Legal, Tax and Accounting Strategies for the Canadian Real Estate Investor

By Steven Cohen and George Dube

Legal, Tax and Accounting Strategies for the Canadian Real Estate Investor begins and ends with the premise that buying property in Canada can be a smart, safe and successful way to invest your money. However, like most things in life, success requires hard work. You need to do your homework, understand what you are buying, and know the pros and cons of various decisions. Most importantly, you also need to know how to structure and maintain your investment. That's where we come in. Experience is a good teacher-but its lessons can be nasty and, in the real estate business, mistakes can cost you big bucks. Our goal with this book is to help you do it right-the first time. Rest assured that this book covers a vast range of topics and you're going to appreciate its breadth and depth if you're wondering about things like whether:

• You should opt for a sole proprietorship versus a partnership or corporate ownership strategy.
• There are things you can do to manage the way HST impacts your real estate investment business.
• You need information about the tax implications of a real estate disposition.
• You can change your bookkeeping system to better meet your needs and those of your accountant.

Who Are We?

This book was written by two individuals whose collective experience in helping Canadians make wise property investment decisions spans several decades. Steve Cohen is a securities lawyer with a great deal of experience in the real estate sector. George Dube is a chartered accountant whose knowledge is based on many years of helping clients with their property buying needs. Both Steve and George are real estate investors themselves. Working from this foundation, we have put together the definitive guide on how to build a successful real estate portfolio in Canada from a legal, tax and accounting perspective.

• Language: English
• Publisher: Wiley
• Release date: Oct 12, 2010
• ISBN: 9780470678541

Book preview

Introduction

Many Canadians dream about investing in real estate. And there are a lot of reasons why real estate investment appears so accessible. For those who own a home, investing in real estate is tangible, compared to investing in stocks and bonds that are controlled by unknown money managers. Many first-time real estate investors like the idea of being able to see and even touch their investment. Compared to tracking stocks from a computer screen, real estate is a very hands-on business venture.

Real estate investors are also often lured by the prospect of a steady appreciation of their investment, especially if they’ve been following the real estate market over the past few decades. While there was certainly some rationalization in several of the nation’s hottest markets, even the recent recession didn’t put much of a dent in average house prices across Canada. Experienced investors will tell you that all investments are risky. The anomalies (and international fallout) of the U.S. housing market’s sub-prime fiasco aside, many long-term investors in this country will also tell you their real estate portfolios are a steadier investment than stocks, even during (and often especially during) economic downturns.

While the authors occasionally hear talk of what it means to have a balanced portfolio that includes equities and fixed-income investments, we’re not really sure what constitutes that sense of balance, since the reality of unpredictable market fluctuations leaves many investors without any of the stability that the pursuit of a balanced portfolio might imply. Alternatively, that balanced approach may offer stability, but at the price of inferior long-term investment performance. Given our experience in real estate investment and our professional encounters with clients investing in real estate, we’re more apt to promote the idea that investors need to work with what works for them. For the seasoned real estate investor, that often means keeping a disproportionate share of one’s investments in real estate, with a smaller amount of equities and fixed-income investments to complement real estate investments and assist with short- and long-term business goals.

With that in mind, we propose that real estate can be a very prudent part of an investment mix. And the trick to this investment is this: there is no trick. It all comes down to the investor’s willingness to take a steady and smart approach to real estate investment.

DOING IT RIGHT

Legal, Tax and Accounting Strategies for the Canadian Real Estate Investor begins and ends with the premise that buying property in Canada can be a smart, safe and successful way to invest your money. However, like most things in life, success requires hard work. You need to do your homework, understand what you are buying, and know the pros and cons of various decisions. Most important, you also need to know how to structure and maintain your investment. That’s where we come in. Experience is a good teacher—but its lessons can be nasty and, in the real estate business, mistakes can cost you big bucks. Our goal with this book is to help you do it right—the first time. Rest assured that this book covers a vast range of topics and you’re going to appreciate its breadth and depth if you’re wondering about things like whether:

• You should opt for a sole proprietorship versus a partnership or corporate ownership strategy.

• There are things you can do to manage the way GST/HST impacts your real estate investment business.

• You need basic information about the tax implications of a real estate disposition.

• You can change your bookkeeping system to better meet your needs and those of your accountant.

WHO ARE WE?

This book was written by two individuals whose collective experience in helping Canadians make wise property investment decisions spans several decades. Working from this foundation, we have put together the definitive guide on how to build a successful real estate portfolio in Canada from a legal, tax and accounting perspective.

