Optimizing Structure for Your Real Estate Portfolio
Embarking on a journey to build a real estate portfolio in Canada entails a multifaceted approach. Your success hinges not only on selecting the right properties but also on the strategic structuring of your investments to optimize returns and mitigate risks. In this series of articles, we will dive into various structuring options available to real estate investors in the vibrant Vancouver market.
The first installment will focus on two fundamental structures: proprietorships and corporations.
Proprietorship:
A sole proprietorship is a type of business structure in which a single individual owns and operates the business. In a proprietorship, there is no legal distinction between the owner and the business entity. To put it simply, it is just you owning the real estate directly.
Pros:
- Simplicity: A proprietorship is the simplest form of real estate ownership, making it an attractive option for newcomers to the world of real estate investment. It involves a single individual owning and operating properties under their name, with no need for complex legal structures. Your real estate income or losses are reported on your personal tax return along with your other income.
- Tax Offset: One advantage of a proprietorship is the ability to offset your real estate income against other losses in your personal tax return. If you have losses in other areas, such as self-employed losses or investment losses, you can use the income from your real estate holdings to offset those losses. This works in the other direction as well. Losses from your real estate can be used to offset other types of income.
- East of Startup and Maintenance: Setting up a proprietorship is relatively straightforward. You can begin your real estate investment journey with minimal legal and administrative requirements. The operation of a proprietorship also typically incurs the lowest maintenance costs compared to other structures. You only need to file your personal tax return, and in some cases, handle GST/payroll, if applicable.
- Direct Control: As a sole proprietor, you have full control over your real estate assets and business decisions. You don’t need to consult with partners or shareholders.
Cons:
- Less Flexibility: Income from your real estate holdings must be reported in your personal tax return. This limits your ability to take advantage of any tax planning or strategies using other structures.
- Tax rate: Without tax deferral opportunities, income from real estate can be subject to the top marginal personal tax rates for high income earners. Top marginal personal tax rates can reach as high as 53.50% in B.C. and ranging from 44.50% to 54.80% across other provinces in Canada.
- Unlimited Personal Liability: One significant disadvantage of proprietorship is the lack of legal separation between your personal assets and your real estate holdings. This means that your personal assets are at risk if you face any legal issues or financial liabilities related to your properties. We are not providing legal advice so please consult your legal advisors on this aspect. We are connected with many lawyers in our network so we are happy to recommend a few to you as well.
- Continuity: A proprietorship’s continuity is often tied to the owner. If the owner decides to retire, sell the business, or passes away, the business may cease to exist unless specific arrangements are made for its continuation.
Smythe pro tip! We don’t see many serial real estate entrepreneurs utilize this structure unless it is just a rental property here and there. However, it is a good start if you are just getting started!
Corporations:
Pros:
- Tax Deferral:
- One significant benefit of using a corporation is the opportunity for tax deferral. You can choose when and how to distribute income to minimize your overall tax liability. This is especially beneficial if your cash flow allows you keep earnings at the corporate level to reinvest for growth.
- Corporations also provide more robust estate planning options, allowing for efficient transfer of real estate assets to heirs or beneficiaries.
- Tax Rates:
- Corporations offer the advantage of being taxed at a lower rate compared to the highest personal marginal rates. In B.C. for instance, passive business income is taxed at 50.67%, while active business income is taxed at 27%. Small business corporations may also qualify for the Small Business Deduction (SBD), which has an even lower tax rate of 11% up to $500,000 of taxable profits per year.
- Rental income from real estate is generally considered passive income for corporations. However, when the real estate business employs more than five full-time employees, the corporation may be able to access to the active business income rate and the small business tax rate.
- Limited Liability Protection: By operating through a corporation, you may protect your personal assets from business-related liabilities. This separation provides an additional layer of security for your personal finances. Again, please consult your legal advisors on this part!
- Access to Capital: Corporations have greater access to capital through avenues such as equity financing and the ability to issue shares. This can facilitate the acquisition of larger or multiple properties.
- Credibility: Operating as a corporation can enhance your credibility and reputation, especially when dealing with partners, lenders, and tenants, as it signifies a higher level of professionalism.
Cons:
- Higher Administrative Efforts and Costs: Establishing and maintaining a corporation involves higher administrative costs. This includes opening a separate bank account, maintaining separate accounting records, and filing separate corporate tax returns. Legal reporting and compliance requirements can also be more complex and costly.
- Separation of Business and Personal: To maintain the separation between your personal and business finances, you must use separate names for your personal and business items, including bank accounts and invoices.
- Loss restriction: Operating as a corporation introduces an additional level of taxation. Income earned by the corporation is taxed at the corporate level, and when you receive dividends, you’ll be taxed on your personal return. The additional level of taxation also means when a corporation incurs losses, the losses cannot be simply used to offset other income for the owner(s), or to another corporation that generates income. This may reduce tax efficiency for the corporate group as a whole.
- Loss-utilization strategy exists but can be complex – refer to our article, “How to Effectively Utilize Tax Losses” for better understanding of tax losses and examples for loss utilization.
Smythe pro tip! Don’t let the administrative efforts and costs sway your decision on incorporating. If you are serious about real estate, you must expect to spend administrative time and costs to run your business. Contact us for help if it has become a burden for you. Smythe can help you find ways to reduce your administrative efforts and time so you can focus on your real estate business.
Other options
We’ll explore the pros and cons of using partnership and join venture in the next two instalments of this series.
The structuring of each real estate property depends on your specific financial situation, goals, and preferences. The decision should be made with the specific investment as well as the whole corporate structure in mind. Ultimately, it’s crucial to consult with a Smythe advisor to assess which structure aligns best with your real estate investment strategy. Careful consideration of your long-term objectives and risk tolerance will help you make an informed decision that serves your interests and optimizes your real estate portfolio’s performance.