When we first met
Miss Take a couple of years ago, she had made the unfortunate
error of borrowing to acquire a new principal residence. She did
not realize that the interest on the borrowed funds would not be
deductible against the income from her rental property (her former
principal residence). Even though the borrowing was against the
equity in her rental property, the direct use of the funds was to
acquire a new personal home, so the interest on this borrowing was
As that previous article mentioned, some restructuring to obtain interest deductibility is possible with the right planning. But once the error has been made, can it be fixed?
Miss Take did not want to involve other individuals to help her with her planning, so she decided to investigate other options. After talking with her advisor, they came up with the following plan:
- Miss Take incorporates a new company (Newco) and becomes Newco's sole shareholder.
- Miss Take transfers her old home to Newco and as consideration; Newco issues a promissory note equal to the value of the property. Let's assume that this transaction is happening shortly after the conversion to a rental property. The gain realized by Miss Take on the conversion is sheltered with her available principal residence exemption (see here for more information on the principal residence exemption.)
- Newco borrows from the bank an amount equal to the promissory note.
- Newco uses the borrowed funds to repay the promissory note owing to Miss Take.
- Miss Take uses the funds received from Newco to repay the mortgage used to acquire her new principal residence.
What has been accomplished here? Newco now has an
interest-bearing loan owing to the bank. Even though Newco did not
use borrowed funds to acquire the rental property, it used the
borrowed funds to repay an amount payable for property acquired for
the purpose of earning income. As such, the bank borrowing is
deemed to be used for the same purpose as the previous debt owing
to Miss Take and therefore, the interest is deductible by Newco
against the rental income.
Before making this decision, Miss Take and her advisor had a number of things to consider:
- The legal costs of incorporation
- The ongoing accounting costs of the annual tax filings
- The tax rates on the rental income earned inside of the corporation vs. the personal income tax rates (the costs / savings will depend on the province of residence) – this is a key consideration
- The costs of transferring the property to Newco. If legal title to the property is transferred, some provinces charge a transfer tax. In British Columbia, this is often avoided by only transferring the underlying "beneficial interest" and leaving legal title with the original owner. The original owner acts as "bare trustee" for the beneficial owner under a "bare trust" agreement.
All of these considerations need to be compared to the savings
from the interest deduction.
What if some time has gone by between when Miss Take converted her old home to a rental property and the time she decides to transfer it to a corporation? If she sells the rental property to Newco at its fair market value and takes back a promissory note equal to that value, she'll realize a gain to the extent that the current value exceeds the value when it was converted to a rental property. Furthermore, if she has claimed capital cost allowance (CCA) - known as depreciation for tax purposes - on the rental property, she'll have to "recapture" the CCA previously claimed and bring it into her income. Depending on the value, this could result in a large tax bill with no cash to pay it (for simplicity, let's ignore certain tax elections that can apply when a principal residence is converted to a rental property).
Is there anything that she can do to avoid this tax hit? Let's assume that when she converted her old residence to a rental property, it was worth $250,000 and that now the value has gone up to $300,000. Let's also assume that she hasn't taken any CCA. A straight sale of the property to Newco would result in a capital gain of $50,000 with the resulting income tax.
Instead, Miss Take can use one of the "rollover" provisions found in Section 85 of the Income Tax Act. These provisions are designed to allow for a disposition of property without the income tax consequences that would ordinarily result from the transfer of property at fair market value. Instead of Newco issuing a promissory note for $300,000, it issues a promissory note for $250,000. Since Miss Take has to get value equal to the value of the property that was transferred, Newco also issues preferred shares having a redemption value of $50,000. Miss Take and Newco file a joint election to deem Miss Take to have disposed of the property for $250,000. Since her proceeds and her cost are both $250,000, she does not realize any gain. The shares that she receives are worth $50,000 but they have no tax cost, so if she were to sell them, she would realize a capital gain of $50,000 at that point. From Newco's perspective, it acquires the rental property at a cost of $250,000 and so when it sells the property, it will realize a gain of $50,000 and pay tax on that gain. Like in the other example, Newco could then borrow $250,000 from its bank and use those funds to repay the promissory note owing to Miss Take. Miss Take would then use the funds to pay down her mortgage.
Incorporation can also be an effective estate planning tool. As the sole shareholder of Newco, Miss Take's estate value will continue to increase as the value of the rental property increases in value. On her passing, she will be considered to have disposed of the shares of Newco at their fair market value (unless they pass to a surviving spouse). Instead, Miss Take could set up Newco with other family members as shareholders. If Miss Take just owns fixed-value preferred shares, her tax liability is fixed and can be dealt with proactively (for example, with life insurance). Future growth in the value of Newco accrues to other shareholders and on an ongoing basis, income splitting with the other shareholders can be achieved.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.