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Real Estate Considerations: Incorporation Part 2

Why Ownership Selection is Important

Any form of investment bears a level of risk.  Risk, I learned back from working for an auditing firm, is any uncertainty that will have impact (positive or negative) to your business.  Sometimes, risk manifests itself in a way that causes personal liability.  When real estate transactions involving such a high volume of cash changing hands, you as an investor and party to that transaction want to tread very carefully.  It just so happens that in the real world, the higher the dollar value of an investment, the greater the chance you can have claims made against you.

To start, written agreements can help you circumvent most of the foreseeable claims, and of course, having a capable real estate agent can help you with this when writing a Contract of Purchase and Sale.  More importantly, your choice of ownership structure is also important.  There is a handful of strategies I will introduce here to help reduce your personal exposure to claims that could easily eat into your profit margin, Return on Investment, and Rate of Return.

Corporations, undoubtedly, can help protect you from these claims in an increasingly litigious environment.  A corporation, as a separate legal entity controlled by but independent of it’s individual shareholders, acts on its own legal behalf and bears responsibility for its actions.

Strategies

Seek a lawyer for this part:

Taking advantage of the protection that personal liability corporations offer is easy.  For example, always sign business documents as an authorized signatory of the corporation of which you’re a part.  A clear statement that are you acting as a representative of the corporation rather than in your own personal capacity will help ensure the corporation, and not you, bears the brunt of any claims.

Similarly, if you make loans to your corporation, become a secured creditor.  The corporation’s director may bear some liability.  Be cognizant that if you’re a director of your corporation, you are liable for:

  • Corporate tax
  • Sales taxes
  • Provincial employment standards legislation
  • Builder’s liens

To protect yourself as a director of a corporation, consider not owning personal assets such as cars or real estate.  You can transfer these assets to your spouse to limit what claimants can seek from you.

To minimize your risk, one strategy is to lessen your involvement in your business as a director.  Another strategy is to reduce the number of possessions you hold in your personal name, such as property.

All these strategies you will require advance customized legal and tax advice.  As always, seek the right professionals first and build a strong relationship with them at the onset so you will have your interests protected.  My job as your realtor is protect your real estate related interests so you can reach your financial objectives with comfort, confidence, and clarity.

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Real Estate Scenario #1: Parents in Control, Children with Ownership

This scenario was taken from “Real Estate Investing for Canadians for Dummies” by Douglas Gray, Peter Mitham.  This scenario depicts how you can maintain ownership and still produce a win-win situation for your children and your family.  Thought it would be useful to share:

Creative ownership arrangements aren’t as dubious as creative accounting!

Take, for example, the case of Duane and Madelyn, a professional couple in Red Deer whose three children were on track to start university in Edmonton within two years of each other. Because the kids would have to leave home, Duane and Madelyn decided to buy a property a 15-minute walk from the university and renovate a portion for rental purposes. They planned to rent out the basement while their children and their friends (who would pay a nominal rent) would enjoy the run of the main floor. The total amount of rental revenue from the property paid the operating expenses of the house, such as the mortgage and related interest, property taxes, utilities, maintenance, and insurance. And $1,500 was left over for Duane and Madelyn to put toward their retirement.

To make the deal work, Duane and Madelyn sought expert legal advice. They decided to put the house in the names of their three children, and received three key documents from their kids in return. One was a declaration of trust stating that the children were holding the property in trust for their parents and would, upon their parents’ request, transfer title back to the parents. The document also stated that any rental income in excess of operating expenses belonged to the parents. The parents also obtained a transfer of title document signed by the children, which the parents kept unfiled. The third document was a letter from the children assuring Duane and Madelyn that the property would remain free of all financial encumbrances, such as another mortgage, line of credit, or judgment filed against it for a debt.

The agreement gave Duane and Madelyn full control over the property, but also ensured that their kids had a place to live. When their children graduated, they could arrange to sell the property and allow the children to retain the net proceeds without any capital gains tax as the property was the children’s principal residence. This could pay off most, if not all, their student loans. However, if the parents needed the money, or the children turned out to be prodigal, Duane and Madelyn could exercise the trust declaration and file the transfer document giving them full ownership. They could sell it, and pay any capital gains tax as an investment property, after getting tax advice on the best tax strategies.

I truly believe one of the two main functions of a professional Realtor is helping you build relationships and make the right connections.  Take into account not just the business and investing experience of the Realtor you work with, but also the perspective of other professionals that come from age, life experience, and long-term goals.

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Real Estate Considerations: Incorporation (limited company)

A corporation is a business that operates as a legal entity but is separate from its owner or owners.  Corporations must file annual reports, submit tax returns, and pay taxes.

A corporate structure, as opposed to partnership and sole proprietorship, has many tax benefits.  With a sole proprietorship, you must declare and pay taxes on all your income in the taxation year you’ve earned income.  Corporations pay a corporate tax in the year money is earned which benefits from a reduced tax rate up to potentially $500,000 if the corporation has three employees or less and other criteria are met.  You don’t pay any personal tax until you take money out of your company, and knowing this, you can optimize your real estate planning options.  Your accountant can delve more into how you can capture benefits based on your unique situation.

WARNING: Although you do benefit from reduced taxes for your taxable income from a real estate corporation, passive recurring income from real estate assets may be subject to a different tax rate.  Again, consult with your accountant to plan the most tax-advantageous arrangement if you incorporate.

A corporate entity will be required to abide by strict reporting rules set forth by provincial law where the company incorporates, but the advantage to you, as a shareholder, is that the company accepts full responsibility for all claims made against it.  Unless you sign a personal guarantee accepting all claims against the corporation, claims are limited to the corporation’s assets.

Taxes are a significant consideration as you choose an ownership structure for your real estate investments.  Ownership of properties through a legal corporate entity may open up various tax advantages.  Since the company operating your properties files its own taxes, you can claim only the income flowing to you as a shareholder in the business.  Business related expenses of the corporation are not available for shareholders to claim.

As a shareholder, you want to always ensure that a shareholder’s agreement and buy-sell clause are signed before entering into any deal that requires putting money to a corporation.  These documents pertain to dealing with management and dissolution of the company if anything goes south.  It also contains possible issues and scenarios related to your participation in the corporation.  A lawyer can help you examine whether the agreements are a fit to your overall objectives.

As always, seek independent legal, accounting, and other professional advice related to your real estate transaction.  Experts will help you navigate this journey and help you avoid unforeseen problems.  Of course, have a realtor on your side to ensure you find the right home all the while connecting you to the right people every step of the way.