The ongoing fluctuations of Toronto real estate values have been a frequent topic of conversation for some time. According to the Toronto Regional Real Estate Board (TRREB), the average price of real estate has increased from approximately $180,000 to $950,000 over the past twenty-five years, representing a rate of return of 428 per cent (6.88 per cent - annualized).
The appreciation of real estate, coupled with a favorable borrowing environment, has provided the opportunity for real estate refinancing. Where real estate is held in a corporation, owners may consider refinancing a property and extracting the funds raised out of their corporation. The decision to refinance and extract funds out of a corporation (to the personal level) may seem like a no-brainer. However, there are a multitude of income tax considerations that must be considered prior to doing so. Here are some ways refinancing can affect your taxes.
Potential for Higher Overall Taxes
When a capital gain is earned through a corporation, there are two levels of taxation: one at the corporate level (tax paid by the corporation on the income earned within the corporation) and one at the individual level upon distribution of the corporation’s after-tax funds as a dividend (tax paid by the individual).
The concept of tax integration suggests that the same amount of tax should be paid on income/gains earned by an individual through a corporation, or income/gains earned directly by an individual (i.e. without the corporation).
Tax integration is achieved when income is subject to the same overall tax, once it reaches the individual taxpayer level, regardless of the number of corporate tiers the income has passed through beforehand.
There are numerous income tax attributes and concepts that exist within the Canadian tax system in an effort to achieve tax integration on passive income and gains, including the capital dividend account (“CDA”), refundable dividend tax on hand (“RDTOH”), and more.
When a corporation holds real estate property on account of capital:
- Any gain realized on a sale of that property would generally be considered to be a capital gain. A capital gain is currently only 50 per cent taxable. The 50 per cent non-taxable portion of the capital gain is added to the corporation’s CDA, which can generally be distributed to the corporation’s shareholders (including individuals) free of any additional taxation. The fundamental purpose of the CDA is to help achieve overall tax integration when a capital gain is realized within a corporation. Had the capital gain been earned by an individual, there would be no tax paid on the 50 per cent non-taxable portion of the capital gain. The CDA is intended to facilitate the notion that the individual shareholder can access the 50 per cent non-taxable portion of the capital gain without incurring any additional personal taxation.
- Additionally, included in the corporate income tax that will be paid by the corporation on the taxable capital gain is a refundable component (RDTOH - taxes that are ultimately refundable to the corporation when taxable dividends are eventually paid by the corporation to its shareholders).
Both of the items listed above are intended to help achieve tax integration. An important item to note is that the items listed above are only generated and made available within a corporation upon an actual sale of the real estate property.
If a real estate property owned by a corporation is re-financed, and the borrowed funds received on the re-financing are distributed to the corporation’s shareholders, it is possible that tax integration may be lost. In order to move the borrowed funds out of the corporation to its shareholders, the corporation may be pre-emptively declaring a dividend prior to an actual sale of the real estate property.
When this occurs, the aforementioned beneficial income tax attributes that are aimed at achieving tax integration (CDA & RDTOH) will not be available to the real estate corporation at the time of the dividend payment, as these would only be generated upon an actual disposition of the real estate property. This could ultimately result in higher overall taxes being incurred.
When the property is eventually sold, the corporation will first be required to use any after-tax funds available to repay the debt incurred on the re-financing and may therefore not have sufficient funds remaining to fully utilize the favorable income tax attributes that would have been generated upon the sale of the property (CDA & RDTOH).
Ultimately, the favorable tax attributes would be left unutilized, resulting in a loss of tax integration and higher taxes paid overall by the corporation and the individual in aggregate.
Refinancing a property is a great way to increase cash flow. However, the deductibility of interest for income tax purposes is directly tied to the use of the borrowed funds received. More specifically, there are four conditions that generally must be met for interest to be deductible:
- There is a legal obligation to pay the interest;
- The interest must be paid or payable during the year;
- The interest cost must be reasonable; and
- The borrowed funds must be used to earn income from business or property.
Consider the following example:
Mr. and Mrs. Smith wish to help their adult son, Patrick, purchase a home in Toronto. Mr. and Mrs. Smith own a personal residence in Toronto and a rental cottage in Muskoka. The Smiths have decided to refinance their rental cottage in Muskoka and will gift the borrowed funds received to Patrick so that he can use the funds for the down payment on his home purchase.
Since the cottage is a rental property, the Smiths are under the impression that the interest incurred on the refinanced loan is deductible for income tax purposes. Unfortunately, this is not the case. For interest to be deductible, there must be a direct link between the borrowed funds and an income generating activity. The mere fact that an income producing property (the Muskoka rental cottage) is being used as collateral to secure the loan is irrelevant.
The Smith’s are not borrowing the funds for the purpose of earning income from a business or property, rather, the funds will be gifted to and used by Patrick as a down payment for a home. As a result, the interest paid on the borrowed funds will not be deductible for income tax purposes.
Conversely, if the funds were used to purchase another rental property, the use and purpose of the borrowed funds would be directly linked to an income generating activity, ultimately resulting in deductibility for income tax purposes on the interest that is paid.
Generally, dividends paid by one Canadian corporation to another Canadian corporation may be paid tax-free unless the payor corporation receives a dividend refund, in which case Part IV tax would apply. However, there are anti-avoidance provisions in the Income Tax Act Canada that are intended to negate taxpayers from stripping corporate surplus by taking advantage of the general rule that allows inter-corporate dividends to be received tax-free in many cases. The anti-avoidance provisions will largely not apply to an inter-corporate dividend if the dividend is paid out of “safe income”. Safe income can generally be described as a corporation’s after-tax retained earnings.
If real estate held with a corporation is refinanced and cash is now available to be distributed through the payment of an intercorporate dividend, careful consideration should be given as to whether the payor corporation has sufficient safe income on hand prior to paying an intercorporate dividend. If the payor corporation does not pay a dividend out of safe income, the dividend may be recharacterized to the recipient corporation as a capital gain, 50 per cent of which would be taxable.
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This article has been prepared for the general information of our clients. Specific professional advice should be obtained prior to the implementation of any suggestion contained in this article. Please note that this publication should not be considered a substitute for personalized tax advice related to your particular situation.