This is information we routinely provide for our clients, and our goal is to share this information with you. As an added bonus, this information will be very useful for those of you looking for co-investors in current and pending real estate deals.

Steve Cohen is a securities lawyer with a great deal of experience in the real estate sector. He has acted for promoters of and investors in a wide range of real estate and real estate-related investment vehicles, ranging from joint ventures to limited partnership syndications and real estate investment trusts (REITs). His expertise covers both private and public market acquisitions and offerings, and spans all asset classes. He also personally invests in real estate. Steve’s knowledge of the real estate business is shared throughout these pages and is invaluable advice you will require throughout the investment process.

Likewise, chartered accountant George Dube will share with you many of the tax and accounting implications that must be considered when buying and selling investment property. His advice (rendered with the help of his former business partner Perm Persaud, CA) is based on decades of helping clients with their property-buying needs, including the best ways to maximize a real estate investment while staying true to the taxman, so you can protect your investments and grow your wealth. (Indeed, George continues to expand his real estate holdings with his family and team members.)

We know that some real estate investors turn to their financial advisors for legal, tax or accounting advice. We do not think that is the best strategy. While we will not discourage you from staying in touch with your advisor, we strongly caution against relying solely on his advice when investing in real estate. This warning comes from our experience. Both of us have seen all too often what happens when specific legal, tax or accounting points are missed by general advisors. This usually happens because these general advisors do not have the requisite specialized knowledge related to real estate investment. In other cases, it occurs because client meetings may be too rushed to ensure that all the necessary ground is covered.

This book, plus information on our websites, will help you understand some of the specific points involved in investing in real estate. Because we work with real estate investors who often ask us where they can get educated about specific legal, tax and accounting issues, we know this book has much to offer experienced investors. It is also a solid tool for market neophytes.

Regardless of where you are on the investing spectrum, this book is for you to absorb at your own pace. Think of this book as a best friend that you can rely on, knowing that the information you require to make informed decisions will be there when you need it and through every stage of the process. We expect seasoned and new investors alike to make this the most earmarked book in every Canadian real estate investor’s home library.

OUR APPROACH

Real-life experience has shown us that when it comes to structuring or operating a real estate portfolio, the legal, tax and accounting issues are highly intertwined. Convinced that real estate investors should be armed with the best and most up-to-date information available, this book takes a similarly integrated approach to dealing with these issues.

Because we also believe investors can learn from the experiences of others, this book includes real-life examples gleaned from situations our own clients have faced over the years. We’re not out to frighten anyone, but we do want you to understand the cumulative impact of individual decisions.

We also want you to understand that this book does not provide specific personal tax, legal or accounting advice. It’s simply not possible to provide boilerplate solutions, since the types of real estate and real estate investors vary greatly from person to person and coast to coast. Our goal is to provide you with as much general information as possible. You can then take this information, talk to your own professionals and empower your investment strategies by applying the information to your specific circumstances.

After reading this book, you should be better able to approach your advisor with specific questions and feel more confident putting your advisor’s comments into context about what works for your business today—and tomorrow. We’re hoping you come across a few Ah hah! moments such as:

• I may not need to claim GST/HST right now, but now I see why it makes sense to register so my business is ready to take advantage of a GST/HST claim.

• In hindsight it turns out that I needed to be GST/HST registered at the very beginning.

• I didn’t know that CMHC insurance costs are generally a deduction over five years!

As a more informed investor, you should also find yourself increasingly confident about making choices based on your personal investment goals. In other words, reading this book should save you time and money—and help you feel even better about your business decisions. Those are goals every savvy investor strives towards!

READ ON!

We know these topics are complicated. To help you digest the wealth of information included in the coming pages, we have divided the book into 12 very detailed chapters. In sum, much of the information presented here represents the kind of background data you need to make sound legal, tax and accounting decisions.

So read on—and happy investing!

Regards,

Steve Cohen

George Dube

Register for Updates!

You know the legal, tax and accounting rules in Canada are subject to change. So do we! Register your copy of this book at our websites and we will periodically provide you with updates and new information. See Steve Cohen’s Real Estate Investment Law site at www.reilaw.ca and George Dube’s website at www.georgedube.com.

CHAPTER 1

Eyes Wide Open

Understanding Why Real Estate Is a Solid Investment

ADVANTAGES OF INVESTING IN REAL ESTATE

All investments include risk, and real estate is no exception. Be wary of anyone who tries to tell you something different. Like all kinds of investments, buying and selling property also has its advantages and disadvantages. It is not for everyone.

