Real Estate and Taxes: Unlocking Efficient Structures and Strategies

With respect to your real estate investment, what we want to do is we want to share with you the top seven strategies to ensure that you've got the greatest tax efficiency put in place. Different sources of income are taxed differently. Passive investment income is taxed at a higher rate inside a corporation than active business income. Something we want to consider. If you have more than five full time employees inside your corporation, you would get access to it as active business income even though it's the same, same source.

Welcome to the Wealthy Entrepreneur Podcast. I am your host, Bob Gover. I'm so grateful to have you here with me today. The Wealthy Entrepreneur Podcast. You are here. This is the place where we dissect the elements that contribute to entrepreneurial success, from mindset and leadership to profits and revenue. This episode we're actually going to focus on the top seven tax planning objectives for real estate investors. So I've been doing a lot of work recently related to real estate investments and I wanted to bring attention to some of the research that we have in some of the presentations that I've been bringing forward to you as our Wealthy Entrepreneur podcast follower and subscriber. So what we're going to do today is we're going to walk through these seven situations. Now we work with many, many real estate investors. Many real estate investors use this as a secondary source of income, meaning that they've got a business that's generating business income, their surplus funds in there and they start reinvesting in in real estate. And it's really a passive investment stream for many business owners. But we have also other businesses that are full time real estate investors and it's certainly interesting to watch and be part of maybe even some of the development process, the purchase and sales. Our legal team is supporting them. Doing the bookkeeping for a full time real estate investor is very interesting. There's usually lots of transactions going on, there's lots of sitting and waiting and there's looking for good opportunities and assessing those opportunities along the way. But regardless of where you stand with respect to your real estate investment, what we want to do is we want to share with you the top seven strategies to ensure that you've got the greatest tax efficiency put in place. So we're going to start off with number one. Number one is that you have the most tax efficient business structure available. So to give you a little bit of background, there's multiple structures that are available. There's and Canadian and tax and us are completely different. So different structures in different countries. But for the most part they're very, very similar with different rates applying and some nuances along the way. So I'm going to walk you through what that looks like. But again I'm going to say fairly surface level. I'm not going to talk about all the benefits of each, but really we're just focusing on the most tax efficient business structure. So when we think of partnerships or sole proprietorships, both. Canada, the U.S. both of those are taxed individually. So sole proprietor. If you've got a business or if it's real estate, you can have it that way. Partnership, same thing, you can have a partner, you own real estate, that income gets taxed on your personal side at full income. So the challenge there is that marginal rates go from zero all the way to about 50% in the U.S. maybe 45% in the U.S. and up to 54% in Canada. So depending on the state, it starts at 37%. Federal is the highest tax rate and then dependent upon the state, it gets added on there. So it gets upwards of 45% depending on the state. In Canada, for the most part the tax is federal, although there's a few slight variations. But the average across the country is about 54%. So a little bit higher in Canada related to real estate, which is interesting. So if you're a Canadian investor, a little bit more tax. If you're a U.S. investor in Canada, you still have to pay that higher tax. If you are a Canadian investor in the US you pay the higher tax as well. So it's really dependent upon where you're a resident or whether your entity is is a resident in Canada or the U.S. that's how what dictates your tax rate that you pay? There's other structures though. So in Canada we've got a corporate structure. A lot of you will have maybe heard me talk about corporations paying a small business corporate tax rate of 12.2%. That doesn't necessarily apply to passive real estate investment income unless you've got five or more full time employees. So that's a bit of a challenge. So really the tax rate on passive investment income is about 50%. So we have to just pay attention to that. I'm going to talk about some ways that we can maybe convert that income into better tax rates. But we just want to be aware that different business structures will provide us different tax rates within our real estate investment portfolio. Same in the US you've got an LLC which is a fairly typical structure for real estate investments. And you are the beneficiary or the member owner of An LLC which means that it's flow through income from the LLC back to your personal level. Again upwards of 47%, 45% dependent upon the state. But you can elect to file as a corporation or as a C Corp or an S corp and get access to the flat corporate tax rates which is 21%. So, so there's your little bit of a short version of corporate structuring and just making sure that whenever we're acquiring real estate that we want to make sure that we're taking into consideration. It's not going to be the only consideration, but taking into consideration the most tax efficient structure. And you'll get to the end of this and you'll realize that, you know, in the US I likely would recommend an LLC based on the protection. And in Canada, I would likely suggest using a corporation to acquire your real estate. And it's just working within the tax rules and the tax rates to make it a little bit better. So let's move down the list and we'll see if we can't make that tax structure and that business structure become a little bit more tax efficient as we go. All right, so that's number one, make sure that you have the most tax efficient business structure in place. Number two, the most efficient source of income. So there's a few pieces of information that we need to