When The Tax Man Will Pay You To Buy The Whole Property
I have to start this conversation off, here, with a bit of a disclaimer that we’re going to talk personal investments and taxes and that such content is offered for educational purposes and shouldn’t be construed as professional, financial advice. I’m going to outline a few ideas and it’s your accountant who should assist you in fine tuning them for your particular situation.
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Here’s a very generalized statement – the government encourages people to be entrepreneurial, providing mechanisms within the tax laws that allow you to divert your pre-tax earnings into legitimate, profit-oriented businesses while deducting any losses from such endeavors from those same pre-tax earnings, effectively reducing the amount of personal income tax you pay.
Now, trust me – this is going to be a very important principal as we move forward here. So, read that paragraph through a couple of times to revel in its awesomeness.
If you’re paying for a son or daughter’s rent while away at school then that is coming off your after-tax earnings. Whereas, if you were to buy a property for your children to live in while away, and that property generated revenue by renting accommodations to other students at the same time, then the costs that you might incur owning that property would be deductible from your pre-tax earnings.
The punchline is that the tax man gives you back the money that you would have been giving him to help pay for the property that your children are living in while away at school. And, depending on the amount of the operating costs that qualify for deductions against your pre-tax earnings, then you could reduce your tax rate to a lower bracket paying even LESS taxes than you would have simply giving your cash away to some other property investor.
Yes. It’s true. Ask your accountant.
Ok, so let’s see how that plays out in the numbers:
Sarah earns $50,000 a year as a law clerk paying about 30% in taxes. Her son, Eddy, goes to university and pays $800 a month rent. So, Sarah’s paying out $15,000 in taxes and $9,600 in rent – about 50% of her gross earnings.
Sarah buys a $300,000 property for her son to live in with 4 rooms that generates $600 from 3 other students that live there. She invests $4,200 in incidental costs to add energy efficient appliances, update safety and security features in the house to meeting local bylaws, put a bit of paint on the wall while providing beds, furniture and a few creature comforts in the kitchen. Mortgage, insurance, taxes and operating costs are about $2,200 a month so, her loss is about $400 ($4,800 a year) plus the $4,200 start-up costs as well as deducting a portion of the closing costs and professional fees of $1,000.
That $10,000 she took out of her pocket comes off of Sarah’s gross income so, now, she’s only being taxed on $40,000 which also lowers her tax bracket to 25%, or $10,000.
Sarah was paying $9,600 a year for rent, to begin with, PLUS $15,000 in personal income tax – that was half of her annual earnings, before!
Now, she is only paying $10,000 in taxes and that $5,000 in savings covers the $4,800 a year it costs to carry the property – with a bit left over for coffee at Timmies!
THAT is the power of real estate, my friends – free coffee for every property owner!
And, that is why everyone has to own rental property – because it’s one of very few opportunities where the government puts skin in the game to assist you in pursuing financial security for yourself.
Of course, you have to buy the property, first.
Banks generally lend only 75% on properties where the principal owner doesn’t live there, permanently. So, in this scenario that I presented, you would need (25% x $300,000) $120,000 in additional financing. You could probably find a second mortgage to finance up to 90% leaving you to find $30,000.
If you choose to use your line of credit to fund the balance then the interest costs for borrowing that money would be considered a cost against the property. Alternatively you could cash in RRSPs to help finance the project but, the cash value will be added to your gross income for the year. And, there would be no tax benefit for you using it as “principal” financing. However, if you used borrowed money from your line of credit for the financing and used RRSP money for start-up and operating costs then your accountant might be able to find a way to minimize your tax burden, especially if there is a way to income-split with your spouse.
With the financing in place, you own the property and you know that your children are living in a safe, affordable and comfortable home while away. Everyone wins.
It’s important to understand that everything we’ve discussed, here, is a WHAT-IF scenario and needs to be evaluated by a financial professional who fully understands YOUR particular financial situation.
Too, owning a rental property IS owning and operating a small business and you have to be wearing your executive hat at all times to minimize the risks associated with operating a rental business because it comes with responsibilities and obligations governed by federal, provincial and municipal law, as well as the possibility of condominium and homeowner compliance bylaws.
At the core of that business is a relationship with your customer – your tenant. The law defines that relationship and distinguishes between weekly rooming house tenants and permanent month-to-month tenancies. It’s best that you school yourself in the law and best practices of managing a rental property to keep your customer safe, happy and update-to-date in their rent payments.
For your children, participating in the day-to-day operation is critical to their preparation for the real world. They’ll learn the value of money and delivering a valuable service. And, they’ll have a practical understanding of the costs associated with home ownership and what it takes to keep a property maintained and running efficiently for when they start their own family.
Then, when school is over, you might choose to sell the property at a profit and buy a rental property closer to home with the confidence and savvy rental-business skills to make it an even bigger financial success for your and your family.
If buying a rental property could be a wealth-building proposition for yourself, or anyone family member, then give me a call. We’ll build a few scenarios with all of the numbers as best we can and then you can take it to your financial advisors for their opinion and advice.
Owning investment properties is a cornerstone of personal wealth and we’re here, as your real estate professionals, to help you and your family put that cornerstone in place.