Our realtor clients are asking us, “how do we qualify for financing in my PREC?”
Before I dive deep into this conversation, you should check out my previous article on whether you should own rental properties in a PREC.
Before you jump all in owning properties in the PREC, it is worthwhile to re-iterate what I learned from my personal experience.
Earlier this year, I tried to refinance one of my properties by my holding corporation. This corporation earned a couple thousand dollars of consulting income in the business annually.
Our application got rejected simply because we earned the extra couple thousand dollars of consulting income in the same corporation.
Earlier this month, I had a lengthy discussion with a top BMO mortgage broker and he confirmed to me that the banks are only allowed to lend to a holding corporation.
Holding corporation is a corporation that does not earn any active business income. At least that is the understanding that we got from the bank.
PREC earns active business income.
This top mortgage broker confirms that this holding company requirement is imposed by the government. I can’t confirm if it is true or not, best to speak to the bank directly. 😊
If you do decide to own the rental properties in a PREC, traditional independent mortgage brokers may or may not be able to get your financing.
There’re a few options available depending on your situation.
You can find out more about this type of property ownership via this post here.
The downside of owning the properties in your personal name is that they can eat up your credit limit pretty easily.
If you have a goal to own large portfolio, owning properties in your personal name may limit the opportunities to buy more properties in the future.
Almost all the banks are willing to lend directly to a corporation. Typically, you have to approach the bank directly.
Different banks might have different cash flow requirements. The bank that I am currently working with requires a cash flow coverage ratio of about 1.2. This means that the rent has to cover all the expenses including the mortgage payment by 1.2.
This bank would take into account my business income from multiple sources of businesses (in the corporation and business that we own personally) and qualify us for financing based on the cash flow of the rental properties.
By owning rental properties and qualifying for mortgages directly inside the corporation, your personal credit report might or might not be affected by these mortgages.
If it doesn’t, it will likely give you an edge in qualifying for more mortgages in the future, assuming your goal is to grow your portfolio to fund your retirement.
Documents you would need if you qualify for mortgages directly in the corporation
100% of our clients are real estate investors and/or real estate agents. We specialize helping our clients to minimize their taxes and help them build their rental portfolio so that they can achieve their goals faster. 😊
Until next time,
Cherry Chan, CPA, CA
Your Real Estate Agent Accountant
One of our business core values is to Always Do the Right Thing.
Core value is like the guiding principle in both my business and personal life. When I am in a difficult situation, I always go back to the basics, which is our core values.
We have gone on dozens of consultations about realtor incorporations in the last few weeks.
We are grateful for the opportunities to help fellow realtors to pay less tax.
Many realtors pose the questions – why do we need to do a valuation analysis and a tax free rollover of goodwill when I can setup a corporation for $1,000 at my lawyer?
In an earlier video that I posted, I explained the process of transferring your realtor business to the PREC.
When you’re transferring your realtor business to a newly formed PREC, you cannot simply shut it down and reopen and continue operating in your PREC.
The Income Tax Act looks at this “transfer” as a sale of business from your personal name to the corporation.
You might argue – well, I don’t have any business assets running my realtor business, other than a laptop and cell phones. What’s there to sell to the PREC?
Because you are selling your entire business to the corporation (and your PREC will continue to carry on the business on behalf of you) and you’re the controlling shareholder of your PREC, you’re deemed to sell the business at fair market value including Goodwill.
“Goodwill is the whole advantage, whatever it may be, of the reputation and connection of the firm which may have been built up by years of honest work or gained by lavish expenditures of money.
It is “the privilege, granted by the seller of a business to the purchase, of trading as his recognized successor; the possession of a ready-formed ‘connection’ of customers, considered as an element in the saleable value of a business, additional to the value of the plant, stock-in-trade, book debts, etc.”.”
In simple terms, when you shut down your sole proprietor business in your personal name, and operate your business in your PREC, without the proper form and documentation, you would have deemed to “gift” your business to the corporation.
Section 69 of Income Tax Act would kick in and you would be deemed to have received fair market value consideration on the “gift”.
If you don’t assign a fair market value to the Goodwill, you’re running the risk that CRA can come back and assign a value to it.
This means that CRA can come back, analyze your business, and impose a fair market value on your business.
This fair market value concluded by CRA would be added as income in your last year’s tax return and you need to pay income tax, penalty and interest on it.
“No one would buy my business.” That’s the most common objection I have.
Say you have been a full-time agent for the last 3 years and you consistently net over $200K to $250K from your business for the last 3 years.
Now you’ve decided it’s time to move the entire business to the corporation to take advantage of the low tax rate in the corporation.
Can you argue that you don’t have any connection and reputation built up in the last 3 years to enable you to make the same level of business income in the corporation?
Can you argue that you did not work hard in the last 3 years with honest work?
Can you argue that you don’t have a “ready-formed connection customers”? Are you getting referrals? Repeat customers? Can you argue that you won’t get any of these in the future?
I can’t.
Yes, the business that you have worked so hard on has value, at least, according to CRA’s Goodwill definition above.
You might not think that anyone will buy it, but I have seen purchase and sale in the realtor business world, and I know there are buyers and sellers out there.
Can you avoid paying taxes on deemed disposition of goodwill?
At the end of the day, we are setting up PREC to pay less tax.
What is the point of setting up a corporation if you have to pay more taxes?
