Do You Need to Incorporate?
By Patrick Francey
One of the most common questions the REIN team is asked by real estate investors is, Do I need to form a corporation?
While the question is short and seemingly simple, the answer(s) is not. There are many legal, tax, and practical matters to understand before you decide how best to invest for your particular situation. Consult with your lawyer and accountant about how a corporation could fit into your total investing picture. Exceptional legal advice is a must; in fact, to support writing this article, REIN consulted one of our trusted legal advisors, Darren Richards.
Investing in real estate can be done (essentially) through one of the following investment vehicles:
- a corporation
- an individual (or individuals)
- a joint venture (with property held in trust by one of the venturers)
- a limited partnership (with the property held by the General Partner)
There are more ways than this, of course, but these four are the most typical. Most lenders require that a multi-family or commercial property is purchased by a corporation, and it can often be an advantage to hold residential property through a corporation as well. This article primarily addresses questions surrounding corporations.
When buying a property held by a corporation, should I purchase assets or shares?
The classic answer to this question is: It depends. Purchasing shares rather than assets can generate tax-saving possibilities, especially when a seller has owned a building for a substantial period of time and has generated a substantial capital gain on the property. In these circumstances, and especially when the property is at least worth $2 million, you can often show a seller how to save big chunks of tax through a share purchase.
Overall, whether you buy assets or shares, tax planning should be incorporated into the due diligence of any seller as there are potentially significant pre-closing transactions that can reduce or eliminate potential tax on sale. Sellers need to focus not on the purchase price but on the net sale proceeds after tax and closing costs. Depending on the needs/goals of the seller (i.e., Do they need cash in their personal name or is it fine in a holding corporation because they want to acquire a different property?), lots of options are available.
Similarly, tax planning should be incorporated into the due diligence of any prudent buyer as the majority of sellers are unaware of tax-planning opportunities. Reducing or eliminating a sellers tax can lead to a significant reduction in the purchase price, which reduces financing costs and so on, plus it can lead to advantages in terms of post-closing structures for the buyers. For example, in the commercial arena, using the right structure may increase the ability of the landlord to write off and deduct tenant improvement allowances.
Simply put, the larger the tax bill, the greater the opportunity for planning. How do you get the information that allows you to do tax planning? Speak with an accountant who has a background in real estate and has experience working with real estate investors.
What is a unanimous shareholders agreement (USA)?
A unanimous shareholder agreement (USA) is a contract to structure the relationship among the shareholders of a corporation. A well-drafted USA should define each partys expectations with clear rules describing the relationship among the shareholders and outline how the business should be managed.
A USA can be useful for numerous purposes, some of which are: dispute resolution; funding considerations; the need for unanimous shareholder approval where there is a majority shareholder, share transfer rules, or right of first refusal, buy, sell, or shotgun provisions.
Does the unanimous shareholders agreement (USA) differ from province to province?
The idea of the USA is the same under the securities legislation for the common-law provinces (excluding Quebec). Even though the idea of and the principles of a USA are similar, provincial legislation differs; therefore, one needs to pay attention to the governing provincial law affecting USAs. Differences should be minor. The Canada Business Corporations Act governs federally incorporated companies and, again, the principles of the USA under federal corporations are very similar to the provincial regulations governing USAs.
What is the difference between a unanimous shareholders agreement (USA), a joint venture agreement (JVA), and a limited partnership agreement (LPA)?
First, you need to understand what a joint venture is (and is not). A joint venture is an alliance (of sorts) between two or more other parties where each party contributes something of value (services, material, or capital) for a specific commercial enterprise or project. This is a worthy strategy where one party has cash (capital) and another party has time and knowledge (services). If each party values the other, and they both decide on a property to purchase, they can do so via a joint venture and thus allocate their respective ownership interest based on the value each brings to the project. A joint venture is not a partnership, a corporation, or even its own legal entity.
Second, you need to understand what a corporation is. A corporation is a specific legal entity or group of people authorized to act as a single entity (legally a person) and recognized as such in law.
Third, a limited partnership is a unique type of partnership created by statute (the Partnership Act in British Columbia, for example) where a general partner and one or more limited partners join together in a business endeavour with a view to profit.
Fourth, it is helpful to be clear on the terminology. There is no such thing as a joint venture partner. If you own a business (real estate or otherwise) through a corporation, you are a shareholder and the other owners are fellow shareholders. If you run a business as a partnership, you are a partner or unit-holder and the other parties running it with you are your partners or fellow unit-holders. And last but not least, if you are participating in a project (notice I didnt say business) that is a joint venture, you are a venturer and the other parties are your co-venturers.
Last, joint ventures and limited partnerships are, from a legal perspective, significantly different than the other ways in which you may want to conduct investing in real estate with others. A shareholder and a limited partner in a limited partnership has limited liability. A regular partner (or the general partner in a limited partnership) or venturer does not. The legal documentation to create, sustain, and manage a corporation, partnership, or joint venture is distinct and unique with very little overlap. A joint venture agreement may have some things in common with a partnership agreement or even with a unanimous shareholders agreement. But there are significant differences, too. There are also legal documents needed for one that are not needed for another.
For example, when one venturer holds legal title to the underlying real estate property and the other co-venturer(s) are not on title, one would expect at the very least some form of trust declaration stipulating that legal title is being held in trust for the actual benefit of others. In Alberta, lawyers would also recommend a caveat (encumbrance) be registered on title to the property, giving notice that there are beneficial owners. This would protect those not on title from having the property sold or mortgaged or their beneficial interest otherwise impacted by a disposition of title without their knowledge. This would expressly not be necessary if you are using a corporation or a limited partnership as your chosen investment vehicle.
Who provides personal guarantees?
Your lender will almost certainly require personal guarantees from all shareholdersvoting and non-voting. Personal guarantees are provided as extra security for a loan. Typically, in multi-family and commercial real estate, the loan is often the mortgage. The lender asks for all of the shareholders to provide personal guarantees. If the lender thinks that the mortgage and the shareholder personal guarantees do not provide enough security, the lender may ask the corporation and shareholders to find other non-shareholder entities to provide guarantees. Lenders always want more security, not less, so they will take personal guarantees or guarantees from any entity they can.
Will my co-venturers in my joint venture have to provide personal guarantees?
A joint venture party, that is not holding legal title, may have to provide personal guarantees. Further, if the parties to the joint venture are corporations, the shareholders of that corporation may need to provide personal guarantees if the underlying mortgage security is not sufficient security from the lenders perspective.
Do banks offer different mortgage rates for corporations?
Mortgage rates for corporations are dealt with by commercial lenders. Commercial mortgage rates might bear a superficial resemblance to residential rates, but they are set differently and can vary between lenders. For example, interest rates can be lower than residential rates if the mortgage is CMHC insured. Without insurance, the interest rates tend to be 50 basis points (bps) to 150 bps higher than residential interest rates. Other factors to take into consideration:
- Commercial rates can vary widely depending on the lending climate, the size, and the quality of the secured property.
- Its important to know your market and what lenders are looking for. For example, there is plenty of lender competition for an A building in downtown Toronto but not so much for a B building in Vegreville, Alberta.
Are there different lender terms?
Commercial lenders have more sophisticated documentation with more terms and they are more hands-on in their concern for supervising the loan. They also require supplementary security to the mortgage. Along with personal guarantees, lenders often have a comprehensive loan agreement as their primary security, with the mortgage, assignment of rents, and general security agreement as their secondary forms of security.
Typically, lenders use a debt coverage ratio (DCR) of generally 1.25 for non-insured commercial real estate. Lenders may factor in a variety of expenses on a case-by-case basis.