Oliver Foote

Tax Benefits of Real Estate Investing

There are many tax benefits to real estate investing in Canada. The first and most obvious one is that you are not taxed on capital gains when you go to sell your primary residence. The idea is that a primary residence is not really an investment and can often cost a bunch more money than it makes you. So dollar for dollar you can move that money into a different home, minus realtor fees, lawyers, and land transfer tax (which don’t get me wrong, can add up). By contrast when you sell an investment property or stocks for that matter you will get hit with capital gains tax on 50% of the appreciation which gets added to your income and taxed at whatever brackets it fits into. This does not occur on your primary residence which is a very big advantage for people who are already in the property ladder and are either moving up or downsizing their home to fund their retirement. If you happen to have built up a good amount of home equity in your primary residence this can provide you with a significant amount of tax free money and save you hundreds of thousands of dollars on taxes in some cases.

Just because a primary residence is a very advantageous assets in term of tax benefits. Doesn’t mean you should discount the tax advantages of purchasing investment properties in the form of residential rentals or commercial properties. These have many similarities and differences. Depending on what type of property you want to manage you might prefer one over the other. You may want to speak with a tax accountant and a lawyer about the best corporate structures if you want to have a large portfolio of properties as they will be able to best advise you on your situation and how to make the most of the tax advantages. For now lets begin by discussing the tax advantages of investing in a regular residential investment up to 6 units (generally anything beyond 6 units is usually considered multi-family commercial). The first thing to understand is that the tax law views purchasing a rental property in a different way than purchasing a primary residence. The laws sees this as an investment with a profit motive, you can think of the investment home purchase almost as it’s own little business. Ideally it is making more money than it is costing the business to operate, or it is growing in value faster than the money you have to put into it to keep it afloat.

The first advantage to owning a rental property is something called depreciation. The CRA calls this CCA (Capital Cost Allowance). When you purchase an asset to run a business (a capital expense), you are allowed to depreciate it a certain percentage every year depending on which CCA class it falls into. The idea is that as you use the asset you bought to run your business, it wears and tears and may even require additional expenditures (such as paint, appliances or new wiring). All of these expenditures might be required to maintain the assets function to continue producing income for the business. However, over time the property will wear out beyond a useable state (this is more so the case with electronics and similar items, but the general idea still applies to rental properties for tax purposes). In this case the capital expense would be the cost of purchasing the home for the business. For typical residential rental properties the CRA allows a 4% depreciation rate per year (this varies depending on building uses etc). Depreciation can benefit you because it can be deducted from your rental income.

Similarly, you can deduct 100% of the interest portion of your monthly mortgage payments (ONLY the interest, not the loan principal you paid down). Loan interest on debt is seen as a cost of doing business. For example in a regular business the owner might take out a loan to purchase machinery for a factory and they owe interest every month. That interest is seen as a cost of doing business and can be deducted against revenues. Interest on a loan is categorized as an interest expense which means you get to deduct 100% of it against income rather than the depreciation expense of 4%. As an aside, when you go to sell and it turns out your rental property went up in value but you depreciated the entire thing. You will have to pay tax on the “recapture” of the depreciation. So you’re effectively deferring the tax burden to a later date, but it will still come (assuming the property goes up in value when you go to sell). Interest expenses are one and done, no recapture.

All of this jargon might be a bit confusing so lets take a look at a quick example. You purchase a home for $700,000 including lawyer fees and renovations and you rent it out for $3000/month. In the first year you would have access to 2% depreciation due to something called the half year rule. The year in which you make a capital expenditure is treated as if you purchased that property halfway through the year, thus giving you half the depreciation for the first year. This means that you can depreciate the rental property 2% in year 1 and 4% in the following years. So 2% of $700,000 is $14,000. Your total rental income is $3000 * 12 = $36,000. At todays mortgage rates of around 5% you would end up paying approximately $32,000 in interest on the mortgage in that first year (assuming you purchased January 1). So what you would do is deduct the interest first leaving you with revenues of $4,000. Then you would apply $4,000 of the available depreciation making your net income before taxes a big fat ZERO.

