Cherry Chan Your Real Estate Accountant

Corporation, Real estate corporations, Real estate investment, Real Estate Investors, Should I incorporate?

4 Reasons to Consider Before Owning Rental Properties Inside an Active Business

Our office has been flooded with phone calls on realtor incorporation and I completed our very first realtor incorporation webinar last night.

Thanksgiving is just around the corner. There’s so much to be grateful for, despite part of Ontario is moving back to modified Stage 2 closure.

If you don’t know, according to Harvard Health, “gratitude is strongly and consistently associated with greater happiness”.

I used 5 Minute Journal, a gratitude journal that requires you to write down three things you’re grateful for in the morning and three things you’re grateful for at night.

When I first started my accounting practice, days were tough, especially with young babies. In those days, I would wake up, wrote down that I was grateful for getting a good night of sleep. It’s such a simple thing, but it shifts our mindset to focus on the smallest thing that makes us happy.

At night, just before I go to bed, I also write down 3 things I am grateful for. It can be as simple as getting home early to have dinner with my family.

It took me years to keep this habit up, took me years to turn from a somewhat negative and judgmental person to a happy person who always chooses to look at life from the positive angle.

I even do this with my 5 year old and 6 year old. I always ask them what they are grateful for before they go to bed.

I want to take this opportunity to thank my entire team, who’s behind the scene, answering phone calls, preparing for our realtor webinar, and also preparing all the follow up series. Without you, I would not be able to do so much. I’m truly a blessed person.

Speaking of the Realtor Incorporation webinar, one of the questions I get asked a lot, especially with personal real estate corporation (PREC), is whether you can own rental properties inside an active business company.

Do you want to mix the business risk with the risk of operating your rental portfolio?

Whether you are operating a PREC as a real estate agent, or simply carrying out a consulting business, there’s no law/guideline that prohibit you from buying an investment property inside the same company.

Your real estate commission or consulting income you get are taxed at the 12.5% active business rate, while the rental income is taxed as specified investment business income.

One important thing you need to consider is the risk of being sued. If you operate in a business environment that you have a high likelihood of being sued, you may not want to put all your eggs in one basket, mixing the rental portfolio or investment portfolio with your business.

If you own everything in one corporation and get sued from your business, the credit can go after everything within the same corporation. This means that they can go after your rental properties as well.

Probably not a good idea if your business is at a higher risk of being sued.

Do you have someone to split income with?

Income splitting via dividend is somewhat limited within PREC or an active business these days (thanks to Justin Trudeau who introduced the new tax law in 2017).

You can structure your investment holdings in a separate corporation and split income with your low income family members legitimately.

If your plan is to split income (or at least have the option to split income) with your lower income family members, it’s often advisable to setup a different corporation to achieve this purpose.

Make sure you consult with a professional accountant before you implement this strategy.

Are you planning to sell your business?

As a Canadian tax residents, we’re all entitled to a lifetime Capital Gain Exemption in the amount of $880K in 2020.

You can only qualify to apply this lifetime capital gain exemption on sale of qualified small business shares.

One of the criteria to qualify is that the company must have at least 50% of assets used in active business.

If you are building a team of realtors working for you, and one day you are planning to sell the business to someone else, owning rental properties that are not used in your business would jeopardize your ability to qualify for the capital gain exemption.

Do you need a mortgage with your property investments?

As an accountant who’s also a realtor and a real estate investor, I can share a bit of an insight with you.

Earlier this year, I was trying to refinance my property that’s owned directly in the corporation’s name.

We were very close in getting the deal done at an A-lender. At the last minute, they pulled back because they noticed that we reported a small amount of consulting income in the corporation.

It turns out that certain banks are only willing to lend money to you to purchase a rental property if the corporation owner DOES NOT have any other active income. It has to be 100% holding company that earns investment income, but nothing else.

You would have thought that earning some extra income in the corporation would help you qualify for financing. It turns out that the bank backed out because we reported $2K of consulting income. ☹ boo!

When you decide whether you want to hold a rental property in a PREC, it’s a good idea to check with the bank to make sure they are okay to lend money to a corporation that also earns active income.

I’m speaking from personal experience – if you know something different, I’m always here to learn. 😊

Until next time, happy Thanksgiving everyone and happy Canadian Real Estate Investing.

