By George E. Dube
When buying real estate today, you need to think about what your situation will be in 10 or 20 years and beyond. What ownership structure will allow you to meet your objectives over time? Instead of having a financially unhealthy focus on what is the bare minimum you need today, think about what structure will allow you to grow the most efficiently so you can get where you want to be. Discussing with your advisors the appropriate ownership structure for your family, and how it will change over time, can save untold grief and taxes.
When you first begin investing in real estate, having the higher-income spouse own the properties and receive the deductions common to the early years of investment property ownership provides some tax advantages. As you earn additional income and sell properties, splitting properties between spouses may lower rates of tax within the family. But changing property ownership can produce expensive tax consequences. The cost of doing it right in the first place by creating a structure you can grow into is often the least expensive option when measured over a reasonable period of time. The cost of “fixing” things later can be a challenge.
Alternate Forms of Ownership
Considering alternative forms of ownership or different combinations, such as corporations and family trusts, is prudent. While alternative ownership may be completely inappropriate for your situation now, from a tax perspective it may be far more effective to allow for the benefits of a structure to accrue over time. For example, creating a family trust for real estate ownership while your children are five years old may provide an excellent vehicle to pay for post-secondary education while potentially protecting assets. The more time you have to plan and implement, the more benefits will be available. You just don’t want to go overboard in setting up an elaborate structure that generates additional costs and complexity to operate.
However, this is not a do-it-yourself project. While splitting income between family members is generally a good thing from a tax perspective, the CRA restrains certain activities with “attribution” rules. In essence, in some situations the CRA believes that income earned by a family member truly belongs to another who contributed the funds for the investment or who previously owned the investment. Significant income tax changes have been announced in the past few years. Dramatic changes are being considered by the federal government as well, which in turn can mean your structure needs to be looked at with a fresh set of knowledgeable eyes.
Five Factors of Real Estate Investment Structures
We like to discuss structuring real estate investments within a framework of five major categories. Determining your priorities within the framework means you can make the best decision for today, and for tomorrow. Often we provide completely different recommendations to different people for very similar situations.
Ultimately, it’s you who must decide what is best for you and your family, but you need the input from your advisors to appreciate the ramification of the various choices. Your advisors may have differences of opinion, so get them to explain why they believe in one course of action over another. Armed with this information, you can make more knowledgeable decisions. Ideally, your advisors can have a brief discussion with each other and with you to highlight areas of agreement and disagreement. Then you can weigh the choices.
Generally, we make recommendations based on a client’s priorities in the following five areas:
Typically, people tend to like having as many choices as possible when it comes to
- how to remunerate owners,
- how to structure investments with co-investors without negatively affecting the co-investors,
- when to remunerate owners,
- who among the owners can be remunerated,
- how much owners should be remunerated, and
- how properties within the portfolio may be disposed and changing the specific investors in a particular property.
Corporations with joint ventures tend to provide more choices as compared to personal ownership or partnerships, for example.
2. Legal issues
While this is the domain of lawyers and their advice is paramount, liability concerns are often critical for many investors so we offer our clients some general comments. From our perspective, the legal profession has no universal opinion on the “should I incorporate?” question, although we certainly work with some lawyers who are adamant that a corporation provides more protection and should therefore be used when possible. While not generally an initial concern for investors, once you own a base level of real estate, it’s likely you will discuss family trusts for some purchases. Advisors often talk about limited partnerships in the context of attracting multiple investors.
3. Taxation impact
From a tax perspective, no single answer exists concerning forms of ownership. A particular investment structure may be better or worse for you in different cases. For example, your timeline for investment, objectives for your investments, nature of your investments, other business and financial activities currently and in the future, plus your family situation, all play a role. For someone unconcerned with flexibility and legal issues who earns moderate employment income and who is interested in a “buy and hold” strategy, there is little tax incentive to incorporate.
Alternatively, someone who wants to flip or develop properties, who has more family members interested in owning real estate, who has family members with differing levels of income now or will have in the future, or who currently earns business income through a corporation may be more inclined to incorporate. Further, someone wanting to attract multiple investors may prefer to remain more neutral from a tax perspective. This can be accomplished using the “flow-through” capabilities of a limited partnership because the investors can themselves decide how they prefer to own their partnership units (for example, personally or through a corporation).
4. Financing considerations
With the guidance of your mortgage broker or financial institution representative, consider the impact of the potential structure on receiving financing for current and future properties. Various financing programs are often restricted to personal ownership, for example. Again, we’ve encountered a wide range of opinions from financing professionals, but we wish to emphasize that many legal and ethical ways exist to obtain financing.
My family’s investment properties are held and financed through our corporations, and approximately 70% of our clients do the same. It is more than possible for most people to get reasonable corporate financing, assuming that they have some reasonable financial strength for qualification purposes. There may or may not be some extra costs, which can then be compared with other benefits of incorporation where applicable. If you’re struggling to obtain financing, perhaps you need to speak with someone who has a fresh perspective.
5. Professionalism and organizational issues
Generally speaking, we think a corporation provides the investor with a more professional image and an ability to segregate personal from corporate activities. This level of professionalism may, however, scare off potential vendors or co-investors. Similarly, some people find it much easier to understand and track their real estate portfolio when everything is basically in the same pot or owned personally as compared to having separate little “shelves” with one or more entities.
This brief synopsis shows that many choices exist, and in fact many more considerations and combinations are available when it comes to ownership. But don’t get taken in by the sexiness of a fancy structure that you don’t understand and that fails to meet your needs. You can grow into a structure when you’re ready. Changing your structure in the future may cost a little more, but you will have additional assets and cash flow to address these costs.
The fine print: This article is brief in nature and omits many important details that may dramatically change how financial plans affect your particular situation. This should not be considered tax, investment, business, or similar advice. Before implementing any plans, always discuss in full with your tax advisor and other relevant advisors.