So what you effectively managed to do here is make an income from your rental property, and you found a way to pay zero tax on it. Over time the property will appreciate and when you go to sell you will owe capital gains tax since it’s a rental. Eventually the interest expense on your mortgage will shrink and the amount that you can depreciate the property will shrink and you will owe tax on the rental income. But in 25 years or so, you will own a completely paid off asset, that is generating you monthly income. With the home equity you’ll be able to take out a line of credit for about 65% of the homes value and do this all over again (or sooner than 25 years from now if it appreciates significantly). I think the best part about all of this that I’m glossing over a bit is that someone else was paying the mortgage and covering all (or most) of the expenses required to operate the home. You are effectively accumulating wealth at double speed assuming you also have a primary residence that you are building home equity in. If you add a third or fourth rental property you can see how this just continually compounds and doesn’t necessarily cost you a lot of money every month to carry the asset. In major cities around the Greater Toronto Area you will most likely face a negative cash flow scenario for the first 5 years or so of owning the property. But maybe somewhat counterintuitively now is a great time to buy a rental property while interest rates are still somewhat high. If you anticipate them dropping in the future, which I do. In 5 years from now when you go to renew your mortgage it’s very likely that your future mortgage payments will be lower than they are today and your rental income will likely be higher, closing the gap of negative cash flow. As another aside, I would recommend talking to an accountant or lawyer if you are going to do a big renovation and want to add it to your homes capital expense bucket because there are certain restrictions to what is or is not considered a capital expense.

We’ve gone over the basics of a simple rental residence that has one or two units. But lets say that you want to venture into the commercial real estate world and purchase a property with more than 6 residential units. What changes? Well the most important thing that changes is that commercial properties are truly treated as standalone businesses. Unlike homes where they are valued based on other homes, commercial properties are valued mostly on the income they are generating (or capitalization rate). Often times people will choose to set up a corporation to hold the property which then means dealing with corporate taxes. The corporate tax rate for small businesses making less than $500,000 is 9% federally and 3.2% in Ontario. Corporate taxation does get somewhat complicated, and as a business owner you can choose to either pay yourself a dividend or pay yourself as an employee, both of which are treated differently under the tax code (speak to an accountant). If you retain the earnings in the business and don’t pay yourself as an employee you will pay the tax rate on the income earned. Similar to the previous example you can deduct costs of running the business, expenses, capital gains, interest expenses, vehicle expenses, etc. all BEFORE you pay tax. This is different from you as an employee in one major way. On your earned salaried income you owe tax immediately and then you get to spend the remainder. Businesses spend first and get taxed later which presents some unique advantages and enables businesses to focus on reinvesting and can grow a business very quickly. Another aside, the rate of depreciation on a commercial property may be different and depending on the type of property the physical land, versus the building that is on the land may be treated differently under the tax code.

The end benefits of operating in a corporate structure is that once you begin to earn taxable income, the tax rates are much lower and it becomes easier to continue to invest within the corporation. You retain more of your earnings within the business which can lead to even faster growth in wealth and there are many more tricks that accountants and lawyers can do to defer your tax burden even further. See estate planning and setting up trusts. If any of this interests you further I would recommend studying the book, Legal, Tax and Accounting Strategies for the Canadian Real Estate Investor by Steven Cohen and George Dube. It was published in 2010, but there are still ton’s of relevant strategies in that book depending on what stage of investing you are in. I do highly recommend simply talking to another real estate investor who has done what you are considering doing as well as an accounting or legal professional as they will be able to best advise you depending on what you are interested in pursuing. It’s very useful to talk to someone who is already doing the thing you want to do because they will have come across many hurdles that you may be able to avoid if you ask the right questions. There are endless layers of depth to this discussion but to avoid an information overload I’ll save it for another time. I hope that between this post and the last post talking about the return on investment (ROI) of rental properties I have got you seriously thinking about the power of real estate investing. You can make it as simple or as complicated as you want and you can even become a developer! (Not for the faint of heart with all the red tape nowadays). Hopefully you found this article interesting or useful and I hope you have an amazing day!