Cherry Chan, CPA, CA

Your Real Estate Accountant

P.S. Thank you for those of you who joined me last night on my realtor webinar. If you still have questions, the best way to get all your questions answered is by scheduling a consultation with us. Visit RealtorTaxTips.ca to get started. Our schedule is filling quick and our sale will end this coming Monday.

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Corporation, Real estate corporations, Real estate investment, Real Estate Investors, Should I incorporate?

How to Setup Personal Real Estate Corporation (PREC) as Real Estate Agent

October 1 seems to be the day that Ontario Realtors can setup a Personal Real Estate Corporation (PREC) to own their business. The reality is that the legislation has not been announced. We’re still waiting.

But this does not mean that you cannot do some prep work to get ready.

In this video, I went through the PROPER STEPS required to setup a PREC to own your realtor business.

Unfortunately, it isn’t as simple as opening a corporation, diverting all income to the corporation, shut down the sole proprietorship and then you pay 12.5% and live happily ever after.

If you don’t take careful steps, CRA can put a value on your business, deem to have you selling your practice from your personal name to the corporation, and impose tax on gain on sale of business personal tax.

If they say your business is valued at $100K, and assuming you didn’t file the proper forms to defer the gain, this $100K can be added to your return and taxed accordingly.

The key is to do an analysis, determine if there is value, file the proper form and you can stay on the right side of the Income Tax Act.

Feel free to reach out to our office to setup an appointment to go through your situation and see if PREC is for you before you dive too deep in. 😊

Until next time, happy Canadian Real Estate Investing.

Cherry Chan, CPA, CA

Your Real Estate Accountant

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Corporation, Real estate corporations, Real estate investment, Real Estate Investors, Should I incorporate?

How to Report Gain from Property Sale the Right Way Part 2

I just received a couple of emails from clients telling us that they got their CEBA loan approved.

CEBA loan application deadline has been extended to October 31.

It’s always heartwarming to see clients’ messages thanking us for hosting the webinar and sharing what we know from our own application process. 😊

I’m happy to report that many of our clients can get the help from the government they need to continue with their business.

The government has also made it clear that they would make the loan accessible to entrepreneurs who do not have a business bank account. Information on how to apply without one has not been updated as of yet. Stay tuned and we will keep you posted.

Last week, we wrote about the criteria to determine the nature of the property sale.

Let’s continue on to apply to a real court case so you can get a better idea of how it works.

Here’s the background story of the court case 9229-2987 Quebec Inc. v. The Queen.

Taxpayer has been in the property management business during the taxation years at issue (2010 and 2011).
Taxpayer is also a real estate investor and has been one since 2007. He started small, just like you and I, by buying a duplex. He went on to acquire multiple rental properties in different areas of Quebec. Some of them are owned in corporations.
In 2010, he acquired two apartment buildings: Bordeaux 1 and Bordeaux 2.
He stated that he intended to continue to grow his rental property portfolio and increase his income.
He even mentioned that he hired a property management company to manage the properties.
He financed the purchase of the building with a mortgage from a credit union and an interest-bearing promissory note.
He had an engineer friend that came out with him to inspect these properties prior to closing. Only a visual inspection was done and they did not inspect the basement.
Unfortunately, after closing in Feb 2011 of Bordeaux 1, he discovered the extent of the structural problems in the two buildings. The goal of earning rental income from these properties was no longer feasible.
His lawyer also advised him that it was impossible to recover anything from the previous owner, especially because the problem could be easily noticed when an inspection of the basement was done – which taxpayer claimed he didn’t do.
He couldn’t afford to pay for the repairs required. His credit union banker advised him to turn the properties to joint ownership for easier financing.
“He decided to repair the structure, renovate the apartments, place the buildings under joint ownership and sell the apartments individually.”
“He did this to limit his damage”, but ended up making profits.

Analysis by court

Let’s revisit the criteria that the court looks at, specifically from this court case –

The taxpayer’s intention with respect to the real estate at the time of purchase and the feasibility of that intention and the extent it was carried out. An intention to sell the property for a profit will make it more likely to be characterized as an adventure in the nature of trade.
The nature of the business, profession, calling or trade of the taxpayer and associates. The more closely a taxpayer’s business or occupation is related to real estate transactions, the more likely it is that the income will be considered business income rather than capital gain.
The nature of the property and the use made of it by the taxpayer.
The extent to which borrowed money was used to finance the transaction and the length of time that the real estate was held by the taxpayer. Transactions involving borrowed money and rapid resale are more likely to be adventures in the nature of trade.

