Jan '24 • Operations
The Holdco Myth (Holding Corporation) and 3-Tier Structure
Be mindful that if you own a property personally you can still take 8-10% from your personal property income and move it to property management income for the corporate active income as well. This is really the only way to create a corporate "tax" advantage other than becoming a specified investment business.
When rental properties are personally owned, the rent is reported immediately on the investor's personal tax return. Additionally, if rental property is held within a corporation, the passive income is subject to the highest tax rate in Canada. However, there are strategies and businesses that can be started alongside real estate investments to help reduce some of the taxes on passive income.
THE HOLDCO MYTH:
Holding property in a corporation does not provide any income tax benefits. Having a company hold real estate can protect an investor from legal liability, as a corporation is a separate legal entity, but income from properties is treated as passive income and immediately taxed at the highest tax rate of approximately 47% in a private corporation. This makes holding real estate less appealing in a corporation.
THE SOLUTION:
A 3-tier corporate structure is ideal for investors considering investing in multiple real estate properties.
If a corporation has 6+ employees, rental income is considered active business income for tax purposes. This classification allows the corporation to be eligible for the small business deduction, which leads to a lower tax rate of 15.5%.
But… beginner investors likely don’t have employees to manage their real estate and would not fall under the specified investment business classification. As a result, the passive income earned would be taxed at the highest rate for tax purposes in Canada.
One of the ways to help create tax advantages in real estate investing is through a 3-tier corporate structure:
A 3 tier corporation is comprised of a minimum of 3 corporations which include the following:
- Holding Company
- Real Estate Companies
- Property Management Company
HOLDING COMPANY
The Holding company will be inactive, generating no income. Its sole purpose is to hold 100% of the shares of the Property Management Company and the Real Estate Companies required for the 3 Tier corporate structure. The Holding Company's role is to retain the cash earned from rental properties.
The holding company owns more than 10% of the shares and value of both the Property Management Company and the Real Estate Company, these corporations are considered connected for tax purposes. Consequently, dividends can be declared and paid from the subsidiaries to the holding company. This arrangement enables the holding company to accumulate more after-tax funds for reinvestment in other projects or for distribution as dividends to the shareholders.
Additionally, the holding company provides opportunities for income splitting. The real estate investor can issue a different class of shares to their spouse or adult children who are over 18 years old. This allows dividends to be issued to them, enabling income splitting.
REAL ESTATE COMPANY
The real estate company is a corporation specifically designated to own rental properties. This arrangement helps protect the investor from legal liability and shields their other assets. Depending on the number of properties an investor owns, it may be possible to establish multiple real estate companies under the umbrella of a holding company. The holding company would own 100% of the shares, and if there are multiple investors, they would become owners of the holding company as well.
Each rental property will be owned by its respective real estate corporation. It is advisable to have each property held within a corporation to safeguard the investor from legal liability, privacy, and protect their other assets by having different ownership for each property. The real estate corporation will hold the title to the property.
PROPERTY MANAGEMENT COMPANY
The property management company is an active operating business that will handle the management of properties. Its responsibilities include collecting rental cheques, paying for maintenance and repair expenses, and more. The company will also charge a management fee to Real Estate companies for its services, typically ranging from 8% to 12%.
The remaining portion of the rental income will be transferred to the Real Estate Companies. This arrangement allows the Property Management Company to earn the income from the Real Estate Companies, which qualifies for the lower active business tax rate of 15.5%, in addition to its management fees. Moreover, this setup will result in an expense or deduction for the Real Estate companies, reducing their taxes.
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The Holdco Myth (Holding Corporation) and 3-Tier Structure
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