Difference Between Real Estate Development and Real Estate Investment
There is much confusion on the tax efficient way to hold real estate. The confusion is because taxpayers confuse real estate development with real estate investment.
If a taxpayer is planning to buy a piece of land and build a new house or substantially renovate an existing house, this is real estate development, NOT real estate “investment”. The distinction is very important because the tax treatment of the profits from development versus investment is very different.
Vancouver Real Estate Development
Real estate development as described in the last paragraph is considered active business income (“ABI”). As such, if development is done in a CCPC, like all ABI, up to the first $500K of profit each year would be taxed at the 11% corporate tax rate.
Vancouver Real Estate Investment
Real estate “investment” is the more common concept for taxpayers – which is buy a condo or a house and collect rental income (short or long term) from a third-party tenant. The profit from renting real estate is not considered ABI by the Income Tax Act. Net rental income is taxed as investment income. Hence if the real estate investment is held in a CCPC, the initial corporate tax rate is a whopping 50.67%. However, 30.67% is refundable tax upon the distribution of dividends to the shareholder, which makes the effective corporate tax on net rental income to be 20%. But the dividends must be paid out to the shareholder in order to get back the refundable tax at the corporate level. Hence personal taxes will have to be paid on that dividend distribution which is 35.71 percent at the highest tax bracket. So the overall tax rate is the 20% paid by the corporation and 35.71% paid at the personal level, totaling 55.71%.
If the rental property was held personally, the highest marginal tax rate would only be 49.8%. Hence, an additional tax rate of 5.91% on absolute term or 11.87 % on relative term will be paid by holding the investments in the corporation. Not to mention the additional professional fees involved in accounting and reporting for a corporation.
Above is a very simplified explanation to support the widely given advice that real estate “investment” is best held personally.
If this is the case, why are so many real estate investments held in a CCPC? Well, if the taxpayer owns a CCPC and his main source of income is from the profits of the CCPC, then it is very likely that all the free cash is held as retained earnings in the CCPC. Remember that CCPC shareholders generally extract just enough income personally to pay for living expenses. The remaining funds are left in the CCPC as corporate tax rates are much lower than the personal tax rates. Hence, if the shareholder is contemplating a real estate investment, if the decision is to hold it personally, personal taxes would have to be paid first on the draws – which is not tax efficient. If the CCPC buys the investment directly, there is no tax consequence on the purchase.
The two options are:
- Using the large pool of corporate funds which have been taxed only at 11% (or 27% on amounts above the SBD limit) and buying an investment property with no further immediate tax cost. However, there is an additional 5.91 percent absolute tax cost on the investment income every year.
- Pay 39.73% (assuming highest tax bracket) personal taxes up front on the dividend draws to hold the investment personally. In addition, any future cash shortfalls would have to be extracted from the CCPC as dividends first.
Note that real estate is a leveraged product that creates large interest and depreciation deductions. Hence, the net rental income is not expected to be a big amount so the additional tax rate is on a relatively small value in a corporation.
On the sale of the property in the future, the gain would be a capital gain with a 50% inclusion rate with the untaxed 50% adding to the CDA pool for a tax free extraction. (This is a similar treatment if the investment is held personally.)
The final answer is this. If the taxpayer earns most of his income through employment, then it only makes sense to hold the investment property personally. However, if the taxpayer earns most of his income through a CCPC he controls, then holding the investment property in the CCPC makes more tax sense.
Vancouver Real Estate Planning Tax Advisors
Mew & Company Chartered Professional Accountants in Vancouver BC are experts in trust & estate planning services, or if you have questions, please don’t hesitate to contact us to learn more about how we can help you!
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