Impact of taxes on RE Investments

Taxes are a crucial aspect of our lives as Canadians, particularly for homeowners and real estate investors. However, many people feel hesitant and confused when it comes to the topic of taxes. Nevertheless, gaining a solid understanding of how taxes work is essential for effective estate structuring, future planning, and maximizing financial gains. In this blog post, we will explore the world of taxes with Mohamed from Tax Heroes, an accounting firm specializing in tax planning and savings strategies. Mohamed will share his insights and expertise on various tax implications related to real estate investing. Let’s delve into the key highlights of their conversation!

Getting to Know Mohamed and Tax Heroes:

We start by introducing Mohamed from Tax Heroes, an accounting firm dedicated to helping individuals and businesses navigate the complexities of taxes. Mohamed initially became interested in accounting due to the allure of high-paying salaries. However, as he delved deeper into the field, he realized that earning a substantial income often required becoming a partner in a large accounting firm, with a focus on wealthy clients. This realization sparked Mohamed’s passion for assisting average individuals and small business owners in discovering tax savings and building wealth through proper tax planning.

Different Types of Real Estate Activities and Tax Implications:

Mohamed sheds light on the diverse types of real estate activities, such as rental properties, property flipping, building and selling properties, and short-term rentals. Each of these activities carries distinct tax implications. When it comes to selling a property, a critical consideration is whether the profit will be classified as business income or capital gain. Mohamed explains that this determination significantly impacts the amount of tax paid. Capital gains are taxed at a lower rate, as only 50% of the profit is included in taxable income, whereas business income is taxed on the full profit amount.

Determining the Intention: Capital Gain or Business Income?

We discuss how the Canada Revenue Agency (CRA) determines whether a property sale should be classified as a capital gain or business income. The primary factor considered by the CRA is the intention behind the purchase. If the primary intention is to earn rental income, the eventual gain on the property will likely be taxed as a capital gain. Conversely, if the main purpose is to flip the property for a profit, even if it is rented out, it is more likely to be considered business income. The CRA also takes into account other factors such as the frequency of buying and selling, conduct, and listing properties for sale.

Challenges in Determining Intentions:

We address the challenges involved in determining intentions, and a hypothetical scenario is shared to illustrate this point. Mohamed acknowledges that establishing intentions can be complex, and the CRA relies on evidence to make such determinations. For example, if an individual consistently experiences rental losses over an extended period without a plan for profitability, the CRA may question the intention behind the property purchase. However, Mohamed emphasizes that arguments can be made to justify intentions, such as expecting interest rates to decrease or building a real estate portfolio for future investment.

The Risks of Property Flipping and New Anti-Flipping Rules:

The conversation then shifts to the new anti-flipping rules that have come into effect. Mohamed explains that these rules impact individuals who sell a property within one year, regardless of their original intention or circumstances. The new rules treat the income from such transactions as taxable business income. This change has surprised many individuals, including those who did not expect to be affected. The anti-flipping rules aim to discourage short-term property speculation and promote long-term investment strategies.

Mohammed further explains that holding real estate in a corporation can be advantageous in certain cases, such as property flipping. If an individual knows they will earn business income from the property, it becomes beneficial to hold it within a corporation. The reason lies in the significant tax deferral possibilities offered by corporations, where tax rates can be as low as 9 to 12 percent, compared to personal tax rates that can reach up to 54 percent on business income. However, for individuals primarily interested in rental income and lacking an existing corporation generating business income, it is generally not recommended to hold the property in a corporation unless personal liability protection is a significant concern.

Seun adds that the decision between personal and corporate ownership depends on the property’s intended purpose. If the goal is to generate rental income, owning the property personally might result in lower overall taxes, considering the ability to combine rental income with other sources of income, potentially resulting in a lower marginal tax rate. On the other hand, if the objective is to flip the property within a relatively short time or generate business income, owning it corporately offers the advantage of lower corporate tax rates, allowing for potential tax deferral and reinvestment of profits without immediate personal taxation.

Moving on to deductible expenses, Mohamed clarifies some common misconceptions. While mortgage interest, property taxes, maintenance fees, utilities, repairs, and advertising expenses are generally deductible, it is crucial to understand what expenses cannot be deducted. For instance, individuals can only deduct the interest portion of mortgage payments, not the entire payment itself. Recognizing what expenses are not deductible is equally important as identifying deductible ones to avoid costly mistakes.

The conversation then delves into the distinction between current expenses and capital expenses. Mohamed explains that expenses incurred to improve the property, such as renovations or additions, generally fall under capital expenses, which need to be capitalized and depreciated over time. However, expenses related to repairs and maintenance can be expensed in the same year and fully deducted. Understanding this distinction helps individuals accurately categorize their expenses and maximize their deductions.

Furthermore, the discussion touches on the concept of depreciation. Mohamed and Seun highlight the importance of comprehending depreciation rules in Canada, as they differ from those in the United States. Depreciation allows individuals to deduct the wear and tear of their property over time against the income generated. Mohamed emphasizes the significance of accurately allocating values between the building and the land when depreciating the property, as only the building portion can be depreciated. Neglecting to determine the land-building split properly could lead to erroneously depreciating the land and potential tax issues.

In conclusion, optimizing tax benefits in real estate involves strategic decisions regarding ownership structures and meticulous attention to deductible expenses. Depending on the property’s purpose, either personal or corporate ownership may be more advantageous. Understanding the distinction between current and capital expenses, as well as accurately allocating values for depreciation, ensures individuals can maximize their deductions and minimize tax obligations. By following expert advice and staying informed about the ever-changing tax landscape, real estate investors can make well-informed decisions to optimize their financial outcomes.

Disclaimer: The information provided in this blog post is for informational purposes only and should not be considered as professional tax advice. It is recommended to consult a qualified tax professional for personalized guidance based on your specific circumstances.