Intention

The judge found that the taxpayer had the intention to sell these two buildings for profit at the time of purchase based on the following reasons:

The taxpayer stated that he didn’t inspect the basement or inside of the apartment units, hence did not discover the extent of repairs required.
Based on the Agreement of Purchase and Sale of Bordeaux 1, the taxpayer had an inspection condition stipulated. The taxpayer confirmed that he was satisfied with the condition of the building. It’s not plausible that no inspection was done in the basement to uncover the structural issue, especially since the taxpayer had been a property manager for a number of years.
The Bill of sale of Bordeaux 2 specified that the buyer had examined the building prior to closing, but the taxpayer claimed that he did not inspect the property until after closing. He found out that the floors were sinking in one of units from a property manager walkthrough after closing.
The Judge did not believe that it could be plausible that the taxpayer didn’t inspect the unit, given the amount of structural problems he experienced in Bordeaux 1.
One of the reasons why the taxpayer was forced to sell the property as joint ownership was because he didn’t have the money to finance all the repairs. He issued a termination cheque of $26,000 to one of the tenants to vacate her housing unit.
He also claimed that he realized that he could not sell one apartment individually and rent out the rest of the building to others, therefore, he set up the joint ownership structure and sold the rest of the apartments. The Judge did not understand why he could not continue to rent out the rest of the units.
After closing, when the taxpayer discovered the structural issue, he hired an engineer to inspect the property in April. Two cheques were issued to tenants at two of the units to terminate the lease 5 days after the taxpayer claimed that the engineer told him about the extent of the structural problems.
The deed of Bordeaux 1 had a release clause that required “the seller to agree to release his mortgage on the undivided rights sold to the first 3 buyers, without any repayment. The buyer agrees to pay the full balance due plus interest accrued upon the 5th sale.” – which basically said that the taxpayer had the intention to sell the property at the time of closing.
The judge was not satisfied that the idea of selling the property under joint ownership came from the banker.

Other factors

Ownership period was very short – 6 to 18 months for Bordeaux 1 and 4 to 7 months for Bordeaux 2. The shorter the ownership duration, the more likely that the intention was to resell them at a profit.
Nature of business & taxpayer’s occupation – he’s an experienced real estate businessman and had years of experience working as a property manager. The judge believed that he must have known that he could make a quick profit flipping these properties.
Nature and use of the property – the buildings are located at a highly desirable area in Montreal, which was indicative of an intention to resell at a profit.
Financing – purchase was 100% financed and taxpayer paid off the sale price less than one year of acquisition, which again was indication that the taxpayer intended to resell the property for quick profit.

Now you know, the court goes deep into the details of the agreements, deeds, mortgage terms, ownership period, your profession, as well as the nature and use of the property, to come to an overall conclusion as to whether you’re selling a property for income or capital gain.

It is extensive and all your evidence should support your original intention.

Until next time, happy Canadian Real Estate Investing.

Cherry Chan, CPA, CA

Your Real Estate Accountant

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Corporation, Real estate corporations, Real estate investment, Real Estate Investors, Should I incorporate?

How to Report Gain from Property Sale the Right Way Part 1

Hope you guys enjoyed the last weekend of August.

It’s hard to believe that we’re already in the middle of September and my kids are expected to go back to school next week.

We managed to spend the last weekend hanging out with friends and their kids. We rode our bike along Hamilton Beach Trail – yes, there’s a beach in Hamilton and the trail is awesome! 😊

We learned from our kids that happiness can be super simple, it can be as simple as finding rocks and throwing them into Lake Ontario. (They spent at least an hour throwing rocks into the water… 😉)

Sometimes, I wish Income Tax Act can be as simple as kids’ happiness.

Oh well, it surely isn’t the case for this real estate investor in Quebec.

He’s the main character in this court case 9229-2987 Quebec Inc. v. The Queen (2019TCC 281) that I found. His case can be relevant to all Canadian real estate investors out there.

Many real estate investors believe that when a property is sold, you pay tax on capital gain tax. The truth is a property sale can be treated as income OR capital gain.

When your intention is to flip a property, profit from flipping the property is considered income, 100% taxable.

