Investing in real estate: Not just a home

When clients treat real estate as an investment, the legal and financial issues can get complex. Persistently low interest rates and investors’ desire for tangible assets have made real estate the vehicle of choice for many looking to grow their income, as anyone shopping for property in the Toronto and Vancouver areas can attest.

Investing in real estate: Not just a home
Illustration: Matthew Billington
When clients treat real estate as an investment, the legal and financial issues can get complex.

Persistently low interest rates and investors’ desire for tangible assets have made real estate the vehicle of choice for many looking to grow their income, as anyone shopping for property in the Toronto and Vancouver areas can attest.

Spending in real estate-related industries including construction, finance and insurance is believed to have propped up the Canadian economy earlier this year. Meanwhile, business investment has dropped in the last few years in tandem with troubles in the oilpatch. Despite concerns that the real estate bubble is about to burst following last year’s record high investment and a series of governments’ efforts to temper the red-hot market, Canadians’ love affair with property persists.

For those investors, keeping up with ever-evolving rules, often involving all three levels of government, as well as other legislative changes could be a challenge as they also search for tax and other advantages.

“People are investing in real estate, to a large extent, because they can put their hands on it. The big issue we’re finding is they’re steering away from the old-fashioned view of investing into stocks and bonds and GICs and they’re actually moving toward something more tangible,” says Darren O’Keefe, partner in Cox & Palmer’s St. John’s, N.L. office. “I’ve seen it since 2008. In 2008, we had the issue with the American stock market, we had issues in the United States real estate. It actually caused us to take a big step back and look at what are the opportunities and what are the risks in real estate investing in Canada. And out of all that, I think people actually became grounded.”

Houses and condominiums can provide a steady and predictable income stream, tax advantages and a more than likely steady appreciation of the original investment, barring disasters such as the sub-prime mortgage fiasco, which crushed the market in the United States nearly a decade ago. It is also generally seen as a very stable investment, leading some investors to not be concerned that rental income may not quite square up with the costs.

For those willing to take on the risk, which often involves becoming a landlord, the upsides could well outweigh the downsides. And many who begin with one or two properties build their portfolio over time, having figured out the nuances of the tax advantages, leveraging one property to finance another and learning where to find other benefits.

“The day I really knew real estate was the preferred investment vehicle for people in Newfoundland, I was at the dentist and the dental hygienist came out and we were chatting and we got into the topic of real estate and she told me: ‘I have four rental properties and just about to close on my fifth.’ Newfoundland is a microclimate and we seem to be more inclined, and maybe it’s a product of our history, to invest in things like real estate, the tangible, if you will, before we invest in the intangible,” says O’Keefe.

But property ownership brings obligations. There are tax considerations, and advantages, at the time of purchase, during ownership for non-personal use property and again at closing.
“It’s all great and wonderful to buy real estate, but don’t forget, you still have the land transfer tax going in,” Andrew Fortis, a partner with Hummingbird Lawyers LLP in Concord, Ont., points out.

Ontario now applies a two-per-cent land transfer rate to homes valued at $400,000 or more. And it introduced a new rate of 2.5 per cent for properties valued at $2 million or more. In addition, the city of Toronto imposes its own land transfer tax as well as a $75 administration charge. So, from a tax perspective alone, it is more expensive to buy a home in the country’s largest city now than it was last year. Add on the new foreign buyers tax and the extra costs can be substantial.

Much of the owners’ obligations turn on how they frame the purchase and use of the property. Whether it is for personal use or meant to generate rental income and if it’s just a speculative buy intended to be flipped or designed for a long-term investment determines the tax implications and can help steer the ownership structure, says accountant Kim Moody, Calgary-based director of Moodys Gartner Tax Law LLP.

GST/HST is always a consideration and can apply when collecting rent, but it could also be added to the acquisition costs, although it can be offset.

“I think it’s always good to look at what the GST/HST implications are on any acquisition of property,” says Moody. “There are no easy rules of thumb on acquisition of real estate.”

During ownership, expenses of a rental property such as maintenance, repairs, operating expenses and property management fees can be written off against the taxes. O’Keefe says property owners have found that the more numerous the properties, the greater chance the owner has of leveraging one property against the other to find greater tax benefits.

