately $100K. If you choose to sell the property then, after paying off the bank and the government, you will end up having only $100K ($700K – $500K mortgage – $100K tax) in your pocket. This may not be as high as you would have expected, since you already pulled out a large sum from the property.

Refinancing the property inside the corporation

Now if you own this same property inside the corporation, the tax impact can be slightly different. When you decide to take out the $160K from the property, similar to owning the property personally, you can deduct 100% of the interest if you use the funds to invest in another property inside the corporation. If you choose to refinance the property and take this $160K out of the corporation, depending on how much the corporation owes you, you may have a large amount of tax liability. It doesn’t matter whether you are taking this $160K out of the corporation for investment or personal use, the same tax implication can apply.

For example, if you initially loan $60K to the corporation to purchase this property, and assuming that the corporation only has one property and only owes you this $60K, the additional $160K that you would like to extract out from the corporation, $60K would be tax free to repay your initial investment. But if you extract more than $60K, any additional amount is subject to tax. The additional $100K can be distributed to the shareholders in the form of dividends. Shareholders would in term be reporting that in their personal tax returns. If you are using this additional funds to invest, my recommendation is to invest inside the corporation. No money going directly to the shareholder’s pocket. No immediate tax impact. When you sell the property inside the corporation, the same tax liability is triggered. Again, if you were to cash out and take all the money from the corporation for personal use, dividend income would have to be reported.

So more often than not, I recommend my clients to refinance the property rather than selling. Refinancing, compared to selling, has a lesser tax impact, and you may end up having the same amount of money left in your pocket after paying CRA. You still get a house at the end! Consult a professional tax advisor before making your investment decision.

Until next time,

Happy Canadian Real Estate Investing.

Cherry Chan, CPA, CA Your Real Estate Accountant