Rental Properties – To incorporate or not to incorporate…

…that is the question. Put to me by FT and his request that I try to address the issue.

First, and most importantly, I am not an accountant, tax lawyer, or anyone else who makes money off the misery of others.

Second, my current corporate structure has evolved over time and I do not advocate one way over the other. Smarter people than myself will tell you better ways to do it, but these are my observations.

My Portfolio

I currently own four properties as follows:

1. My personal property – owned jointly by my wife and I. This is not relevant to the discussion, but just thought you should know.
2. One mixed-use property – owned in my wife’s name. It is a old house in the downtown that is commercial first floor and has two residential apartments upstairs.
3. One residential duplex – owned 50% by myself and 50% by my partner. It is a house that I purchased with my buddy when we were in university. At the time, we squeezed 7 guys into the place over three years and pretty much demolished it. Subsequent to graduation, we converted it into a duplex (basement apartment) and now rent to a grad student and a nice family who take care of it for us. Not the most efficient use financially, but definitely the best use from a PITA (Pain in the A**) factor. There is an identical house across the street and the landlord gets 8 girls in the place and takes in almost triple the rent we take in. However, he is there almost every other day and that is his full time job.
4. One mixed-use property – owned by a corporation which in turn is owned 25% by myself, 25% by my wife, 25% by my partner and 25% by his wife. This is a multi-unit complex with 5 commercial units and 3 low-income apartments.

Our Structure

As you can see, I don’t have just one solution for any model.  Each scenario was dictated by the circumstances at the time of purchase. For example, the first property I bought in partnership with my university friend just began as joint owners on the deed. At the time (we were 18 and 19), the house was our only asset, and we were using the cash flow from 7 guys to pay the mortgage. We had accelerated the payments and paid the thing off in 12 years. Neither my buddy or I required the income from the house after we graduated, so we ploughed every dollar it made back into paying off the mortgage as soon as possible.

Once the house was paid off, we started looking at other opportunities together.  The last property on my list was discovered by my friend in my hometown.  We looked at the potential and decided to go for it. The decision to create a corporation was made purely from an organizational point of view, as opposed to any specific tax benefit.  We were able to set up a shareholders agreement and loan the money to the corporation to purchase the building.

Using a corporation like this, we are not eligible for the capital gains allowance on this corporation and we would be subject to the capital cost allowance recapture when we sell the property. However, we have plans to tear the building down and redevelop.  For us, the corporate model worked.  We have even discussed including the other house in the corporate structure and establishing ourselves as a REIT (real estate income trust), but that is long term planning.

Finally, putting the other property in my wife’s name was based on the fact that she had some money saved up and wanted to invest.  After our kids were born, she did not want to go back to work, so this allowed us to use her savings to create cash flow for her, and let’s us legitimately income split.

Property Management Company

We did create a second corporation to act as a property management company. The property management company creates active income and can be eligible for the capital gains allowance. There is a caveat to this. If a property management company makes its money solely from one source which would be related, it can be deemed ineligible.  There are a series of rules about this and this comment is only based on conversations I have had with my accountant on an informal level, so do your own homework.

Pros and Cons

It used to be that a corporation would protect you from liability in the case of claims.  However, that is proving to be less and less the case as directors and officers are drawn into lawsuits. The key is having the right amount of insurance.

The corporation has additional costs with the annual filings, but we also have an annual shareholders meeting (which we can deduct) and get a chance to have dinner and discuss the corporate plans with our friends.

While the corporation is financially strong, no bank is loaning on the basis of the corporation alone and thus any future loans/mortgages would still require personal guarantees from the shareholders.

Conclusion

Perhaps there is nothing to be concluded by how I have things set up. It does appear to be a bit of a hodge-podge of systems and can be a bit of a nightmare from an accounting point of view. The property management company basically handles all the transactions for all the properties and thus simplifies things. It also leads to some confusion as to when some properties may be in deficit verses surplus, but I try to keep a handle on cash flow on a monthly basis.

For the real estate investor readers out there, how do you have your business structured?

QCash is a young retiree and self made millionaire. He has built his net worth up to $1.5 million by the ripe age of 36.  QCash writes the occasional article for Million Dollar Journey to share in his experience of obtaining a large net worth at a young age.