Many investors have approached me in the last little while asking me when is the best time to incorporate to own real estate. Most people are often hesitant due to the initial setup costs and the annual filing costs involved in owning real estate in a corporation.
In my previous posts, I talked about my Big Why and how I plan to use corporations to achieve my Big Why in the most tax efficient manner.
In this post, I will briefly discuss and compare some common structures investors use, their benefits and pitfalls.
One corporation, multiple properties
Benefits
- Limited liability against personally owned assets
- Potential for income splitting opportunities
- Relatively low setup cost as only one corporation is used to own multiple properties
- If portfolio is large enough and investors hire more than five employees to manage the properties, rental income can be considered as active business income and enjoy 15.5% small business tax rate
- With proven record of financial performance from properties, potential for the bank to allow the corporation to qualify for financing on its own without personal guarantee on the mortgage
Pitfalls
- Annual filing cost is likely around $750 to $1,500 for one corporation; you need to make sufficient cash flow to cover the cost of annual filing.
- Rental income is considered passive income and hence is taxed at 46% in the corporation. If investor’s marginal tax rate before rental income is less than 46%, no immediate tax savings
- Cannot prevent liability caused by landlord’s gross negligence
- Personal guarantee on mortgage is likely required
- Qualification on mortgage can be more challenging with corporation
One corporation, one property
Benefits:
- Protection against principle residence from all rental properties
- Protection from one rental property against others
- Appropriate if rental portfolio is higher risk, such as large multi units buildings and commercial properties
Downside:
- Setup cost is high. The legal fees to setup each corporation are roughly $1,000 to $1,600 each
- Annual filing cost is likely around $750 to $1,000 for each corporation; need to make sufficient cash flow to cover the cost of annual filing. Best to make sure there is sufficient cash flow or appreciation for the filing
- Cannot prevent liability caused by landlord’s gross negligence
- Personal guarantee on mortgage is likely required
- Qualification on mortgage can be more challenging with corporation
Three tiered corporations
Benefits:
- Protection against principle residence and personal assets from rental portfolio
- Able to convert a portion of the rental income into property management fees and enjoy a lower tax rate (46% vs. 15.5%)
- More money available for investing in Real Estate Corp.
- If investor is self-employed and earns income through Property Management Company, the after-tax money available to invest can be significantly more
- Tax planning opportunities available for income splitting with lower income spouse or other family members
- With proper planning, Real Corp. can have limited third party credit exposure
- With proven record of financial performance from properties and self-employed business, potential for the bank to allow the corporation to qualify for financing on its own without personal guarantee on the mortgage
Downside:
- Setup cost is high. Setup cost for each corporation roughly cost $1,000 to $1,600.
- Annual cost of filing is high. Annual cost of filing for each corporation by an accountant can range anywhere from $750 to a few thousand dollars.
- If tenant of one rental property sues the landlord, Real Co, for a large amount that insurance cannot covers, may affect other properties owned by Real Co.
- Cannot prevent liability caused by landlord’s gross negligence
- Personal guarantee on mortgage is likely required
- Qualification on mortgage can be more challenging with corporation
These are the most common structures used by real estate investors who own a real estate portfolio in the corporations. You may question which structure makes most sense from a tax perspective. The answer is not always easy and it all depends on your own personal situation. I can definitely help you in recommending the most appropriate structure. Contact me to schedule a meeting to determine the best strategy for your own personal situation.
In the next post, I will analyze the cost involved in setting up a couple of these structures and take a closer look at when it will make sense to use this strategy from the tax saving perspective.
Michelle Spencer
Hi Cherry,
During one of the Rock Star seminars, corporate structures came up as a discussion topic and a variation from the setups you have described above was proposed. It seemed to be met with approval by the people there. It was a 3-corporation structure that was in a straight line. I can’t remember the correct order. Are you familiar with that? If so, can you show the advantages and disadvantages like you have done for the other structures above…which I found very useful, by the way 🙂 Thanks!
cherry
Michelle, Great question indeed. Straight line 3 tiered corporations are essentially the same as the pyramid structure that I have shown here from a tax point of view. I personally prefer the pyramid structure for the following reason –
Usually with straight line structure, the Hold Co owns PM Co which owns Real Estate Co. Suppose PM Co gets into any type of legal issue, theoretically, the creditors can go after the PM Co’s shares in Real Estate Co. Although this is rare, the pyramid structure provides added safeguard against the asset in Real Co.
And let say you have an incorporated business to begin with or you are planning to incorporate your self-employed business, PM business can be an add on business offered by your active business (in which case you can save the filing fees for a completely separate corporation). You likely don’t want to have this active business corporation owning your Real Co, because there is a chance that your corporation can get sued and your investment can be taken away.
Hopeful this helps! 🙂
Real Estate Corporations: Examining the Numbers and Seeing the Long-Term Benefits
[…] the last blog post, I provided an analysis on the benefits and pitfalls of the common corporate structures used by […]
KR
Hi Cherry,
Great post! Just confused about a few things… In a 3-tier structure how would the income flow? Would the real-estate company collect the rents and pay the PM a fee and then PM pays for the expenses the property incurs? Also, does the real estate company hold the property and the liability (mortgage) on the property?
Is there any benefit with this structure when it comes to transferring property to children in the future?
Thank you!
Cherry Chan, the Real Estate Accountant
Hi KR,
Great questions. This would be a much more detailed conversation than simply a few lines answered on the blog post. Consult a tax accountant that actually is familiar with the structure and he can help you out from there.
Cherry
Jason
Hi Cherry, Firstly, I wanted to say thanks for putting together a terrific blog. My question has to do with structuring of ownership.
What are the implications if the Holding Company did not have 100% ownership in the Real Estate Corp? Can the Real Estate Corp have shares that split the ownership up between family members?
Thank you.
Cherry Chan
Hi Jason, I didn’t see your message until now. The answer is yes. Apologized for the delay.
Xing
Can the current rental Moved to this 3 tier structures?
If yes, how much does it cost initial to setup?
What are the annual fee for running this structure?
Cherry Chan
Yes, the biggest cost is land transfer tax.
Annual fees can run from $3,500 to $5,000 to more than that, depending on the type of service you would want.
Ivan
Hi Cherry,
Is there any verified use case where CRA audit really accepted this structure to deduct property management fee from rental income?
CRA says “You cannot deduct the value of your own services or labour.”
Do we have any proof that a “fake” property management corporation successfully passes CRA’s audit?
Cherry Chan
Ivan, we don’t ever endorse any “fake” property management corporation. I think you have misinterpreted the information provided.
Ivan
I have interpreted everything perfectly correct. And the benefit #2 for three-tiered structure that you mention in the article clearly confirms it.
I only asked if you can support that potential benefit with successful case story from passed CRA audit.
Unfortunately, not.
There are also lots of hidden traps that must be taken into consideration that you don’t mention. Like reasonable fee for property management company etc.
Cherry Chan
Ivan, thanks for your comment. Tax planning is very personal. My blog post is simply a general discussion in terms of what I observed in the market space. I advise my clients based on their own specific situation and we don’t endorse any “fake” property management fees arrangement.
This site provides general information on various tax issues and other matters. The information is not intended to constitute professional advice and may not be appropriate for a specific individual or fact situation. It is not intended to constitute professional advice. Readers should always consult with their professional advisors in respect of their particular situation.
I understand you have very specific question, but we are here for a general discussion rather than providing tax planning for your particular situation. You should consult with a professional accountant to get his/her opinion on any type of planning arrangement.