You can elect to sell your business on a tax deferred basis to the corporation under Section 85 of the Income Tax Act.
You can do a valuation of the business, determine a value, draft up a proper agreement of purchase and sale and file the tax election form to defer the capital gain tax on the sale of business.
Yes, it is going to cost a couple thousand dollars more, but doing it the RIGHT way can save you the risk of being randomly assigned a fair market value by CRA on the sale of your business to the corporation.
CRA cannot come back, disagree with you, and add some additional income on your personal income tax return.
They can disagree with the value, but we have the appropriate clause in the agreement of purchase and sale to make sure that even if CRA disagrees with our valuation, no tax impact will be triggered.
For a business that is producing $150K net income year over year, if we use an earnings multiple of 3x to determine your business value, this might mean that your business can be worth as much as $450K. An earnings multiple is one way to value your business.
Imagine adding $450K to your income tax return and the tax related to it?
If you have worked hard to build a database and a referral network, you have goodwill. Schedule a one on one consultation with us to discuss the tax implication and how you can avoid this tax trap once and for all.
Until next time,
Cherry Chan, CPA, CA
Real Estate Agent Tax Expert
I recently had a consultation with a prospective client. She asked me the following question,
“I’m considering turning my current primary residence as a rental. I’ll use the HELOC that’s already setup on this property and use the funds to purchase my next primary residence. What is the tax implication?”
According to CRA Income Tax Folio S3-F6-C1 Interest Deductibility,
“Where money is borrowed, the use of the money must be established and the purpose of that use must be to earn income. Borrowed money used to acquire a life insurance policy or property the income from which would be exempt will not qualify.”
In another words, if she borrows money from her rental property and use the funds as downpayment for her future primary residence, the interest on the loan would not be deductible.
The purpose of the primary residence is NOT to be used to earn income, therefore, the interest on the borrowed money to acquire the primary residence is not tax deductible.
If you borrow money to invest in RRSP or TFSA or RESP, the interest incurred would not be deductible since the income from these registered accounts are tax exempt.
Interest on money borrowed to invest and earn taxable income is deductible. Interest on money borrowed to buy personal used properties are not deductible.
She shared my opinion with her bank mortgage broker, who did not believe it.
In the mortgage broker’s opinion, people do that all the time. People refinance their rental properties and use the proceeds to pay down their primary residence mortgage. He has never heard that taxpayers could not deduct the interest on a rental property against the rental income, specifically referring to the interest on HELOC used to purchase primary residence.
As much as I would like to agree with this mortgage broker, the Income Tax Act just isn’t written this way. ☹
Just a messenger here…
Don’t get me wrong. The original mortgage on the rental property is tax deductible. You’re incurring mortgage interest to earn rental income.
It’s only when the taxpayer either refinance or use the HELOC to purchase the primary residence, it is the interest portion related to the additional money you borrowed that isn’t deductible.
Using an example here, say you have a mortgage of $300K on a rental property and a line of credit of $200K available for you to use, you draw out this $200K line of credit to purchase your primary residence.
Interest on the $300K would still be deductible.
Interest on $200K wouldn’t be deductible because the funds are used to purchase primary residence, which is non-taxable.
Similarly, say you have a mortgage of $300K on a rental property, you go to the bank and get a mortgage of $500K. You use the additional $200K as the downpayment of your primary residence.
Say, at the end of the year, you incurred $20K interest expense on this new mortgage.
Interest on the $300K portion is deductible – that is $20K x $300K / $500K = $12K is tax deductible.
Interest on the $200K portion is NOT deductible – that is $20K x $200K / $500K = $8K is not tax deductible.
Years ago, when I first met Erwin, my husband, he was in the middle of settling his real estate investment from his previous relationship. He owned a few properties with his ex-wife and had been reporting rental income from his portfolio.
When I was preparing his personal tax return 🤓 as an amateur accountant then, I noticed that one of his rental properties did not have any mortgage interest claimed.
I wondered, ‘did they pay off the entire mortgage on this property? 🤔🤨’
He explained to me that they refinanced this property, which was their primary residence before, to take some equity out to purchase their next primary home in north Burlington.
He was half eager, half upset to share that he was the one who found out mortgage interest isn’t deductible when they used the funds to purchase their primary residence.
He confirmed his understanding with a renown real estate accountant in the industry.
As a result, he never deducted his mortgage interest on this rental property.
All these taxpayers are doing it and didn’t have any issues deducting interest expense.
I get this a lot.
A perfect analogy is speeding on highway 407.
I used to take 407 all the time. Speed limit on 407 is 100km/hour.
Most cars are going way faster than 100km/hour. Some would consider driving at 100km/hour on Highway 407 as unsafe – as most cars are way faster than you.
Occasionally there is one that gets caught, but most speeding drivers do not get caught.
If I speed and I don’t get caught, it doesn’t mean that I’m complying with the law, I am just lucky that day.
You can claim whatever you want in your tax returns. Ultimately, it is your tax return.
Just like the speeding analogy, my opinion is just the speed limit sign, what you do ultimately is up to you.
Are there ways to legally deduct the interest when you refinance your rental properties to purchase your home?
Yes, but not without a cost. Make sure you consult with a qualified accountant that knows interest deductibility.
Until next time, happy Canadian Real Estate Investing.
Cherry Chan, CPA, CA
Your Real Estate Accountant
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.
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.
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.
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.
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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