That said, real estate is often considered to be a lower-risk investment than investing in the stock market. Moreover, real estate investment can have more advantages, depending on your investing style and your willingness to do some legwork. Let’s run through the pros and cons of investing in real estate.

LEARNING NEVER STOPS

Do you need to think about why you invest in real estate if you’re already doing it? Yes. Reviewing what we think we know helps investors identify areas where they’ve gone astray. Occasional reviews will help you re-focus your investments.

Appreciation

Why does real estate appreciate over the long term? Because people will always need places to live and places to conduct their businesses. Moreover, real estate has a finite quality few other investments can emulate. In the words of Mark Twain, the great American humourist, Buy land. They’re not making it anymore!

Investing in real estate, especially over the long term, usually results in a steady appreciation of property value. Historically speaking, property values have also outpaced the rate of inflation each year. As a general rule, real estate appreciates when inflation rises because the cost of building properties rises over time. Everything from the cost of land to the price of bricks and the bricklayer’s wages trends upwards.

Real estate values also rise with regular upkeep or the kind of renovations that add value to a property. This is why many real estate investors deliberately seek out rundown properties as they may be able to manufacture immediate appreciation (although this can also get people into trouble where the appreciation is less than expected). Here, their business goal is to fix up these properties in a cost-effective way and thereby increase the value and hopefully boost their return on the investment when it’s time to sell. The property flip is so common across North America and Europe today that it has spawned a special genre of television programming. It is also worth noting that some investors deplore the word flip because they think it undermines the serious work that goes into identifying, buying (when the price is right!) and renovating these properties. This is, after all, one segment of the real estate investment market where the appeal of easy money most frequently leads market newcomers towards nasty economic outcomes. Indeed, such investments may prove very costly when appreciation is less than expected and an investor is working with borrowed money.

Leverage and Minimal Starting Capital

In real estate investment, leverage is the ability to borrow money towards your investment. When it comes to investments, this is huge, since real estate investing allows you to use leverage to increase your return.

Buying property typically requires minimal starting capital of roughly 5% to 10% of the property value, and the ability to borrow the rest. The exact minimum payment will depend on a number of circumstances, such as the lender, the nature of the property and your own credit profile. There are a variety of methods to acquire properties with little or no money down, some more risky than others, but all with issues that need to be addressed. (Note: Under new mortgage rules that came into effect April 2010, changes to qualifying standards mean borrowers must be able to handle a five-year, fixed-rate mortgage (but the borrower can opt for a shorter term and lower rate.) As well, refinancing homes are limited to 90% of the value of a property, down from 95%, and a minimum down payment of 20% is required for government-backed insurance on properties not lived in by their owners. That’s up from 5%.)

Generally Lower Risk

Real estate is generally viewed as lower risk when compared to other traditional investments, such as stocks and various equity funds. That is because the housing market is often less volatile, even during an economic downturn. Since people will always need places to live, there will always be a market for housing. During the last global recession in 2008-09, the Canadian housing market dipped about 10% across the country on average. Ten percent is significant but pales in comparison to the 40% drop in the S&P/TSX Composite Index.

Over the past several decades, the stock and equity fund markets have swung dramatically, even when the economy was doing well. In the meantime, the housing market has continued its steady, long-term appreciation. This was particularly noticeable after the drop in the late 1980s and early ’90s.

Success in real estate investment is linked to several inter-connected factors. These can include the length of time you carry a real estate investment and the conditions under which you buy and sell. Those conditions may be impacted by market cycle, location and the condition of the property. (A property located in walking proximity to a new commuter transportation line may be worth more than a property a few blocks away. The latter property may, however, appreciate in value if it features more upgrades.)

There will always be real stories of people who lost money in real estate. New and seasoned investors need to take a case study kind of approach to these situations to ascertain what really happened. Were the investors short-term speculators who were unprepared for the risks involved with deals whereby the potential for higher profits includes a potential risk for greater losses? Did they buy a property where the cost of unexpected upgrades pre-empted cash flow?

Cyclical, rare and unusual circumstances can also inflict damage to an investment. For example, anyone who purchased property in Calgary or Edmonton at the peak of the market in 2006 undoubtedly expected continued strength in a housing market buoyed by a booming economy. If those same investors were forced to sell when the market retrenched in late 2008 and early 2009, they likely lost money. Investors may also have lost money if they bought a leaky condo in British Columbia in the 1980s and ’90s, since costs for repairs to the defective units wiped out longer-term gains. Similarly, investors in small manufacturing towns in places such as southwestern Ontario, or in forestry towns in British Columbia, may have seen their properties depreciate after the recent recession, which wiped out thousands of jobs in those communities, causing real estate values in those areas to drop.

