As of October 1st, 2020, real estate agents will be able to incorporate as personal real estate corporation, otherwise known as “PREC” type corporations. This will open the door for real estate agents to enjoy similar benefits that other corporate businesses have been able to use for years. However, important restrictions are unique to these types of incorporations not found in other corporation set-ups such as restrictions on who can be shareholders.
The goal of this article is to help real estate professionals understand the important advantages, disadvantages, restrictions and planning opportunities involved with incorporating a personal real estate corporation. The article will focus mainly on tax aspects of the introductions of PRECs.
The main benefit of incorporation for a real estate professional is the tax deferral that arises from the difference between the corporate tax rate and the personal tax rate. Currently, an active business corporation is subject to a combined corporate tax rate of 12.5% in Ontario on its first $500,000 of income and 26.5% for each dollar after. In contrast, the highest personal tax rate for individuals in Ontario is 53.53%. Incorporation, in most cases, for a real estate professional should only be considered when they generate more money than they need to subsidize their family’s personal living expenses and RRSP contributions - if applicable or desired. If, in the case where every single dollar generated is needed for yearly expenses, then incorporation might not be an appropriate option. Tax deferral might also be very useful when income fluctuates year to year. For example, an un-incorporated professional earning $400,000 in year one, $100,000 in year two and then $400,000 in year three, will be paying high taxes in years 1 and 3, and less in year 2. Previously, there was no option to average the 3 years for tax purposes. However, if instead they had a corporation, the individual can then decide exactly how much taxable income they want every year, regardless if it’s a good or bad year. This can also create a nest egg by using prior good years’ excess left in the company to help in a year that isn’t so good. This result is attainable because the corporate tax rate is flat at 12.5% within the corporation for the first $500,000 of active income.
A real estate professional who makes $200,000 a year but only requires $80,000 after taxes to subsidize their living expenses would be left with only $45,485 to reinvest after taxes. If this same real estate professional was incorporated, after removing the $80,000 required for living expenses in the form of either salary or dividends, they would have $74,191 to $79,186 remaining in the corporation to reinvest as they choose. In this case, incorporating the practice leads to an additional $28,706 to $33,701 annually in excess funds to reinvest in the corporation, leading to growth of the business, reserve funds, or additional retirement funding.
Shares of a real estate professional corporation may qualify for the lifetime capital gains exemption, which is $883,384 for 2020. Therefore, if a real estate professional plans to be able to sell the shares of their PREC (or any qualifying corporation), the first $883,384 of the sale price is tax free. Depending on their personal marginal tax rates, this could represent a saving of at least $199,523 from taxes in Ontario based on the sale price of the practice at $883,384 for the shares.
A PREC is not allowed to carry on the business of trading in real estates other than providing the services of its controlling shareholder to the brokerage that employs that individual. OREA later confirmed that a PREC is allowed to hold passive investment income including rental properties. OREA also confirmed that holding type corporations can own shares directly into a PREC, as long as the shareholders within the holding respect the PREC shareholding restrictions. This leads to a multitude of interesting investments opportunities and tax planning for the PREC, which are not usually allowed in other professional corporations, or even in PRECs from other provinces. Therefore, the PREC could decide to invest its excess funds in either regular investment such as mutual funds, stocks from the stock market, GIC, or directly into rental properties. For those who plan on either owning multiple rental properties, or seeking additional creditor protection or want to make sure to qualify for the capital gain exemption within the PREC, will have the option to incorporate a second corporation to act as a holding corporation. This holding in turn will own some shares inside the PREC and would invest in passive investments such as rental properties. This would attain a separation of the PREC business from the passive income business.
In a regular corporation, liability is usually limited to the assets in the corporation and not to the shareholders’ assets. For a personal real estate corporation, the controlling shareholder registered as a broker or salesperson will still be personally liable for the services provided to Ontario’s consumers and will be held accountable by RECO for breaches of TRESA and misconduct.
Even though incorporation might be a good solution for your business, having a PREC might not be the best solution for your situation. We would recommend any real estate professional looking to incorporate to visit the RECO and OREA website in order to familiarize themselves with the restrictions unique to PRECs, such as not being allowed to carry a business of trading in real estate, and not allowed to advertise the name of the PREC. For us, the main important restriction will be who can be a shareholder. PREC regulation split shares into two categories: equity shares, which are voting shares, and non-equity shares which are non-voting. The regulation is clear that equity shares must be owned by the controlling shareholder only and no one else can have any voting rights in the corporation. Because there is only one controlling shareholder, this means there can only be one agent flowing there commission income in the PREC. This means a PREC can’t be put in place to flow all commission from a team, same for a situation where controlling shareholder and spouse are both generating commission income, in this case each agent would have to have their respective PREC to receive the commission income through the PREC instead of personally. As for the none equity shares, the regulation limits the holder of those shares to the spouse, child and parents of the controlling shareholder. Therefore, we have a lot of flexibility and planning opportunity when it comes to possible income splitting.
