- June 29, 2021
- Posted by: pts123
- Category: Finance & Accounting
3 Tier Corporate Structure For Real Estate Investments
In recent years, we have seen major growth in the real estate industry making it one of the hottest markets. This rising trend is showing no stopping and is likely to continue a steady incline for the next coming years.
Needless to say, real estate has become very a attractive investment opportunity to investors and as a result, many are including it in their portfolios. A first-time investor can either choose to acquire a property as an individual, at the personal level, or decide to acquire it through a corporation for the purpose of renting it out.
The tax rules regarding the income reported from a rental property will differ considerably depending on whether if one is reporting as an individual, or if it is reported through a corporation.
In the case of individual tax filing, if the property is held personally, the revenue generated will be reported directly on the investor’s personal tax return. However, if a property is held under a corporation, the revenue generated will be subject to the highest tax rates in the country, because the rental income in a corporation is considered to be passive business income.
As far as a corporation is concerned, even though it is a separate legal entity that offers the investor protection from legal liability, the tax rates for rental income, royalties, and interest, are immediately taxed at about 48% (passive business income tax rules). This is far from ideal from an investor perspective, thus making the holding of real estate in a corporation a much less appealing proposition.
Given this fact, however, there are strategies that can be implemented alongside your real estate investment to help offset the tax burdens levied on the income generated from property rentals.
Setting up a 3 tier real estate corporate structure for tax benefits
Any serious investor looking to purchase multiple revenue properties would definitely benefit from setting up a 3 tier corporate structure.
First, we need to look at 2 important considerations to understand how the tax rules apply to each.
1) If an investor has less than 5 employees working for them on managing their properties in a real estate company, they would fall under the specified investment business classification (passive income). This means that they would be taxed at the highest rate in Canada on any passive income earned.
2) In order to benefit from a lower tax rate, a passive business income corporation must have 6 or more employees in which its revenue gets treated as active business income. This makes it eligible for the small business deduction tax rate which is considerably lower at somewhere between 15.5 and 20.5% as opposed to 48% (depending on the province and other specific tax elements).
A 3 tier corporation is comprised of a minimum of 3 corporations which include the following:
1) Holding Company
2) Property Management Company
3) Real Estate Companies.
1). Holding Company
The first tier implemented in this strategy involves the creation of a holding company. The sole purpose of this company is to hold 100% of the shares of the property management and real estate companies which are the other necessary components of the 3 tier structure. The holding company will hold all the future net revenue earned from the rental properties, however, it will not generate any income itself.
As long as the holding company owns more than 10% of the shares of the property management and real estate company, dividends can be paid upward to the holding company. This is because they would be considered as connected corporations which offer certain tax benefits by allowing the holding company to pool money as after-tax dollars with no supplementary income tax involved. This money can then be used to pay dividends to shareholders, and or can be used to reinvest in other projects.
The holding company can also offer other advantages such as allowing for income splitting opportunities. The way this works is that the real estate investor can allocate another class of shares to their immediate family, such as a spouse or children over the age of 18. This allows the issuing of dividends to them and income split which can lessen the tax burden for the investor. Recent specific tax rules apply to income splitting strategies, therefore, professional advice should be requested before doing anything.
A holding company will also offer the investor limited liability should they be faced with any type of litigation from their tenants. Unfortunately, this is quite a common occurrence these days and will protect the investor’s personal assets if a lawsuit ensued against them.
2). Real Estate Company
The real estate company is the corporation designated to own the actual rental properties. This protects the investor from legal liability and from exposing other assets. Depending on how many proprieties an investor may have, it would also be possible to set up multiple Real Estate Companies under the umbrella of the holding company. The holding company would own 100% of those shares, and if there are multiple investors, these will be added to the owners of the holding company.
3). Property Management Company
The role of the Property Management Company is to manage all daily operations, such as signing the leases with the tenants, rent collection, deal with maintenance repairs costs, and will also charge a management fee for its services between 8% to 12% to the real estate companies.
The property management company will then bill the Real Estate companies for fees which will be considered the income of the management company. With this structure in place, all income earned by the Property Management Company comes solely from the earnings of the Real Estate Company making it eligible to access the lower rate of 15.5 – 20.5% as it is an active business income. The Real Estate Company can also declare the fees charged by the property management company as a deduction or expense, thus reducing the taxes owed at the highest tax rates.
Is setting up a 3 tier corporation the right decision for you?
There can be significant costs involved in setting up a 3 tier corporate structure, as one has to also take into account the additional legal and ongoing accounting fees. Therefore if you are not planning on developing a large real estate business, then the costs associated with a 3 tier stricture may not be feasible for your needs. However, if your goals are significantly more ambitious, and you are dedicated to growing your business, then the benefits could certainly outweigh the costs.
It may seem like a logical decision to wait until your real estate business grows to a certain level before deciding to create a 3 tier structure. Many tax professionals may even advise you to start out in your own name at first, then switch over to a holding company or 3 tier structure later on, however, the problem is that you would have to deal with the capital gains at the time, making it less worthwhile. However, a Section 85 (ITA) election could be made at that later time, for a rollover procedure, that will eliminate the capital gain at the time of the transfer, however, the procedure could be costly.
The image above gives an example of a 3 tier structure. You are the shareholder of the holding company, which is a shareholder of both the Real Estate and Property Management Companies. The property management company is under contract to manage the properties for the real estate company. This structure offers a significant tax benefit to the real estate company as its earnings can now be taxed as active income somewhere between 15.5 – 20.5% tax rate, as opposed to being taxed as an investment income at a rate of 48%.
As we can see, having a 3 Tier Real Estate Corporate structure set up for tax purposes can offer numerous benefits. One, it allows for using a portion of the rental income to pay for the management fees of the property management company to access the lower tax rate of 15.5 – 20.5 % for active businesses income. Two, it protects the investor from legal liability, in case of a lawsuit, and three, it is possible to channel funds from the Holding Company that would allow opportunities for income splitting with immediate family members.
This article only provides information in a general nature and is only as current as of the date on which it is posted. It is not updated and therefore may no longer be current. This document should not be relied upon as it does not claim to, nor provide advice on legal or tax matters. All tax situations are specific in nature and will likely differ from the situations that are presented in the article. It is advisable that you seek and consult a tax professional if you have any specific legal or tax questions. This document is intended to provide general information on a particular subject or subject (s) and this article is not an exhaustive treatment of such subject(s). In accordance, the information in this document is not intended to constitute or replace accounting, tax, legal, investment, consulting, or other professional advice or services. Before any decision is made, or any action taken which might affect your personal finances or business, you should consult a qualified, professional adviser.