All the best,

Oliver

Why Owners are 28x Wealthier Than Renters

I wanted to talk about the ever popular debate on renting vs. owning with a focus on how the finances pencil out at this moment in time, and which option makes more sense from a Return on Investment (ROI) perspective. Toronto is a notoriously expensive housing market, especially when to comes to ownership, and renting often times appears more affordable at a glance. For the same space in Toronto it is often much cheaper to rent than it is to own (although this gap has narrowed with increasing rents and a temporarily stable housing market), and this is true across many major cities in Canada. On the face of it most people would think, “I’m getting better bang for my buck renting! Why would I ever bother purchasing?” This is somewhat shortsighted in my view and I think many people do not run the numbers on why homeownership over the long term is a more beneficial route financially (plus having the freedom to do with the property as you wish and not having a landlord). There are many very important factors that people forget to include in their renting equation which I am going to be calling the 4 horsemen of real estate ownership.

There are a few reasons why people might be biased towards viewing renting as the better option in the short term. Firstly, it can be difficult to predict prices and appreciation in the short term. For example, if you purchased a home in 1990, it would have taken about 10 years for your home price to recover from the housing market lull. If you purchased a home in early 2022, the value of your home in the current market (February 2024) is likely below what it was in 2022 and may be for another 2-3 years until those prices come back. This is partly why if you look up renting vs. owning you will often notice that ownership becomes more beneficial the more long-term you plan to hold onto the real estate. Often times if you plan to stay somewhere short-term it may actually be more beneficial to rent. I always lean towards the side of ownership when possible because there are ways to own and manage property even if you are out of province or out of country. In many cities you also have various options whether that is renting your property short-term or long-term. If you can afford to stomach a month or two of rental vacancies, you will almost always come out ahead in a high demand real estate market.

I would encourage any young person to try to enter the property ladder as soon as possible, and I’m not just saying this because I have my real estate license. I have held this belief well before I had my license. Allow me explain why I think home ownership is so benificial with some data you may find interesting. According to Statistics Canada, in 2019 the average renter had a net worth of $24,000. You might be saying, “well that makes sense, it could be a demographics thing where younger people tend to rent and some people just can’t afford to save for a home.” According to the same study, the average homeowner, on the other hand, had a net worth of $685,400, or 28 times higher. There may be some truth to the demographics of younger renters and older owners, but I believe it’s more of an education and discipline problem. So allow me to explain why this gap is so massive.

The first reason deals somewhat with human nature, most people are not savers by habit, and our 6% national savings rate proves this, in the US it’s even worse at 3.7%. For people who are not the pro-active and disciplined type, “spending” money on a mortgage can actually turn into “investing” money into real estate. Paying down a mortgage becomes a “forced savings plan” for the average person. Furthermore, many people will lack the discipline it takes to budget and save 20% or more over a number of years for a down payment. It takes a different kind of mentality and work ethic compared to simply paying rent and neglecting to find ways to save some extra money. You might have to find a place that is not as nice and therefore cheaper, you might need a second job to squirrel away all the extra cash, and you may have to skip out on a few vacations. Many people are not willing to sacrifice in order to save a down payment or they make poor financial decisions taking on debt they should not have before they even think about saving.

Luckily, not everyone is a financial mess. For people who are savers they may just prefer renting for one reason or another, or have never been shown the numbers in order to pull the trigger on home ownership. So for these people let me begin by stating that the returns on real estate (can) surpass the stock market due to a combination of reasons. Being a home owner has almost a quadruple benefit compared to renting or simply investing the equivalent which I will explain next.

Firstly, as a homeowner you get to feel the joy (or pain) of paying your own mortgage rather than paying your landlords mortgage. From a selfish point of view, it’s nice to know you’re paying into something you own rather than something someone else owns. Down the line maybe you get a tenant of your own and have them help out with your mortgage, that is known in the business as Cash Flow. Often times even if a home is “negatively cash flowing” (i.e. costs you money every month to “operate”), the other three benefits can hugely outweigh this.

