IS IT TIME FOR YOU TO LOSE THE LANDLORD?
Acquiring your Own Land and Building in an Active Business
Congratulations! Your business has grown to the point where you no longer want to pay someone else's mortgage and you have decided to buy your own property. You have a lot of issues to deal with; one of the chief ones being "How should I acquire the property?"
If your business is an unincorporated proprietorship and you buy the property personally, one of the key concerns is going to be paying down the debt used to acquire the property. Assuming that you are in the top tax bracket in Ontario, for every dollar of profit earned you will pay 46.41 cents in income tax and have 53.59 cents left to pay down the principal on the mortgage.
This might be a good time, therefore, to consider incorporating your business and acquiring the real estate in a corporation. The first $500,000 annually of "active business income", or ABI, is taxed at 15.5% in Ontario. That would mean that for every dollar of profit earned you would have 84.5 cents left to pay towards the principal and so this will help speed up the debt repayment process.
But should you buy the property in the same corporation as the one in which you carry on your business (Operating Company)? What if you want to sell your business down the road but want to keep the real estate and be someone else's landlord to finance your retirement? Having the operations and the real estate in the same company like this may prevent you from accessing your $750,000 lifetime capital gains exemption (CGE) because you may be stuck with selling the business assets of Operating Company (which would be taxable) as opposed to the shares of Operating Company (a portion of which may be non-taxable). It can be very difficult to separate out the business from the real estate in the future if a sale is already in the works. What if your business runs into trouble? Having the real estate in the same company as the operations may expose the real estate to claims of creditors.
So assuming you decide to set up a holding company to buy the property, then your next question may be "How do I pay off the debt in Holding Company?" Operating Company and Holding Company would enter into a lease agreement whereby Holding Company would lease the property to Operating Company. The rental income earned by Holding Company would be taxed at the 15.5% rate (because it would also be considered ABI) and so Holding Company would use the after-tax profit to pay down the debt.
Another good question concerns the ownership of Holding Company. With proper planning, family members could own an interest in Holding Company. This could allow for additional CGE claims on the sale of the shares of Holding Company, thus reducing the income tax bill on the eventual sale of the real estate even more (consideration could be given to bringing the family members into ownership of Operating Company now as well).
What if instead of buying an existing building you decide to build your own? In Holding Company, the entire cost of the building would be written off for income tax purposes on a very slow basis (it would take almost 40 years to write off 90% of the cost). With some planning, Holding Company could bear the cost of the main structure of the building and Operating Company could bear the cost of the interior "fit-up". Operating Company would treat this cost as a leasehold improvement and could write it off over 6 years, thereby significantly increasing the tax write-off and the resulting tax savings.
As indicated above, only the first $500,000 of annual ABI is eligible for the 15.5% tax rate and in Ontario, this rate goes to 25% for income above $500,000. Operating Company and Holding Company would have to share this $500,000, so if their combined income exceeds $500,000, the higher rate applies on the excess.