When profit is reported as capital gain, 50% of the profit is taxable. If you have $100K profit made, only $50K is taxable. At 50% personal income tax rate, you are liable for $25K of tax payable.

When profit is reported as income, 100% is taxable. $100K profit at 50% tax rate means that you are liable for $50K of taxes.

If you flip a property inside a corporation, it is considered active business income and therefore it is only taxed at 12.5% in Ontario before accounting for any personal income tax impact.

Most real estate investors would be biased to report a sale as capital gain, since 50% of the gain is taxable if a transaction is reported as capital in nature.

The tax impact is simple, but how doses CRA or the tax court decide whether a property sale is considered business income or capital gain?

Well, Income Tax Act does not have any rules to measure whether “the gain from disposition of a building is attributable to income or considered business income or attributable to capital and considered capital gain,” according to this court case.

The term “business” … includes “an adventure or concern in the nature of trade”.

(If you’re lost because you don’t understand what “an adventure or concern in the nature of trade” is, it’s okay. I read this term over 100 times, and I am still having trouble understanding it. 😉)

The court and CRA are relying on judgements from prior court cases and an Interpretation Bulletin IT-218R developed by CRA to analyze whether a transaction is considered business or not.

Particularly, the court case called out paragraph 17 of this bulletin to analyze the case facts (and yes, these are the criteria you use to apply to your situation):

The taxpayer’s intention with respect to the real estate at the time of purchase and the feasibility of that intention and the extent it was carried out. An intention to sell the property for a profit will make it more likely to be characterized as an adventure in the nature of trade.
The nature of the business, profession, calling or trade of the taxpayer and associates. The more closely a taxpayer’s business or occupation is related to real estate transactions, the more likely it is that the income will be considered business income rather than capital gain.
The nature of the property and the use made of it by the taxpayer.
The extent to which borrowed money was used to finance the transaction and the length of time that the real estate was held by the taxpayer. Transactions involving borrowed money and rapid resale are more likely to be adventures in the nature of trade.

The most important factor to determine whether a transaction is business or capital in nature is the intention of the taxpayer at the time of acquiring the property.

Also, if, at the time the property was acquired, you also have the secondary intention that if the long-term investment project could not be worked out, you can sell the property at a profit. This profit would be attributable to income, and not capital. ☹

So…how do you determine intention?

Intention isn’t just what we say our intention was at the time of acquiring the property. Your stated intention must also be corroborated with surrounding evidence.

CRA and the court both look at evidence such as:

What did you do to the property?
- If you buy, renovate, sell immediately after within a short period of time, it’s more likely the transaction is considered to be a flip.
- If you buy, renovate, rent for a long period of time, sell it after you retire in 10 years, sale is likely attributed as capital transaction.
How often do you do these transactions?
- When you operate a business, you tend to transact more. You do not stop at one. You buy, renovate, sell a few. The more often you do these transactions, the more that you look like you are considered conducting a business and the more likely the transactions are treated on business account, therefore 100% taxable.
Agreement of purchase and sale
- Conditions in the agreement sometimes include vacant possession. If the intention is to flip the property, as a real estate investor, you want to ask for vacant possession.
- Some agreement of purchase and sale requires the seller not to rent out the vacant unit. This can also be viewed by court that your intention
- As a buyer, when you agree to take over the existing tenants, it is more likely that the transaction is viewed as long-term investment (on capital account and only 50% taxable upon sale).
Mortgage terms
- Short-term financing can generally be viewed as a support that the transaction is a business and therefore profit from the sale of the property is 100% taxable. If you intend to flip, you tend to sign up for short term mortgage to avoid the large mortgage penalty.
- Long-term financing, a five-year fixed interest closed term mortgage, gives support that you intend to hold the property long-term.

Other factors
- Did you hire a property manager? Assumption is that you would only hire a property manager if you intend to hold the property long-term and you intend to earn rental income.
- Are you an insider? Are you a real estate agent/broker? Are you a property manager by trade yourself? Are you a real estate lawyer/developer? If you’re in one of these professions, the transaction is more likely to be viewed as business transaction.

It isn’t black and white, as you can see. Hence why there’re court cases after court cases that I’ve been reading about these transactions.

In the next week’s blog post, we will dive deep in this 2019 court case to get a better grasp at how these principles are applied in real life. 😊

Stay tuned, happy Canadian Real Estate Investing.

Cherry Chan, CPA, CA

Your Real Estate Accountant

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