Secondly, every month a portion of your mortgage payment goes to interest and a portion goes to principal (i.e. the original loan amount). The part of each payment which goes towards principal is known as principal pay down, which becomes “equity” in your home. For example, if you purchased a $1 million home with a 20% down payment, immediately out of the gate you have approximately $200,000 of home equity and the other 80% is a loan. Lets say your mortgage rate in present day (February 2024) is 5.29% fixed for 5 years, with a 25-year amortization. By 2029, or the end of the first 5 year term, you will have paid down approximately $88,755 in principal and $198,392 in interest. In this case you now have approximately $288,775 in home equity, before factoring in appreciation. You might look at this and say, “hey! I just paid $200,000 in interest! That’s crazy, what a waste of money!” This is often where people forget that homes tend to appreciate in value over the long term. The value of your $1,000,000 asset likely increased to beyond $1,000,000. Therefore the equity in the home has increased, but the loan value DECREASES at the same time thanks to your principal pay down. Over a long time horizon these two lines diverge and what’s left in the middle is (often significant) home equity.

Thirdly, the GTA over the last 40 years has appreciated at approximately 6.7% per year (in the 10 years prior to 2020 it was closer to 10% appreciation due to continually decreasing interest rates, we likely won’t see that same type of growth again). Factoring this 6.7% appreciation into the equation, in 5 years the $1,000,000 home might now be worth $1,383,000. That’s an ADDITIONAL $383,000 of home equity. Combining the original $200,000 down, the $88,775 principal pay-down, AND the $383,000 appreciation, you now have $671,775 in home equity! If we take the TOTAL return on investment between principal pay down and appreciation, in just 5 years the initial $200,000 has grown by 235%! Even if you subtract the interest you paid over the loan term you are still sitting at a new net value of around $471,000, which is still over 100% ROI in 5 years. If you took that initial $200,000 and put it in the stock market at an average 8% return every year you would have $293,865 in 5 years. Which is not even 50% of the total home equity (i.e. $671,775).

Finally, you also have the ability to create “forced appreciation” by doing some simple improvements to the property, or dividing a property into 2 or more rental units to add value from an income generation perspective. There are a few well known improvements that can significantly increase the value of your property on the open market, and if you DIY it on the cheap you can add a ton of value while saving a good portion of the labour cost. That being said PLEASE hire someone if you’re not construction savvy, a hack job could actually cost you money in materials and hurt the value of your property. If done right, by not overspending or doing a poor job, this fourth horseman of real estate ownership can help send your return on investment even higher than I outlined above.

All of the reasons listed here prove why real estate ownership can be so powerful as a wealth building tool and why the average home owner has a net worth more than 28 times higher than a renter. Many people do not take the time to do the math on real estate ownership, or might not be aware of all the ways that owning real estate provides an amazing return on their investment. Naysayers might argue that the return is not guaranteed, well, neither is the stock market or pretty much anything else you invest in. However, real estate has the benefit of being a hard tangible asset compared to an intangible piece of paper (stock certificate). There is risk to any investment, your home could theoretically blow away or burn down. But you can mitigate this with insurance. Overall, you can make a good amount of money in real estate when you purchase at the right price. If you take the example about further you might also be able to see how owning multiple real estate investments can compound your wealth even faster, and it explains why many people who are well-off have a significant stake in real estate. Even if your home appreciates at a much slower rate than the one I present here, you are likely to come out ahead of the average stock market investor and well ahead of the average renter. I hope that after reading this you think about breaking into the real estate market sooner than later and begin to benefit from the 4 horsemen of real estate ownership.

All the best,

Oliver

P.S. When you sell a primary residence your capital gains are tax free, in Canada. Also, you can deduct mortgage interest from your taxes on an investment property and you can benefit from depreciation around 4% per year. I’ll cover these tips and more in later articles. The benefits to real estate as a tool for investment and tax deferral and wealth building is bar none in my opinion.