Annual accounting fees for the preparation of the corporate tax return, bookkeeping and financial statements.
Risk of potential audits by the Canadian Revenue Agency (CRA).
As shown in figure 1 above, where the real estate professional earning a net of $200,000 but only requires $80,000 to subsidies their living expenses, that same individual can decide to pay themselves either in the form of a salary or a dividend. Figure 1 demonstrates that there would be an overall savings of $4,995 by distributing a dividend instead of a salary to the real estate professional in order to net out $80,000 after taxes. Of course, other factors must be considered, such as the value of CPP contributions, the creation of RRSP room, various personal tax credits that might require salary income, etc. The answer is never as simple as the result of the math, but this is a flexibility that is afforded only to those who are incorporated. Those individuals can also control how much funds they want to remove year to year from the corporation in order to defer taxes to another fiscal year. It is important to discuss the option of salary and dividend, or a mix of both with your accountant in order to put forth a good game plan.
PREC can only have real estate professionals (registered broker or salesperson) as shareholders of equity shares (voting shares), while family members (parent, spouse, children) are allowed to own non-equity shares (non-voting). Therefore, income splitting can be achieved by ‘sprinkling’ dividends to individuals other than the real estate professional. But in order to do so, we must also meet certain criteria to avoid what we call “tax on split income”, or TOSI. If a dividend distributed to a family member falls into the TOSI trap, that dividend would then be deemed to be taxed at the highest individual marginal tax rate, eliminating the benefit of income splitting. Learn more about the TOSI rules.
They are several ways to have family member receive dividends without having the TOSI rules apply, but require careful planning and attention to detail. Paying out reasonable salaries for instance could be one way to income split with family members as long as the salary is reasonable to the work performed. Here are three main possibilities to successfully income split by giving shares to family members:
Declaring a reasonable dividend to a family member in exchange for work that was contributed to the corporation.
Once the professional reaches the age of 65, the PREC can distribute dividends to the spouse without further restrictions.
Conventional retirement planning for real estate professionals would have consisted of maximizing RRSP and TFSA, which have a limit of $27,230 and $6,000 in 2020 respectively, and then investing the rest in unregistered investments that are fully taxable. When you are incorporated, you have the flexibility to start investing by using the corporation as an investment vehicle instead of having personal unregistered investments. Keep in mind, in our earlier example, our real estate professional who only needed $80,000 for their living expenses, had an excess between $74,191 and $79,186 in the corporation to reinvest, whereas they would have only $45,485 if not incorporated. This allows them $28,706 and $33,701 more money to reinvest in what could be a retirement fund, and then used to grow every year, and only removed later in retirement. A corporation means having the option and flexibility of having investments in RRSP, TFSA, and in a corporation as an investment vehicle, as well as using the PREC or a holding corporation to hold rental property investments. Appropriate planning is required to decide on the proper mix of RRSP, TFSA and corporate investments/rental. For some, a corporate investment is a better option than RRSP and TFSA. Others will want to contribute the maximum to RRSP and TFSA while leaving the excess in the corporation to reinvest and grow. Every situation is different and unique and needs to be properly analyzed. There are also specific types of investments that should be prioritized inside a corporation rather than in RRSP and TFSA and vice versa.
Owning life insurance is an important part of any proper family and estate planning. As being an incorporated business, you will have the option of having the corporation own the life insurance policy through the corporation and the corporation can be the beneficiary of the policy, compared to owning the policy personally and having family members as beneficiaries. Life insurance payments, in most cases, are not deductible in the corporation, in the same way as they are not deductible on a personal tax return. However, since the corporation is taxed at a lower tax bracket, it is often much cheaper to own the policy through the corporation. For example, let us compare a policy that costs $10,000 per year for a real estate professional at a marginal tax bracket of 40% or at their corporate tax rate of 12.5%. That individual will require $16,667 of personal income to pay the annual personal life insurance policy of $10,000, but the corporation requires only $11,428 to pay for that same policy. Therefore, there would be a yearly saving of $5,239 in cash flow to finance the same policy.
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