How to Buy Primary Residence Using a Corporation
It’s a big day here in our new office. We’re expecting new furniture to come in and security system to be installed.
I got into my car at 8:30am, turned on my audiobook for the first time in a very long time, started heading to the office. We’ve been extremely lucky that we got to work from home most of the time.
Although I didn’t run into any traffic like I would before the pandemic, QEW was getting busy.
Seeing these many cars on the road make me excited for once. It’s a signal that our economy is slowly going back to normal.
Of course, it’s also exciting to see the office furniture being delivered – we’re coming down to the final stretch!
We even have a feng shui master picking an office opening date. 😉
Now onto this week’s topic. A client of mine recently shared with me a Youtube video on a tax strategy, whereby a small business owner can use the excess cash available in the corporation to purchase his/her primary residence.
It works something like this.
Oscar owns a small business in a corporation. As we are all aware, owning an active business in a corporation provides significant opportunity for tax deferral.
As a result, Oscar Owner accumulates a large amount of cash in the operating company and now he wants to buy a nice home for himself to enjoy.
Oscar Owner wonders how he would be able to use his cash saved up in the operating company to purchase his primary residence without triggering significant personal tax.
One strategy was to have the operating company (OpCo) lending the money to a second corporation that we call primary residence company (PR Co).
In exchange, the PR Co pays interest on the loan borrowed. Interest rate is based on the prescribed rate as set out on CRA’s website. Currently the prescribed rate is 2%.
PR Co purchases the primary residence, qualifies for the mortgage and pays for the expenses that a landlord would normally pay for.
Oscar Owner makes a fair market value rent payment to PR Co.
In this case, Oscar Owner does not need to withdraw a large amount of dividend from OpCo as the downpayment to purchase his primary residence.
Bingo!
Well…it isn’t that simple.
There’re a few points missing in this strategy.
Missing primary residence exemption
Although Oscar Owner is able to save personal taxes that would otherwise be triggered from withdrawing a large amount of dividend from OpCo, he would misses the opportunity to shelter the tax on capital gain on the primary residence.
Since the PR Co owns this home, it is treated as an investment property in the eyes of CRA. One day, when Oscar Owner decides to sell the property for a large gain, the realized profit would be considered capital gain and therefore be subject to the corporation tax.
Oscar Owner would have to weigh the amount of taxes that he has to pay when he withdraws the dividend out to purchase the property, compared to the potential appreciation of the property to decide whether this setup is more beneficial.
Extra filing obligation
PR Co is a corporation after all.
A corporation is required to file it’s tax return on an annual basis.
There’s extra administrative cost on maintaining the corporation’s record for annual filing purpose. This would not have happened if Oscar Owner owns his primary residence outright.
More difficult to qualify for financing and potentially higher finance cost
Generally speaking, most banks do not like to work with corporation on financing a residential property. Only a couple of top tiered banks are willing to work directly with corporation owner.
In most cases, interest rates are higher. Consult with an experienced mortgage broker before proceeding.
Would I still consider this as a viable strategy to recommend to my clients? Absolutely.
I would also consider a couple other strategies before jumping to conclusion.
Let’s discuss how we can apply the same strategy to buy rental properties next week!
Until next time, happy Canadian Real Estate Investing.
Cherry Chan, CPA, CA
Your Real Estate Accountant
It is almost end of the tax season. We see cherry blossoms everywhere. Weather is warming up and I hope you guys got to enjoy some sunshine these days.
It feels like it’s the nature’s way to tell us to get out of this pandemic and get back to our normal lives slowly.
Businesses are starting to open slowly. Schools are cancelled for the rest of the school year.
It’s always interesting to watch how these pandemic policies unfold in different part of the world.
Back home, my mom’s drapery store never got shut down. My dad’s contracting business never stops operating. I frequently see chats about eating out in our family chat group.
Schools back in Hong Kong are also opening up this week.
Everyone is still wearing masks. In fact, if you don’t wear a mask in Hong Kong, you’re not even allowed on the public transit system. People judge you if you don’t have one.
I’m not qualified to say whether wearing masks are useful or not, but we did “masked up” when we visited the grocery stores and food court – to protect ourselves and to protect others. 😊
Kids don’t know the difference but they’re just excited to try on something new.
Speaking of kids, did you know that the COVID-19 additional childcare benefit $300 per child has been deposited to your bank account this week?
It was nice to check my bank account to receive an additional $600 benefit from the government.