share. Different sources of income are taxed differently, passive investment income and is taxed at a higher rate inside a corporation than active business income. Something we want to consider. If you have more than five full time employees inside your corporation, you would get access to it as active business income even though it's the same source. But if you have that number of employees in there, we would be able to get access to the lower tax rates. So that's one thing to consider. And the other source of income that we have are capital gains. Capital gains are at 25%. However, in Canada you're aware that there's a proposed legislation change to move that from 25, 33% so there will be an 8% increase, at least how it appears at the moment. Even with the 33% capital gains tax rate, it still is the most efficient source of income, obviously aside from tax free money, but as taxable earnings. That is the lowest tax rate we can get access to. Dividends are the next eligible dividends are better than non eligible dividends. But we're really looking at somewhere between 24% to 43% related to dividends. So there's definitely some, some room in there dependent upon how much income we're generating and whether it's eligible or ineligible. And then you've got property income or income from property employment income. All of that is definitely going to be at the highest rate. It's a full income inclusion. So that would be on the personal side, subject to the highest marginal tax rates, which would be in Canada that 44%, that 43, 44% and in the US that 37% plus. So that's something we need to be aware of. So we want to understand the sources of income. Because if we can create something where we maybe take it from passive investment income into active business income, we want to be aware of it. We also want to be able to look at it and say, well, real estate is great if we can continue to reinvest in it and its appreciation. Maybe we avoid paying some of the passive investment income tax, but we're paying capital gains tax as we continue to reinvest in there. That's an understanding of the different sources of income, how we eliminate some, maybe passive investment income, but we pay capital gains tax later on. So we want to be aware of of the sources of income and how maybe there's differences between them and how we ensure that we have the most tax efficient source of income coming through. Number three, income splitting opportunities. So what does this mean? This means that if I have the opportunity to, and we don't always, but if I have the opportunity to, I want to be able to split income with my, my spouse, with my children, maybe with some other related members of the family. But if I have the opportunity to be able to do that, I want to be able to do that to the maximum extent possible. Really good example of this is paying your kids salary. If they're actively involved in the business, you can pay them a reasonable salary. It's a deduction in the business or against the real estate. It also is taxable to them but dependent upon their personal income. If they're under $15,000, they likely won't pay any tax. So there's ways to get advantage, take advantage of their deduction inside the business and the fact that they don't have to pay any taxable income on that source. You can also look at other areas where we say it's an unreasonable wage. The Canada Revenue Agency doesn't suggest that we can't pay an unreasonable wage. It just says it's not deductible inside the business. So depending on our tax rate in the business, it may make more sense for us to have a non deductible Salary and that paid to a family member, that they have to pay tax on it at their rate. So we may not get the business deduction, which may be 12%, but that person may be substantially less than 12% tax lower than we are. So it still makes sense to be able to income split with them. So there's ways that we can get fairly creative there and be able to save some tax money as well. The other way is to be able to make sure that if there's a family trust opportunity that involved in there, if there's a sale of a property, that we might be able to split the income or the, the capital gains on the distribution or sale of the shares of the holding company. However, that might work. Not very common that that's the case. But if we're selling the real estate inside the corporation, the corporation would pay capital gains tax and then we could distribute the proceeds out to maybe some of the family members as well. And just a quick note, the Canadian rules have changed a little bit. Maybe five or maybe even ten years ago now I'm maybe dating myself a little bit, but the rules changed and said essentially the only way we could income split with a family member through the use of dividends is if they're actively involved in the business, which means more than 20 hours a week. Now, there's other ways that we can get them in here. If they have significant investment that they've contributed and they have risk of loss in there, they may be able to still participate. But the easiest test for us is the 20 hours a week. So if any of your kids or spouses are included in the business and they're actively working in there, we can likely do some income splitting through dividends as well. So just again, some context, something to, for you to be aware of. Number four, the maximum asset protection. So this one's important. So this doesn't necessarily deal with tax efficiency, but it is very efficient when it comes to ensuring your assets are protected. Because the last thing we want to see happen is that we've worked really hard. We've accumulated this surplus earnings inside our business or from whatever source, whether it's maybe from real estate investment. And all of a sudden something happens and there's a lawsuit and people take all of your equity that you worked hard for. So part of the objective in a real estate investor's situation is to ensure that any of your equity is protected and hopefully distributed into a separate entity, to completely separate and protect all of your equity and your assets from each other and protect them for you for the long haul. So maximum asset protection is definitely a tax planning objective for a real estate investor and really a strategic objective as well as, yes, it's for tax that we want asset protection. Maybe in different entities we can create some tax efficiency, but for sure, strategically, that