March 21, 2021

Mike McLenehan on rental property taxation

Mike McLenehan on rental property taxation

Mike McLenehan CPA, CGA is the founder of McLenehan and Associates Chartered Professional Accountants with two locations Winnipeg. In this episode we talk about holding investment properties personally vs in a corporation. We also discuss some of the tax...


Mike McLenehan CPA, CGA is the founder of McLenehan and Associates Chartered Professional Accountants with two locations Winnipeg. In this episode we talk about holding investment properties personally vs in a corporation. We also discuss some of the tax implications to consider. 

Transcript

Adrian:

I'm joined today by Mike McLenehan of McLenehan & Associates. They're an accounting firm with locations, both on Roblin and Pembina. Welcome Mike.

Mike:

It's great to talk to you, Adrian.

Adrian:

So let's start out. Can you tell me a little bit about yourself and your firm?

Mike:

Yeah, absolutely. We're a CPA firm, charter professional accountants here in Winnipeg. I opened this practice in 2013. Started it from scratch, it was me a desk, a laptop, and no clients. And over the years, like we've been able to grow to a multi location firm. We've got offices in the west end of Winnipeg on Roblin Boulevard and the south end of Winnipeg on Pembina Highway. We've got about 14 people working here right now, a team of CPAs, certified tax specialist, as well as bookkeepers here that serve probably 400 or 500 small business owners in Winnipeg and probably 1,200 to 1,500 personal tax clients every year.

Adrian:

Well, congratulations. I think that's a great achievement to grow an accounting firm that fast. Obviously there's something that makes you special. What are some of the unique value propositions that you offer to your clients?

Mike:

Well, like I would say that most small business owners struggle to be profitable because no one's teaching and supporting them. There is a real problem in the accounting industry right now, where everyone is so busy preparing financial statements and tax returns that accountants are often overlooking their most important role, which is providing the value of professional advice. And so as a firm, like we've really organized ourselves in a way where as the owner of the firm, like I can be very available to our clients in terms of providing that advice and good guidance on how to run and grow profitable, successful companies. And then I've got a great team behind me here that handles financial statement preparation, tax return preparation, all that good stuff. And so I think that our clients benefit not only from having their financial statements prepared and their tax returns done, but then also like having a partner that they can refer to and have conversations with about how to run and grow a better, more profitable, more successful company.

Adrian:

A lot of families and small business owners obviously understand the value of investing in real estate. What are your thoughts or your professional advice on holding rental properties in personal versus corporate name?

Mike:

So there's a couple of options there and like a couple of different structures. And I think we're talking about whether or not to own rental properties in your personal hands versus your corporate hands. There's advantages and disadvantages to both. Certainly people are making these decisions pretty heavily on the tax consequences of that. And then I find like often people are having a conversation with their neighbor and their neighbor is saying, you should incorporate, you're going to save a lot of money on income taxes. And maybe aren't fully understanding the consequences of that before setting up a more complicated corporate structure.

Mike:

If you go to your lawyer and you say, I'd like to set up a corporation, your lawyer is going to say, yep. And they'll do the work and they'll set it up. And then it's up to you as the owner of that property to then like manage that and make sure that you are reaping the benefits of a more complicated structure. And so often the decision-making process, well, it should be one that's informed based on like facts and numbers and a complete understanding of like what your intentions are for a rental property. And that's going to govern like what it is that you do, like in terms of how you structure this, how you own this, how you receive the income and how that's going to result in taxable income to you or this separate entity that you're setting up.

Adrian:

And from a high level, how is rental income taxed when holding the property personally?

Mike:

What happens is ... Like rental income, like it's not a different tax return apart from your personal income tax return. What happens is rental income gets calculated on an additional form that gets added to your personal income tax return when we prepare it. And that form is the statement of real estate rentals, form numbers T776. And in that form, like you're making a calculation of your gross rents, so that money which you're receiving from a tenant, minus the costs of maintaining or holding that property, and those costs can include like just commonly mortgage interest, repairs and maintenance property taxes, insurance utilities, things like that. So when you take your gross rents and you deduct the eligible expenses, you arrive at a number that is either net income or a net loss for rental purposes. Like just depending on how profitable that rental unit is. And the net rental income gets added to your total income in the calculation of taxable income.