In addition to this nice surprise in my bank account, Prime Minister Justin Trudeau also announced expansion of the Canada Emergency Business Account qualification criteria on Tuesday.
Canada Emergency Business Account (CEBA) qualification criteria expanded
Background:
Expanded criteria announced by Prime Minister Justin Trudeau on May 19, 2020 Tuesday:
Potential impact on real estate investors who own your real estate properties in the corporation:
Potential impact on real estate agents/realtors/brokerages:
There’s still a lot of confusion in the program and we’re waiting anxiously for more clarification!
Will keep everyone up to date over the next few days!
Until next time, enjoy the nice weather.
Cherry Chan, CPA, CA
Your Real Estate Accountant
It has been a few busy weeks here at our little home office. From following all the latest and greatest COVID-19 government measures, reviewing clients’ tax returns, learning to stock hacking, to managing the office renovation, we have not slowed down a bit.
It hasn’t been easy with the unknown. I had doubts about renovating our office, when it seems that the entire world is turning to virtual office.
I had doubts about learning stock hacking, when so many people had seemingly lost money in stock investing.
I also had doubts about my accounting practice, when our revenue dropped quite a bit in March and April.
Just like the COVID-19 lockdown, there’s light at the end of the tunnel. We just need to be patient, and learn to adapt.
Number of confirmed cases have declined. Ontario is slowly opening up. Hopefully we can go golfing in the near future.
Accounting business has been picking up as well. Clients are uploading their information to beat the deadline June 1. 😊 Renovation is moving along, kitchen has been installed and some furniture will be delivered by the end of the month.
There’s light at the end of the tunnel.
Just need to have some faith.
Now, onto this week’s topic.
A few of clients moved into their rental properties in 2019.
Some of them are in transition, staying in their rental properties until they got their permanent home.
Some of them simply decide to move into their rental properties for good.
You may not be aware, everytime you change the use of a property, whether it is from primary residence to rental property, or from a rental property to primary residence, you are considered to have sold the property at its fair market value.
You are also considered to have acquire the property for the same amount.
Fair market value of the property is based on the time of change.
You can buy a property for $500,000 as a rental property, rent it out for a few years, and then you decide to move in.
At the time of move in, your property can be valued at $600,000.
You would have deemed to have disposed your property at $600,000, making a capital gain of $100,000.
Even though you never sold the property, you might be triggering a capital gain of $100,000 on your tax return.
If you also claim capital cost allowance on this property to offset some of the rental income previous year, you would also have to add the cumulated capital cost allowance (also known as recapture) as your income, the year you move into the property.
In some cases, it can trigger an unexpected tax bill.
Thankfully, CRA allows taxpayer to make an election to defer the capital gain tax until you actually sell the property.
To qualify for this election,
This means that, if you have claimed capital cost allowance throughout the years, you cannot defer the capital gain tax. You will have to report $100K to your income when you move into your rental property. You will also have to pay tax on recapture of capital cost allowance that you have claimed.
As a bonus to this election, assuming you qualify, you can also designate this property as your primary residence for up to 4 years before you actually occupy it as your principal residence, assuming you don’t have any other property designated as your primary residence during this 4 previous years.
What does this mean?
Let us look at this example.
You work in Toronto, currently renting a condo, making good money.
However, Toronto housing prices have skyrocketed and so you venture out and decide to buy a property in your hometown Hamilton as investment property.
Your family lives in Hamilton, it’s an easy commute for you.
Maybe one day, you would move back to Hamilton, who knows?
You bought your investment property, converted it to legal secondary suites, and rented it out for 5 years.
5 years later, you got a job offer in Hamilton. You decided that it is time to relocate and move to your rental property.
What is the tax implication?
You would have reported income and expenses incurred on this Hamilton rental property for the 5 years.
If you claim capital cost allowance on this property, you would have to take the recapture on the capital cost allowance into income the year you move in.
You would also need to report the capital appreciation on your personal tax return the year that you move in.
If you did NOT claim any capital cost allowance on this rental property,
Scored!
Even if you already had a primary residence in the previous 4 years, you would still be able to defer the capital gain tax on this rental property in Hamilton until you sell it with this election.
Planning lessons?
If you have plans to move into a rental property, don’t claim capital cost allowance!
Until next time, happy Canadian Real Estate Investing.
