Should You Incorporate Your Rental Property

For anyone looking to build wealth, achieve financial independence and/or retire early (see FIRE movement), it is important to build streams of passive income i.e. sources of income that are generated month to month without having to actively work for them.  One of the most popular methods of building passive income is to purchase a property that generates rental income.   If done correctly and with some luck, the return on investments (ROI) , which is composed of both rental income and appreciation in the value  of the property, can significantly improve your net worth.

An important decisions when purchasing a rental property  is whether you should own the property in your own name or purchase it through a corporation.  The right decision depends on a variety of factors which are discussed below:

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1.       Is the rental property part of a principal residence ?

Many owners have a rental property that is part of their existing home in the form of a duplex, triplex or simply a basement apartment that has been rented out.  In this case it probably doesn’t make sense to incorporate (unless part of some more sophisticated tax planning) since you risk losing your principal residence exemption which can be a significant tax savings on any appreciation of the value of the home upon its eventual sale. The principal residence exemption in Canada allows you to sell your home without paying any tax on the capital gains.

2.       Do you own the property in partnership/co-ownership with someone else ?

If you decide to purchase the property with someone else (including a spouse) it might make sense to incorporate as this gives the co-owners/partners a separate legal entity clear beneficial ownership  in the corporation based on whatever proportion that is decided at the outset.  For example, if two co-owners decide to contribute an equal portion of the down payment then the ownership percentage can be allocated at 50% each.  It is important to draw up an partnership agreement between co-owners that outlines the % ownership, who handles the difference  management aspects of the property , how any major repairs down the road will be handled and who will pay for them, who takes care of the accounting and tax reporting etc.

3.    Do you want limited liability to protect against potential lawsuits?

If you believe that there is a risk of litigation/ lawsuits with respect to the property you’re purchasing, then it might make sense to incorporate to provide limited liability protection. This means that the shareholders of the corporation can only lose up to the amount of their investment thereby protecting your personal assets.  It might also be possible to replace the limited liability protection of a corporation with liability insurance if you decide to buy it personally.

4.       Are there any obstacles to selling the  rental property to the corporation?

Before incorporating, it is important to verify with the seller and you bank if there are any restrictions about selling the property to a corporation.  Some properties may only be sold to individuals.  Also, a bank may have different criteria with respect to the mortgage financing to an individual vs a corporation or in many cases a bank may require a personal guarantee from the purchaser of the property.

5.       Are the costs of incorporation and ongoing administrative costs worth the investment?

There are one time costs involved with setting up a corporation.  There are several online incorporation services that can be used or you can get a lawyer to set it up.  To save costs you can also do it yourself but it is important to make sure that it is done correctly.  More information is available at Industry Canada for a federal corporation or if you are registering the corporation in Quebec or another province, you would want to go the provincial website for details on how this is done and the various fees involved.

Once you have set up a corporation, you are required to prepare a corporate tax return on an annual basis for which an external accountant is recommended.  The fees for a corporate tax return can be anywhere from $750 to $3000 per year depending on the accountant and the services that you require.  Additionally, if your rental property is profitable and you want to withdraw funds from the corporation as a dividend, there are additional administrative requirements as T5 slips have to be prepared.  Finally if the property purchased is a commercial property (where a corporation is usually recommended) you are required to charge sales taxes (GST/HST and QST) for which there is additional reporting. 

Regardless of whether you are incorporated or not, you want to make sure that account for the revenue and expenses of the rental property and properly report them on your tax return. Accounting for a corporation can be a little more complicated and should be discussed with your corporate accountant.

6.       What are the tax implications of owning property in a corporation ?

Owning a rental property in a corporation does not unfortunately provide much in the way of tax benefits and can in fact result in higher taxes than if you owned it personally.  The tax rate on passive income earned in a corporation, which may vary depending on the province, is approximately 50%   The only way to reduce the tax rate is to have more than 5 full time employees which essentially turns it into an active business.  Much of the taxes paid are refundable and can be recovered if you pay yourself a dividend, which must then be declared on your personal taxes.  If your personal tax rate is lower than the top tax rate, the net taxes payable will likely be lower than in the corporatioin.  That being said, often rental properties don’t generate significant amounts of net income after deducting mortgage interest and other expenses including property tax, insurance and repairs.  There is also the option to take depreciation on the property which defers the taxes payable to when the property  is sold.  Not all advisors recommend taking depreciation as this could result in a significant tax bill down the road when the rental property is sold.

7.       Do you plan to buy more rental properties?

If you only plan to have one rental property, then it might not make sense to incorporate.  However, if you plan to build a portfolio of properties then having a corporation can be significantly more beneficial as it provides limited liability and the administration costs are spread over various properties.  Additionally losses on one property can offset gains on the other.  Of course, some property owners have a separate corporation for each of their properties to further limit their liability but this again depends on your specific situation. 

8.       Should you transfer an existing property to a corporation?

You might already have an existing property that you want to transfer.  If this is the case, you generally have two choices:

a. You can transfer the property at its fair market value.  In order to do this you would need to get an independent appraisal of the property by someone certified to do this.  Once the property has been appraised you would reflect the difference between the original purchase and the fair market value as a capital gain (or loss) on your personal tax return and pay the associated taxes.

b. You can use a section 85 rollover to transfer the property at its original cost.  This is can be a complex transaction and it is advisable to speak to an accountant.   

The decision to invest in a rental property can be a significant step towards wealth creation but there are a number of business and tax implications that should be considered before taking the plunge.

Ronika Khanna is an accounting and finance professional who helps small businesses achieve their financial goals. She is the author of several books for small businesses and also provides financial consulting services.

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