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Capital Gains and Taxes For Real Estate Investors

Source: vipul patel

 

Today we have a guest post from Patrick Ruiz, a partner at Campanella McDonald, who are one of the accounting firms we use.
It focuses on of the most common questions we see investors have; the use of corporations to hold your properties.

 

We know accountants like to be sure to bill for all their advice, so a little bit of insight “pro bono” can be a good thing sometimes. 🙂

 

Enjoy…

 

How To Plan With A Holding Company If
Capital Gains Inclusions Rates Go Up

 

Recently, I was in my corporate tax update class as part of my mandatory professional development. I always take this as an opportunity to not only sharpen my skills but to get the pulse on issues that other practitioners face. With the many events that Rock Star puts on, I noticed a similar benefit Rock Star members receive while attending classes and the events. Events and classes offer a great network effect to gain valuable knowledge from and with your peers.

 

Outside of interesting tax and practice related issues, our discussions usually jumps to the rumour mill of what tax related changes are coming from the current government. While I cannot imagine anyone reasonably forecasting potential new mortgage rules, (ie. lower amortizations, posted rate qualifications) the rumour that the capital gains inclusion rate may increase as part of this year’s budget set to be released on March 22nd is a popular topic of speculation.

 

Capital Gains And Taxes

 

As we all know, capital gains are half taxable, meaning 50% of the gain is included in an individual’s taxable income, the same effective inclusion rate is applied for corporations as well.

 

A Brief History Of The Capital Gains Inclusion Rate

 

The inclusion rate, when first introduced was 50%, but then increased to 67% or two-thirds in 1998, then increased again to 75% or three-quarters in 1990. Ten years later, the rate was then dropped back down in early 2000 to 67% to only then be decreased again to its current inclusion 50% later that fall. So, inclusion rates in Canada have been on a rollercoaster, we believe, if history is any indication, a move towards a higher rate could definitely be in the cards.

 

So How Does This Apply To Real Estate Investors?

 

Since most real estate investors are investing to generate income from property, the underlying asset or property on disposition would be considered on account of capital versus on account of income. Real estate investors who have invested, especially in the past 5 years have most likely enjoyed substantial unrealized capital gains in their portfolio. A rumoured 50% increase to the inclusion rate to 75% could mean a 50% increase in tax payable on budget day!

 

What Can Be Done To Plan For A Potential Increase?

 

While the simple answer would be to realize your gain in the next week or so, this would be poor planning or tax advice to act on a rumor or make an investment decision for a tax treatment, however as we all know tax does factor in when making decisions – even in finance theory it is always about after-tax cash flows!

 

A Holding Company Can Hold Off Your Gains Treatment Increase

 

Besides realizing a gain, a crystallization reorganization is a strategy that can be implemented by creating a holding company to crystallize the gains current inclusion rate of 50%. This is done by selling the properties to a holding company in exchange for shares equal to the fair market value of the properties being transferred in. This, however, would be a taxable transaction so the tax bill must be funded today (a cost or drawback)

 

Now the holding company would carry the properties at a cost of the fair market value at transfer and any future growth or appreciation would be at the corporation at the new inclusion rate once the properties are sold. Note, this strategy would work if you plan to continue to hold the properties. As well, you would have to consider the other costs, besides paying the tax today, you would pay for costs to set-up a holding corp. (lawyer) and accounting fees for annual corporate returns and compliance (T-slips) as well as land transfer tax.

 

If the rate does not move, you can file an S.85 rollover and elect the properties to be sold at the lower of their UCC and ACB to transfer the properties in tax-free.
Also note, this crystallization reorganization would have to be completed by March 22nd, so the opportunity to do so is shrinking by the day, however, given the past history of inclusion rate changes, once they increase once, it may not necessarily be the last.

 

We thought the inclusion rate increase would also be another benefit for an investor looking at incorporating their current portfolio. A corporate structure really depends on the investor's current situation.

 

We believe having a substantial unrealized or pregnant gain alongside a potential inclusion rate increase would be a factor in favour of incorporating your current rental portfolio. As always, we recommend seeking out professional advice when considering a reorganization or incorporating your investment portfolio.

 

About the Author

Patrick Ruiz, CPA is a partner with Campanella McDonald and his practice focuses on real estate investors, small business owners, and incorporated professionals. patrick@cmllp.com

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