Cherry Chan, CPA, CA
Your Real Estate Accountant
I have been on a few webinars lately sharing my insights/interpretation of the latest government programs.
There was one question that I thought that would be useful for all my landlord friends out there.
If you offer a payment plans to your tenants, you may be exposing yourselves to these two hidden tax costs.
Tax is due based on when revenue you are entitled to, not what you have received.
Let me explain.
Income Tax Act requires taxpayers to report their income and expenses on an accrual basis. Not cash basis.
Let’s use insurance expense as an example.
You may receive a bill today to pay insurance expense June 1 for a property you newly purchased that is closing on the same date.
You issue the payment on May 15 for $1,200.
The insurance policy covers the period from Jun 1 of current year to May 30 next year.
Assuming your year-end is calendar year-end (December 31 is your year-end), how much insurance expense can you deduct this year?
Technically speaking, you can only deduct the portion of the expense that belongs to Jun to December of current year.
That is, 7 months in total. You can deduct $700 in this example, even though you pay a total of $1,200 in current year.
The remaining $500 deduction belongs to next year.
Now, let say next year, you renew your insurance policy for $1,800 from Jun 1 Year 2 to May 30 Year 3.
The amount that can be deducted from the cash payment of $1,800 that you make of $1,800 in year 2 is:
= $1,800 / 12 months * 7 months = $1,050
Total insurance that can be deducted in year 2 is
= $1,050 + $500 (amount that was carried forward from year 1) = $1,550.
The undeducted portion of the year 2 premium you paid $1,800 – $1,050 = $750 will be carried forward to Year 3.
How does it relate to you as a nice landlord?
If you apply the same principle from the insurance example before to your rental income, your rental income is calculated based on when you are entitled to charge them.
For the month of March, you’ve earned your income by the end of March 31.
For the month of April, you’ve earned your income by the end of April 30.
For the month of May, you would have earned your income by the end of May.
As a nice landlord, you might decide to make a payment plan with your great tenants to spread out these 3 months of delinquent rent to next 12 months.
Let’s use some numbers to illustrate.
Let say monthly rental income is $2K a month. 3 months of rent = $6K total.
You want to help your tenants out and decide to spread out he $6K over the following 12 months with monthly equal instalment.
This means that every month from June 1 onwards, your tenants agree to pay you $500 more over the next 12 months, until May 30, 2021.
By the end of December 31, 2020, you would have only received $3,500 out of the $6,000 outstanding, still having $2,500 to be collected in 2021.
When you file your 2020 tax return, by the Income Tax Act, you are required to report the full $6,000 of rent as income.
In CRA’s eyes, you’ve earned your income for the full year. Even though you have not collected the full amount, that’s not their concern.
You will be paying tax on the full $6,000 of rent, even though you still have only received $3,500 in total.
You’re essentially prepaying tax, on amount that you have not received yet.
Hopefully, by the time you file your taxes in April 2021, your tenants would have paid in full.
At least, the money is in your pocket for the tax you owe.
If you are commercial landlords, the same principle extends to HST owing.
Using the same example above, as a commercial landlord, you decide to give a break to your tenants. You decide to arrange a payment plans to spread out their March to May rent over the next 12 months.
The only difference is that, instead of $2K a month, you charge $2K + HST a month to your commercial tenants, i.e. $2,260 per month. ($2K rent and $260HST in Ontario.)
Similar to the residential case above, commercial landlord would be required to report the full amount of income at their year-end, even if they have not fully received the payment from their tenants yet.
On top of it, the HST $260 per month on the rent deferral is also due at your HST filing period, even though the HST will not be collected over the next 12 months.
If you’re an annual HST filer, this HST receivable from your tenant would be due 3 months after your year-end.
If you’re a quarterly HST filer, this HST receivable is due in that quarterly filing period, much sooner than when you will expect to receive the full amount of HST.
It would be even worse if you’re a monthly HST filer.
What if the tenants decide to leave before the balance owing is repaid?
It sucks, but it can happen.
Both Income Tax Act and Excise Tax Act (the Act that governs sales tax HST) allow the landlords to write off bad debts when the amounts become uncollectible.
You can write off the amount that is uncollectible as an expense on your tax return. Effectively lowering your taxable income.
You can also write off the Input Tax Credits against the HST collected on your HST filing, effectively lowering your balance payable on HST.
Until next time, happy Canadian Real Estate Investing.
Cherry Chan, CPA, CA
Your Real Estate Accountant
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