These are bleak examples of what can go wrong in the real estate investment business. They are also the exception compared to the majority of long-term real estate investments in Canada. Many property owners have done very well over the years. They’ve watched the value of their investments rise, despite economic downturns.

The most important thing investors need to remember on this point is that the real estate market is cyclical and, over time, it has demonstrated that it involves less risk than the stock market, especially for long-term property investors. But this doesn’t mean there are guaranteed profits in real estate by any means.

Building Equity

Equity is the difference between fair market value and the unpaid mortgage balance on a property. Real estate investors (and homeowners, for that matter) build up equity the longer they own a property, assuming the property is not refinanced with additional debt. Making regular mortgage payments means you pay down the principal, thereby reducing your mortgage debt. The lower your mortgage, the higher your equity in the property. You can build equity even more quickly when renting out the property by putting that monthly income towards your mortgage principal.

Better still, equity is leverage! The more equity you have in your property, the more room you have to borrow against the investment, if necessary or desirable.

Income

One of the biggest bonuses of a property investment is the income you will receive from tenants. Whether the property is residential, commercial or industrial, the monthly rent payments can be used to pay the bills and the mortgage. Because it’s considered income, that money can also be used for other purposes, as you see fit. Just remember that income is what is left over after expenses. That includes taxes, utilities (if they aren’t paid by the renters), insurance and regular and unexpected repairs. In the early days of an investment, it can also include closing costs.

Investors who need the income side of their investments to be positive look for cash-flow properties. These are investments that cover the monthly expenses of property ownership.

Tax-Planning Opportunities

Real estate investors also realize many tax advantages. These advantages will be discussed in greater detail throughout the book. For now, just consider the various write-offs (tax deductions) investors can make against their property investments. For instance, property investment expenses, including insurance, can be deducted against income, as can property depreciation.

Rental income can also increase your RRSP contributions, because, if personally owned, it is considered by the Canada Revenue Agency to be earned income. When you sell the property, often you pay taxes on only 50% of your profits.

There is also capital cost allowance, which will be discussed in detail. Capital cost allowance is a tax deduction you can claim for loss in value of the capital assets due to wear and tear or obsolescence, for example. You use the capital cost allowance to deduct a calculated portion of the asset cost as an income tax deduction over a period of years as the property depreciates. Since real estate often appreciates in value, you can receive a deduction for an appreciating asset. The amount you deduct depends on when the property was purchased and what class it belongs to, as defined by the Canada Revenue Agency.

No Experience Required (at First)!

One reason so many people are interested in real estate investing is because it’s one of the few ways you can make good money without having to spend years, and thousands of dollars, in school. You can also invest while keeping your day job.

To become a real estate investor, all you need is a little up-front money (yours or someone else’s) and the motivation and desire to learn the necessary skills. (You are reading this book, which means you are already on the right path!) Although no experience is required to get started, we want to stress that you will want to educate yourself and, over time, build up a variety of skills. We will also tell you that, while there’s no need (or the ability) to be an expert at everything, you will always need to be an expert at putting together the team you need to cover the skills you don’t have.

YOU CAN BUY EXPERIENCE

Experience is not a pre-requisite of real estate investment. You will want to educate yourself and, over time, build up knowledge and skills to optimize your investment returns. In the beginning, however, you can hire individuals to form a team that delivers the skills you don’t yet have. And the members of that team can change. With experience, many investors actually hire out even more functions, since this frees them to focus on aspects of the business that need their attention.

Freedom

Once you’ve learned the right skills, as a real estate investor you will have more free time than, for example, a day trader who makes his living off the minute-by-minute moves of the stock market. Real estate investors can also choose how much time they want to spend keeping their books or managing and repairing their properties. In strong and weak real estate markets, investors often hire professionals to help them run their businesses instead of trying to do all the work themselves.

THE FLIP SIDE: WHY LONG-TERM COMMITMENT MATTERS

The advantages of real estate investing present a pretty compelling picture. Those pros aside, we want investors to recognize that real estate investment is not about chasing quick profits. Why can real estate investors talk up the advantages of appreciation, equity accumulation and cash flow? Because they understand the connection between real estate investment and a long-term commitment.