The option for individuals wanting to buy several properties who want to distance themselves somewhat from the asset is to go in on purchases with other people. Winnipeg real estate lawyer Rick Adams, a partner at Thompson Dorfman Sweatman LLP, says buyers’ groups have been quite active in the real estate market and can be shielded by the corporate structure.
That, along with insurance, protects the individual investors from liability related to the property.

Individuals purchasing property on their own acquire more risk because they are personally on title as owner and landlord. But even the smaller investor has become more astute and looks for ways to avoid risk.

“What I have seen in recent years is even the small guy creates a numbered corporation and buys his duplex that way to shield himself from personal liability,” says Adams. “You see people more conscious about the risks and liabilities arising out of ownership of property. They’re more inclined to look for protections.”

Upon exit, there’s always been that hefty capital gains tax. While the principal property exemption has been a way of getting around the tax that applies to the appreciated value of the property, new rules introduced in October suggest there will be stricter enforcement and that the exemption may not be applied as loosely as it has been used in the past.

Starting with the 2016 tax year, individuals are required to report all real estate sales on their personal income tax statements, even if it’s considered their principal residence and subject to the principal residence exemption.

“That is really the area where there has been a change,” says John Sliskovic, an accountant and tax partner in Ernst & Young’s private client services practice. “What it really does is it gives the Canada Revenue Agency more information. In the prior system, if the gain was completely sheltered from tax in the principal residence exemption, the administrative policy was you didn’t have to report anything. So now, it gives the Canada Revenue Agency more information to assess whether the claiming of the principal residence exemption is appropriate or not.”

Ron Choudhury, a partner in the tax group at Miller Thomson LLP in Toronto, where he leads the sales tax specialty group and advises primarily on the tax implications of real estate investments, says he has seen two primary motivations for those investing in the real estate market in the past 10 years or so. One is those who buy with the sole purpose of flipping. And there are “slightly more sophisticated, slightly higher net worth individuals” who buy a home, live in it for a short period and then sell it.

“In each instance, they want to claim the principal residence exemption on those sales. Many of those are effectively flipped with them spending just a few months in there to make it not look like a flip,” he says. “Correctly so, the CRA has become vigilant and aggressive on this issue.”

Previously, it was difficult for the CRA to find the short-term occupiers who claimed the principal residence exemption. But now that everyone is compelled to report on the disposition of the principal residence, the CRA can more easily track sales and flag a rapid succession of home sales to see if they’re all claimed as principal residences. The new system offers low-hanging fruit for the CRA to pick for auditing, says Choudhury.

While the definition of principal residence in the Income Tax Act doesn’t lay out a specific period of time in which the home must be occupied, it does outline that the intention of the owner must be that it serves as their permanent home.

Choudhury believes the reasoning behind the new reporting requirement is in part to cool the housing markets in Toronto and Vancouver in particular as well as allowing the CRA to crack down on the use of tax exemptions.

Another attempt to cool down those two markets is the introduction of a foreign buyers tax, introduced in B.C. last summer followed by Ontario earlier this year.

Choudury points out, however, that some builders have got ahead of the new wrinkle by offering to pay the foreign buyers tax, taking out advertisements in Hong Kong to promote the initiative.

And while Fortis quotes the old phrase that you buy land because they’re not making any more of it, meaning it will always hold value, he points out that people don’t usually purchase property on their own because they require financing, so there is always some kind of a risk. “The bank is your involuntary partner; unless you’re in a cash position, you have no choice.”

By the numbers

The heated residential market

•    Home sales in Canada jumped 6.5 per cent last year, although the Canadian Real Estate Association reported a six-per-cent month-over-month sales drop in May largely focused in the Toronto area and believed attributed to a series of new initiatives including a foreign buyers tax, introduced the previous month;

•    Two-thirds of credit outstanding to household is for residential mortgages and mortgage finance companies have gained significant market share in residential mortgage underwriting since the early 2000s, according to the Bank of Canada;

    About 40 per cent of the country’s growth has been related to housing since 2014, although it represents only between eight and 10 per cent of overall output.

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