Tax Considerations for Commercial Real Estate

Investors with stock holdings often turn to commercial real estate to diversify their portfolios with assets they can develop, own or manage for profit.

Opportunities in commercial real estate span a wide range of sectors, from the retail and office sectors to multifamily, industrial and even farmland. Within each asset class are a variety of different investment options, like in the retail sector, where investors can consider everything from small mom-and-pop convenience stores to mixed-use properties with both residential and retail tenants to hotels, malls and special-purpose retail operations like cinemas and sports arenas.

Investing in real estate can be an excellent strategy for generating immediate passive income and building wealth over time as assets appreciate. However, real estate investors in Canada need to understand the tax implications of various investment types and utilize tax professionals to help with ongoing tax planning in order to keep taxes from eating away at profits and reducing returns.

Understanding Different Types of Commercial Real Estate Income

Real estate investors earn income in three ways:

• Rental revenue from properties in any sector
• Capital gains from the sale of appreciated assets
• Distributions of annual profits from real estate investment trusts (REITs)

How Tax Treatment Varies by Commercial Real Estate Income Source

Different commercial real estate income sources are treated differently within the Canadian tax system.

Rental Income

Commercial real estate rental income in Canada can be taxed in three ways, depending on how it’s owned.

• Personally
  If you own and manage a commercial real estate property, your rental is considered a sole proprietorship, meaning it isn’t viewed as a separate legal entity from you personally. As a result, the amount you’ll be required to pay in taxes will depend on your marginal tax rate.To arrive at your marginal tax rate, you’ll need to add your net rental income to any net income from other sources, such as the part- or full-time salary you receive from an employer /or your net investment income.
• In Partnership
  If you teamed up with a few family members or friends and acquired one or more commercial real estate rental properties, you’re considered co-owners, and your business is considered a partnership by the Canadian Revenue Agency (CRA). Like a sole proprietorship, a partnership isn’t a separate legal entity.As a partner, you simply add your share of any net rental income to your personal income sources (as above) to arrive at your marginal tax rate.
• As a Corporation
  If you created an incorporated company and the rental property belongs to your corporation, your tax rate gets more complicated. Because a corporation is considered an entity legally separate from you, your business is responsible for paying the taxes.The Corporate Income Tax (CIT) rate in Canada is made up of both federal and provincial taxes. The federal rate is fixed at 38%, while the provincial tax rate varies. Because both the federal and provincial governments offer additional tax breaks for businesses, your corporation’s setup determines its tax credits and final CIT.

Commercial real estate taxes can be minimized through allowable deductions for property tax, property management fees, utilities, insurance, mortgage interest, etc. And because commercial properties are physical structures that deteriorate over time, a portion of the property’s value can also be deducted each year to account for this fact.

Capital Gains

Capital gains are based on the profit investors make when they sell commercial real estate that has appreciated from its initial purchase price.

The capital gain is calculated by subtracting the adjusted cost basis (ACB) plus eligible outlay expenses incurred to sell the property from the sales price.

The ACB considers improvements made to the commercial real estate property over its holding period and property depreciation. Eligible outlays include legal fees, sales commissions, surveyors’ fees, advertising costs, transfer taxes, etc.

The Canada Revenue Agency (CRA) then applies tax to 50% of the net capital gain. The taxes owed are based on the individual’s marginal tax rate for the year in which the capital gains were realized.

Investors can lessen the burden of commercial real estate capital gains taxes by timing the sale of their assets to coincide with years when they experience capital losses or by deferring them using a strategy called a 1031 Exchange, which allows an investor to use the proceeds of one property sale to invest in another property of “like kind.”

Distributions from Commercial Real Estate Investment Trusts (REITs)

REIT distributions typically consist of a mix of return of capital, capital gains and other income, each of which is taxed differently. Most REITs publish the tax characteristics of their annual distributions in REIT marketing materials or in the Investor Relations section of their website.

So long as REITs are not day-traded, interest, distributions or capital gains earned on REIT investments in a Tax-Free Savings Account (TFSA) are not taxable either while held in the account or when withdrawn.

Tax Planning Tips for Commercial Real Estate Investors

You can minimize tax payments on commercial real estate investments and ensure compliance with Canada’s tax laws by:

• Consulting with Experienced Tax Professionals Before Taking Action
  Tax professionals specializing in commercial real estate investments can help you make informed decisions before buying, selling, renting, or investing in commercial real estate assets. By evaluating investments with an eye toward their potential after-tax profits, you can generate better returns.
• Keeping Organized and Accurate Records
  Organized and accurate records will help you tally your taxable income and allowable deductions and serve as supporting documents in case of an audit.
• Fully Utilizing Deductible Expenses
  Building repair, renovation and maintenance costs, property taxes, mortgage interest, insurance premiums, utilities, advertising expenses, property management fees, plus legal and accounting fees all qualify as allowable commercial real estate deductions at tax time. Consult with a tax professional to determine if you’re missing out on other deductions that could help lower your annual tax remittance.
• Claiming the Capital Cost Allowance (CCA)
  Investors can claim the CRA’s Capital Cost Allowance (CCA) for their income-generating properties’ wear and tear or depreciation. Consult a tax professional to determine the optimal CCA strategy for your commercial real estate investments.

Considering Incorporation

Incorporation can provide various tax advantages for commercial real estate investors and can protect your personal assets from liabilities stemming from your business operations. Because incorporation involves detailed financial and legal considerations, consult a qualified tax professional to determine if it’s the right option for you.

Look Before You Leap into Commercial Real Estate Investing

Tax planning is vital to successful commercial real estate investing in Canada. Seek professional advice before you take any action, keep organized and accurate records of income and expenses, fully utilize all allowable deductions, explore CCA opportunities and consider the benefits of incorporation. By understanding the tax implications of your investments and implementing effective tax planning tactics, you can minimize your tax payments, maximize your returns and still comply with Canadian tax laws.