As you read through this next section, think about your willingness to work with issues such as commitment, liquidity and government red tape. We’ve said it before and we’ll say it again: successful real estate investing does not require a great deal of money or a predetermined set of skills. It also owes very little to luck! The profits associated with appreciation and cash flow are real, but there is no substitute for an investor’s due diligence.

. . . INVESTORS NEED TO INVEST WITH A TIMEFRAME IN MIND

It is easy to toss around words like short-term and long-term investment without really thinking about what those words mean in the context of an investment’s lifespan. We want you to approach this discussion thoughtfully. Looking at your financial future, you need to decide what constitutes a long- or short-term investment in your portfolio. Generically speaking, short-term investments could run for less than two years, less than five, or even less than eight years. Others might view anything over five years as long term.

The reality of real estate investing is that some investors excel at holding properties for relatively brief periods of time. That is, they renovate and re-sell, or strategically re-sell (perhaps with knowledge of an impending development boosting appreciation in a particular neighbourhood) within one to five years of property ownership. Other investors might want to hold a property for a minimum of five years and view that as a long-term investment.

Going into an investment with a timeframe in mind can be a good way for an investor to calculate risk. Knowing you will hold an appreciating property for 10 years, for example, can help an investor keep negative cash-flow months in perspective.

Then again, a timeframe should never be set in stone. Your timeframe guides your exit strategy, but market-awareness remains critical. There may be good reasons to sell a long-term property well before you’d planned to sell and good reasons to hang on to a property for much longer than you’d originally intended.

In real estate, as in life, there are no absolutes. Seasoned investors manage the uncertainty with the best market data they can find.

Here are some things to think about in terms of long-term commitment. First, real estate is typically not about the quick buck. To make money in real estate, you usually need to stick with it, which often means an investment of time that runs five to 10 years. Of course there are exceptions, but most real estate investors are in it for the long haul. That may be seen as a disadvantage for those seeking a quick return on their investment.

You also need to commit time and money to the tasks of making the investment work. That includes managing the property, dealing with tenants (including unplanned vacancies), bookkeeping and covering unexpected costs such as a leaky roof or a broken stove. The good news is that advanced planning, which includes reading this book, helps investors manage their time and money wisely. You can, for example, hire someone to run the property and keep the books. You do not, in essence, need to have answers for every issue that comes your way—but you do need to be determined to look for those answers when they’re needed.

Less Liquidity

Liquidity speaks directly to one’s ability to sell an asset quickly. And let’s be clear: real estate properties have some liquidity. Unlike a stock, however, it’s not possible to click a button or simply call your broker and sell a piece of investment property the same day. Selling your property takes time and money, which makes a real estate investment much less liquid than investing in the stock market.

Here again, the issues regarding liquidity can often be dealt with via planning and with the help of outside experts. Ideally, investors never sell properties because they need the money quickly. Instead, dispositions are planned in advance as part of an investment exit strategy, then timed to take advantage of specific market changes.

You Need Money Up Front

Above, we noted the appeal of an investment that often only requires putting 5% or 10% down. That can, of course, also be a disadvantage if you don’t have much equity to work with, or if the property you want to buy is expensive. Pulling together even a small down payment can be especially complicated when buying a multi-family unit, or even a single unit in an expensive city such as Toronto or Vancouver. That said, you still have to spend money to make money—and experienced real estate investors probably appreciate the reality of that expression more than most investors!

MONEY IS NOT AN OBSTACLE

Real estate investment is possible without using any of your own money, even if you’re new to the industry. That’s because you can manage an investment that was purchased with money you raised from family and friends, for example. The structuring, operation and disposition of investments that use other people’s money can be tricky. This book shows you how to do this in a legal and tax-efficient manner.

Lower Risk, Not No Risk!

The first part of this chapter covered the idea that its relatively low risk is one of the advantages of a real estate investment. But low risk does not mean no risk. A disadvantage to real estate investment is that, when the housing market falls, some investors may have to sell property to pay their debts. That said, patient investors who are prepared for bad times may be rewarded. The key is advance planning. Here, discipline is critical. Disciplined investors will use cash flow to increase their equity in a property (by reducing the mortgage balance), build contingency funds to carry them through periods of low vacancy or build a war chest for future opportunities.

Government Red Tape

One risk that sometimes takes new real estate investors by surprise involves changes to government laws and regulations that could have an impact on the investment property. The key is to do your homework on any potential issues that may arise and be aware of any new changes that could crop up. These include municipal zoning restrictions and changes, provincial standards and tax implications at all three levels of