Across Ontario, there was excitement on October 1, 2020 when legislation passed allowing real estate professionals to incorporate by setting up a Personal Real Estate Corporation (PREC). That’s largely because incorporating can deliver significant opportunities for tax deferral.
Rather than paying personal tax rates up to 53.5 percent, income earned through a PREC will be taxed at corporate tax rates as low as 12.2 percent. Thanks to this tax deferral opportunity, you may have extra cash in your corporation that you can invest. This article discusses the tax implications associated with investing in real estate.
Property flipping versus buy and hold strategies
If you wish to invest in real estate with the cash proceeds that have been deferred by setting up your PREC, real estate properties typically are purchased to hold and earn rental income (e.g., buy and hold) or with the intention of reselling for profit (e.g., property flipping).
Buy and hold properties that are eventually sold are taxed at an integrated rate of approximately 29 percent as they are treated on account of capital (meaning they earn capital gains rather than active income). Conversely, properties resold for profit (e.g., property flipping) are taxed at an integrated rate of approximately 54 percent[1] as they are treated on account of income (meaning they earn active income rather than capital gains).
The tax rates associated with the disposition of real estate, and the consequent flow through of cash to the real estate professional, can be summarized as follows:
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To take advantage of the tax deferral, however, it’s important to properly structure both your PREC and your related real estate investments. Dispositions of real estate properties that are treated as active income will provide you with a greater tax deferral, but a higher combined tax rate when you withdraw your profits. Conversely, dispositions of real estate properties that are treated on account of capital will provide less of a tax deferral, but a lower combined tax rate once you withdraw the funds.
Understanding the rules
Given the alternative tax treatment on dispositions resulting in capital gains versus those resulting in active business income, it is important to understand the factors that are typically evaluated by the courts and the Canada Revenue Agency in making this determination. Some of the factors that are considered are included below and each one is important in determining the ultimate tax treatment:[2]
- The nature of the taxpayer’s business. If you are in the business of buying and selling real estate, then a gain on the sale of the property is more likely to be treated on account of income.
- Length of period of ownership. If you hold property for a long period of time, its sale would have more of the characteristics of capital treatment as opposed to income treatment.
- Frequency of similar transactions done by the taxpayer. Real estate professionals who sell real estate properties frequently are more likely to be considered property flippers, with the resulting tax treatment being on account of income.
- Motive and intent. What were your intentions at the time you initially purchased the property? If you had an intention to subsequently sell for a profit, the income generated would likely be considered on income account as opposed to capital account.
Choosing an investment strategy
It is important to be aware of the tax implications of buying and selling property if your intention is to use the excess funds in your PREC to invest in real estate.
The opinions expressed in this article are for information purposes only and do not serve as tax or legal advice. Please consult your Grant Thornton advisor to learn more about how to structure your real estate holdings.
[1] Assuming the original income in the corporation was taxed at the small business rate of 12.2 percent.
[2] IT-218R Archived – Profits, capital gains and losses from the sale of real estate, including farmland and inherited land and conversion of real estate from capital to inventory and vice versa.
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