Under new legislation, Ontario’s real estate professionals are now allowed to incorporate by setting up a Personal Real Estate Corporation (PREC). Before doing so, however, it’s important to understand the ins and outs of the new rules.
That’s especially true when it comes to the activities that can be undertaken by a PREC. Generally, a PREC cannot carry on the business of trading in real estate other than providing the services of its controlling shareholder to the brokerage. Although the controlling shareholder can earn commission income within the PREC, no other real estate professional can earn the same type of income within the same PREC. It is worth mentioning, that the PREC may use any excess funds in the PREC to invest in real estate such as holding real estate to earn rent.
Controlling individuals may benefit from the income tax deferral obtained by setting up a PREC and as such, use these excess funds in other real estate ventures. An income tax deferral may be obtained since commissions earned inside your PREC are taxed at the small business tax rate of 12.2 percent, up to $500,000 of taxable income, rather than your personal marginal tax rate, which may be much higher. The only time you pay personal taxes is when you withdraw those funds from the PREC, giving you the opportunity to substantially defer taxes.
With proper structuring, setting up a holding company to be a shareholder of your PREC may allow for certain tax advantages associated with preserving the small business deduction. To the extent commission income and rental or other passive income is earned in the same PREC, the amount of passive income earned would generally ground away at the availability of the small business deduction. The federal small business deduction is ground down by $5 for every $1 of passive income above $50,000 earned and completely eliminated when passive income reaches $150,000. So, how can a holding company help?
Setting up a holding company
At a high level, a holding company—or Holdco—is like any other corporation. Its main difference from an operating company (Opco) is that it typically doesn’t engage in active business activities. Instead, it’s created to protect the value accumulated in an Opco, potentially invest in passive assets and provides the opportunity for dividends to be paid from the Opco to the Holdco without the incidence of additional tax.
So how could a real estate investment in a rental property be structured with excess cash earned in the PREC? In essence, your PREC (the Opco) would flow its profits into the Holdco on a tax-free basis. Holdco, in turn, could use that money to Invest in other real estate or other investment opportunities and protect the value accumulated in a PREC. With proper structuring and ownership by family members, there also could be an opportunity to avoid the grind to the small business deduction in the PREC by separating the PREC activities from the rental investment activity of the Holdco.
Although simple in theory, this structure can be complex in practice, which is why it’s important to think through how you set up your Holdco in advance and consult legal counsel. Setting up an ownership structure that allows for the equity shares to be owned by the controlling individual and the non-equity shares by family members through a holding company could be an effective structuring alternative. Dividends may still be paid out of the PREC to the Holdco based on its percentage ownership and the funds in the Holdco can be invested.
In addition, by introducing family members as shareholders in the PREC structure, there may be the added benefit of income splitting with family members. That is, dividends may be paid to your family members at their potentially lower personal marginal tax rates. Be careful of the Tax On Split Income rules and consult with your accountant prior to distributing any after-tax profits to family members.
Why share structures matter
While this structure may make sense for you, it’s also fraught with pitfalls for the unwary. Part of that is because under the PREC legislation, you as the real estate professional must own 100 percent of the voting shares either directly or indirectly of the PREC. This means your family members, as shareholders of Holdco, can only own non-voting shares. It’s imperative to think through the ownership structure of both your PREC and your Holdco.
This is a complicated process and is unique for each individual. Fortunately, we’re in your corner. If you’d like to learn more about setting up a PREC and Holdco, contact your Grant Thornton advisor.