Mike:

And so you as an individual owning a rental property personally, you're going to pay tax on the rental net income at your marginal rate. And that marginal rate can be depending on your other sources of income, it can be anywhere from 25% to 50.4% like being the highest marginal tax rate, Manitoba. Some rental properties also don't achieve profitability immediately. Sometimes you've got to buy a property and hang onto it for a number of years before it becomes net income and cashflow positive. And so to the extent that you have net losses for rental income purposes, you actually get to deduct those losses from other sources of income to reduce your total and taxable income. So if you had say a salary or wage that was $50,000, and you had a $5,000 rental loss, you could actually deduct that rental loss from your other sources of income to reduce your total and taxable income, which is going to reduce your taxes payable at the end of the year.

Adrian:

Now when acquiring an investment property, a lot of people are using their home equity line of credit or a refinance equity takeout to get the cash for the necessary 20%, minimum 20% down payment on a rental property. Is the interest that you pay on that home equity line or on the proportionate share of the equity takeout of the primary residence, is that a tax deductible expense, if it is recorded and tracked properly?

Mike:

It is. Yeah. What you want to do is really want to set yourself up in a position where you can draw a clear line between the expense that you're incurring for a rental property and the rental property itself. And so what I like to see is when clients will borrow money from the equity of their home, using a home equity line of credit, and then use that money for a specific purpose, like earning investment income or rental income in this case. Because if you've got expenses like interest expenses and that interest expense is blended with sort of personal expenses, like you take out a home equity line of credit and you use a portion of it to build a deck on your house, and then you use the other portion to buy a rental property or an investment. It can be difficult to segregate or separate the expense incurred for earning income from the personal use portion of that loan.

Mike:

And so what I like to see is for people to sort of take out lending that is specific for that investment purpose, so that you can clearly identify the interest that you're paying for income generating purposes and claim that as a tax deduction in reducing your taxable income on that investment.

Adrian:

Now, are there any tax benefits of holding an investment property inside a corporation?

Mike:

So there's definitely some advantages and there's some disadvantages to owning a rental property within a corporation. Some of the advantages and the first one, this is going to be stuff that like your lawyer will probably talk to you about, is that you'll benefit from limited liability and creditor protection. And so if in owning this rental property, you were sued or sued successfully. If that property was owned within a corporation, then that corporation becomes the legal entity that's being sued. If that corporation is sued successfully, the assets that will be subject to a judgment would be limited to those assets, which are owned by the corporation. And so it provides you some protection in that your personal assets in terms of your home or your vehicles or your cash or your investments, aren't subject to that.

Mike:

Creditor protection, again, like any corporation that is taking out a loan or receiving credit from like a company or a bank is its own separate legal entity apart from you personally. And so you would be protected against claims by creditors so long as you hadn't made personal guarantees on those loans or those claims. And I think most banks or financial institutions do require personal guarantees except in instances where you've got a significant amount of capital contributed, where that allows them to limit their risk. And so wherever possible, like you want to avoid personal guarantees and really draw a line between yourself personally, and your personal assets and the investment assets that your corporation owns.

Mike:

The other advantages that I see, like to owning a rental property within a corporation, thinking about this, like depending on what it is that you're doing with that property, that can change the nature of the income that it's receiving or earning, and that can affect the tax rate. Like I know that like real estate investment is not just about buying and holding properties. There's a number of people in Winnipeg who buy properties and flip them. And so like if you're buying a property with the purpose or intent of renovating and selling it, that piece of property is not a capital asset. It's actually a piece of inventory that you're going to sell at a cost higher for what you paid for it after you improve it or develop it.

Mike:

Active business income is taxed at preferential rates. And so property that's treated as business inventory that's eventually sold, a corporation would actually pay tax at a really low rate of tax. In Manitoba active business income is earned at a tax rate of 9% federally and 0% provincially. And so potentially like if you're running this as an act of business of flipping houses where the properties themselves are inventory, you could be attracting a really low rate of tax within a corporation.