asset protection is going to be very important. Number five, max deductibility on expenses. So in a few situations, there are circumstances where an entity, for example a corporation, if you are considered an incorporated employee, which is a personal services business, the deductibility of expenses is not vast. It really is only going to be that you can deduct salary and payroll, which typically is to yourself, maybe your family members. So we just want to be aware of that. Let's ensure that whatever structure we have in place, whether it's a proprietorship, a partnership, a corporation, that we're ensuring that we get the maximum deductibility of our expenses. And this is one of those questions I get all the time is Bob, well, how do we make sure that we're paying the least amount of tax possible? Well, for sure, you want to make sure that you're maximizing the deductibility of what you actually have to pay for. And the best way to do that honestly is to have really good record keeping. If your record keeping is good. Our team does bookkeeping for a lot of businesses, hundreds of them. To be honest, I think over 300 now, maybe even approaching 400. And having up to date bookkeeping is the best way you're going to maximize your deductibility. Having receipts and whatnot as well, making sure that they're being saved. That ensures that your deductibility is going to be approved should it be questioned. So ensuring that we can maximize our deductibility is definitely going to help inside our real estate investment. Now, one thing that I just want to bring to top of mind when we talk about maximum deductibility really comes down to capital investment or repairs and maintenance. So the difference between the two is a capital investment has a future life, it has a future value, meaning that if you make a substantial difference to the building, it increases its value. You could sell it for more money. A good example of this would be putting a steel roof on versus an asphalt roof. It's well known that a steel roof would likely increase the value of the property, and in doing so, it's really a capital item versus repair. So if you replace your asphalt roof with another asphalt roof, that is a repair, that is a replacement, it's not adding any value. It's just putting a roof back on because it needs to have a roof on. So the value of the building is the value of the building. Assuming there's an asphalt roof on there, Steel is increasing the value. It's a better product, it has a greater lifespan. Replacing with another asphalt is just essentially keeping a roof on the building. So there is a difference between the two. And what we want to be conscious of is when we're thinking of tax deductibility, making sure that it's a deduction of repair and maintenance that is not adding improvement, we want to maybe be as aggressive as possible with arguing that this is not adding value to a business or to a property. My apologies. So one area, for example would be like a new furnace, a new H vac system. You're essentially replacing an H vac system. Yes, it might be newer, but if it's not like a new state of the art system, it's a replacement, it's a deduction. You get full deduction in there, you get to expense 100% of it. If you're upgrading and you're putting in this new state of the art H vac system that likely has air purification, maybe it's significantly AI controlled thermostat, whatever that next level H vac system looks like, that could be considered a betterment because it's improving the existing property. So what we want to try and do is typically argue as much as possible to get full access to the deduction now. Now, depending if it's active business income, that's a 12% deduction. And whereas if it goes to capital, you would be saving that 25% capital gain tax in the future. So we want to be very cautious and strategic about which way we want to maximize our deductibility. If it's capital gains rates are higher than active business, if it's at 12.2%, then we want to maybe strategically move those items and shift those items over to capital versus being expensed. So just a couple ideas there for you with respect to maximum deductibility on your expenses. Number six, convert higher taxes to lower taxes. Now this goes back to the idea of understanding the source of income. So inside a corporation, which is where I would highly recommend at the end of the day, most people utilize a corporation. If you're in this for the long haul, if you're in this to build a portfolio of real estate, this isn't a one off situation. Put your real estate inside a corporation. It protects you if anything happens. And if you do, and if you create this corporation in the most efficient way possible, you're likely going to be able to pull money out of there and protect it as well. Keeping your investment very, very much protected and not giving it access to impacting other assets or your individual wealth. So back to converting higher taxes. So if you are inside a corporation, like I mentioned, passive investment income is taxed at 50%. It's a little bit higher than what we would like. What we can do is, and again it's passive investment income with less than five full time employees. One thing we could do is we could actually create active business on the side. And as part of our active business, we charge income to this property. So for a good an example, as we create a property management company, we've got multiple sources of income, which means that we're charging multiple properties or multiple entities or multiple people for property management. And as part of this, we charge one of the corporations that we own that has less than five full time employees, but we're charging them property management fees for taking care of their of of our property that's owned in a different company. And by doing that it reduces the income of the property. And so we could aggressively charge for things like management, making sure that leases are in place, stuff like that. So we can push the extent of which the fair market value of those services is at the highest level, likely wipe out any of the passive investment income, that 50% income and convert that over to 12.2% income or taxable at the small business with the small business deduction. So it converts fairly well over to that situation. Again, one of the objectives here, tax planning objectives for real estate investors, being able to convert the higher taxable income into lower taxable income, passive investment into active business income. So that's a good one. We like that one as well. Number seven and last but not least is making sure that we have the optimal and flexible remuneration strategies. So what this means is when we've got real estate owned personally and we own it as a sole provider or, or as a partnership, whatever that taxable income that comes in from property, whatever that net is, it's taxable at our marginal rates. There's not really much we can do about it. We can depreciate the property, we can take advantage, make sure we're maximizing the deductibility of all expenses. However, if there's still taxable income, it's going to be at our marginal rate. What we want to be able to look at is how we maximize the flexibility of this setup and this is where a corporation comes in as well. So yes, we might be dealing with passive investment income. We've maybe got some strategies to get that down to the 12.2% level. But from that 12.2% tax, we are able to pay ourselves out. We want to be able to have the flexibility to choose how we pay ourselves, which could be either as a dividend or as a salary. So dividends are more tax efficient. Personally, salaries are a little bit more tax heavy. However, if we want the reduction inside the company, because maybe the corporation's paying higher taxes, which we might look at a salary, dividends are not deductible inside the company. So we want to be able to have the flexibility to play with that a little bit so that we can really realize the greatest tax efficiency when it comes to our real estate investment. So as a bit of a recap here, we've got the top 10, seven, or sorry, not top 10, the top seven tax planning objectives for real estate investors. Number one, ensuring that we have the most tax efficient business structure in place. We now know what that means a little bit more. Number two, we want the most efficient source of income. So again, whether we're looking at maybe capital gains or we're looking at active business income or passive investment income, we want to be aware of the different sources, how they're taxed, and we want to ensure that we're taking full advantage of moving it to the most efficient source of income. We want to be able to income split. This was number three. We want that opportunity to be able to do it again. Again, sometimes we can't, but certainly as we get older, if we have real estate investment properties and we get over that 65 level, we can income split with family members even if they're not actively involved in the business. So we want to have the opportunity to be able to do that. We want to, as number four, maximize our asset protection. We want to ensure that everything we work hard for gets protected to the greatest extent possible. Number five, we want the maximum deductibility on expenses. We talked about this a little bit. Some structures in some circumstances don't allow for maximum deductibility. We also want to have a situation where we would be able to create good arguments to deduct as much as possible. One of those areas is, is deducting repairs and maintenance versus capital costs and adding that and depreciating it over time. I'd rather get access to that deduction now. So we want to look at that as well and see if that makes sense. Number six, we want to convert higher tax rates to lower tax rates. We talked about converting passive investment income into active business income by creating some sort of management company and creating that to be an active business income where we have multiple streams and multiple sources of income. And we're essentially taking on a little bit of risk with that business. We charge fees over to the property, we wipe out the property income, and now we're paying active business income in the management fee company or the property management company. So that's a great strategy as well. And number seven, optimal and flexible remuneration strategy. We want to be able to pay salaries, dividends, other compensation metrics. We want to be reimbursed from our investment into the company. We want to be able to take capital dividends if we sell a property that comes out tax free to the shareholders. We want to be able to get access to the lowest tax possible. So for everybody listening, I know this was a lot. This is really the top seven areas where you can save, tax, maximize your protection and build wealth by using real estate to fulfill that. So as a real estate investor, these are the things you should be thinking of. Guys, if this makes sense, I would love for you to leave me a comment. I'd love you to give me a like, share some insights, ask questions. Maybe I'll do a follow up podcast related to it. Your communication and your support related to that is invaluable because that's what directs us going forward. Make sure you do like and follow the podcast. We'll make sure you get access to the next episode as soon as it's released, which will be next week because we release every single week on our podcast. And also we're going to attach to this podcast, especially on the YouTube side, a document with the top 10 tax planning tips for real estate investors. So we've got these seven that I included and we're going to add a few more in there to sophisticated, a little bit more. We talk about estate planning in there, we talk about other capital gains related treatments in there. So if you're interested, download that document. Would love for you to have that. Implementing that will save you tax money, guaranteed. If not, if you've done everything right from day one, it will give you the reassurance that you've considered everything and there's nothing that you need to do or change. So that will be attached here. Feel free to download that. If you know somebody who's a real estate investor and you feel like this podcast would support them or help them in any way, share it with them. Let's get this out there. We're on a mission to empower entrepreneurs, real estate investors, practicing professionals, to ultimately have the financial confidence and tax efficiency reinvest in their business, the confidence to make your decisions and change the world. And we can do that together as part of the movement we're trying to create. So, once again, I hope you've enjoyed this. This has been the Wealthy Entrepreneur podcast. I'm Bob Goverow, your host. I look forward to seeing you again next week.