Mike:

And the other advantage that I see to owning like a rental property, like a pure rental property, where you're just receiving rental income and deducting the expenses related to that is, especially for the owners of incorporated small businesses. Like as we mentioned, like active business income in Manitoba is tax rate of 9% federally and 0% provincially. And so what you see is owners of businesses will actually use the profits from their company to purchase revenue generating investments like rental properties. If you're paying tax at a really low rate, 9%, that gives you 91 cents of every dollar of net income that you have to invest in that revenue generating property. Whereas if you were running a business as a proprietorship, you'd be paying tax rate of 25 to 50%, and that would give you 75 cents to 50 cents of every dollar of net income with which to reinvest. And so I think there's a attraction there for people who are running active businesses to then take their profits and use that to make a larger down payments or buy many multiples of rental units to generate like more passive investment income.

Adrian:

There's definitely a benefit to someone investing in real estate to speak to a professional accountant, a lawyer, obviously a real estate agent and potentially mortgage broker, to discuss all of the different aspects and facets of real estate investing. One of the things that comes up regularly for me when I'm speaking with clients is how to protect their family for the debt associated with the real estate investment. And without of course, I mean, either a mortgage protection insurance or term life insurance or other types of insurance products that can help mitigate some of the risks associated with the debt on the investment properties. My question for you is if someone is investing in a rental property and they then go and purchase life insurance or mortgage protection insurance to cover the debt associated with that rental property, is that also a fully tax deductible expense, that premium?

Mike:

I think the premium would be deductible so long as the corporation was going to be the beneficiary of that insurance, to be able to use that money to pay off the mortgage. If the intent was that that money would flow out to like beneficiaries of that person's estate, you wouldn't typically like claim a deduction for that type of insurance.

Adrian:

Okay. So if you're holding it personally, that would not be the right course of action?

Mike:

Right. Yeah. Well, I think it's about sort of protecting that investment and protecting like the equity that you have in there, and then not like having that property seized by a bank. However, like my expectation would be that your renter and the rent that they're receiving, like should fund the mortgage. In which case, like proceeds of life insurance, typically, like we're adding back as a nondeductible expense on tax returns. And then the receipt of the proceeds of that life insurance policy can then be flowed out to family members of the deceased through like a non taxable dividend. It's called a capital dividend.

Adrian:

You clearly know a lot about structuring real estate investments correctly and how it pertains to both personal and corporate structure taxes. How do people reach you?

Mike:

Well, we've got two offices in the city, one in the west end on Roblin Boulevard, one in the South end, which is Pembina Highway. They can reach me by phone at 204-505-3113. They can reach me by email at success@mclenehan.com or they can visit our website, which is www.mclenehan.com.

Adrian:

Thank you, Mike, for your time today.

Mike:

Great. Thanks, Adrian. Thanks for having me.

Mike McLenehan

CPA, CGA

Mike has served a wide range of industry sectors in the areas of accounting, tax, and assurance. Mike has extensive experience with owner managed businesses, including small to medium enterprises, with experience in nonprofit organizations, manufacturers, agriculture related entities, healthcare, retailers, equipment sales and leasing, and construction contracting.

Mike has also specialized in the areas of business taxation and advisory where he has consulted with numerous clients regarding achieving tax minimization and effective tax planning. Mike has extensive experience in corporate and individual tax planning.

Mike received his Honours Bachelor of Commerce degree from Laurentian University. He is a member of the Chartered Professional Accountants Association of Manitoba, the Chartered Professional Accountants Association of Canada, and the Institute of Professional Bookkeepers of Canada.

Mike is currently involved in the Chartered Professional Accountants of Canada Tax In-Depth course, Canada’s leading professional development program for tax practitioners.

His leadership has been recognized locally where Mike was awarded the Grant and Sandra Kirkup Leadership Award in 2013 for service to the community and his professional association.

Mike and his wife Lindsay and his son William live in Winnipeg, and have a golden retriever named Tax