I am sure many people have been witnessing the rising price of real estate in the last few months. Why does the price keep going up? Government stimulus, low interest and as most middle class families invest the maximum amount of money in their homes. Some real estate investors are betting the price can go even higher in the long run. So, getting involved in real estate development seems to be a promising career and rewarding business. Today we are going to talk about some business and tax considerations if you plan to become a developer.
Before we start, one piece of advice is that, other than business consideration, tax should always be a critical part of your planning process, no matter whether you build from scratch or carry on operating real estate business. Some people may say that tax consideration should come in second place and should not drive business decisions. But, once you get to know more about how various taxes play at different stages in the real estate projects, you may have to incorporate tax planning as part of the overall plan at the beginning, rather than at the end of the project.
Let’s start with the business aspect of a developer first. Simply say, purchasing a site/property with/without city permit (if not yet approved, likely permit can be obtained over 1 to 3 years), then selling the constructed property at a large profit. So, the future is bright – selling at a large profit. Money!!! But, for a developer/developer planning to build from scratch, it is always a good idea to assess the risk exposure in various areas in interest rate, loan/capital requirements, market influence, investors relationship and sometimes it is so critical to the success of the project – project management. The more depth you understand/assess those risks, the better you are prepared to succeed.
Projected Profitability
Generally speaking, depending on which municipality/region that you plan to build as a developer, pricing for building and development costs can range from $120 to $200 per square foot. But if you look at a custom home in the Greater Toronto Area, then the cost can jump up to $300 per square foot easily. In addition, the cost in acquiring the outdated property, the demolition cost , permits and inspection paid to City/Town should be included in your project budget as well. And don’t forget about Tarion. According to the Ontario New Home Warranties Plan Act, if you are planning to build new homes in Ontario, you will need to register with Tarion as a developer and pay a warranty fee. Once you get familiar with the cost structure of building a house and the price that you expect to sell, the profit is then determined. Is that what you put it in your pocket? No, not yet.
Depends!
Corporate Structure
It depends on the structure of your developer business. Generally, it is not advisable to run a business under individuals as business risks may outweigh the return. Corporations are the most popular structure used in the business. If you have other investors to work with, partnership may be a recommnedation. Each structure has its own characteristics in corporate law and under Canadian tax laws. So it is important for you to think yhrough how various structures play out in your business.
Corporations have carried limited liability for shareholders. Another benefit is that a business that qualifies for the small business tax deduction will enjoy a tax rate that can be as low as 12.2 percent in Ontario starting in 2020. One of the areas that many business owners often take it for granted is shareholders agreement. If the business has multiple shareholders, then all of them are supposedly working together towards a common goal. In reality, it may not work as you wish. A shareholder agreement may help you. A shareholder agreement is a contract to structure the relationship amongst the shareholders. A well drafted shareholder agreement should clearly define each party’s expectations with rules that describe the relationship amongst the shareholders and outline how the business should be managed to avoid any disagreements. Another area is the organization of shares issued. Issuing various classes of shares can help divide the equity interest/rights among shareholders properly based on the underlying objectives of the shareholders. It is advisable to consult with your corporate lawyer if you have any concerns about corporate structure.
Partnerships are commonly used in real estate business. Each partner is jointly and separately liable for the obligations of the partnership and jointly share in profits. However, Limited Partnerships are slightly different from Partnerships that we just discussed. The main difference is that, when limited partnerships are established, limited liability is created for limited partners as long as they are not involved in the control or management of the partnership. As compared, general partners hold unlimited liability. Another interesting part is that limited partnerships have flexibility in allocating returns amongst limited partners and the general partner. It is not a DIY project to set up a limited partnership. Consult with your corporate lawyer if you have any ideas about limited partnerships.
Those corporate structures are commonly used in the real estate development industry. Quite often, multiple-tier corporate structures are used as well. For example, for limited partnerships, a general partner can create a corporation to be the general partner to mitigate the unlimited liability as set in the partnership agreement.
Tax Planning
In addition to daily operation, business owners have a hard time when dealing with taxes from various areas, like HST, income tax, etc.. Then, how to conquer those challenges? An easy way is to do your homework and try your best to understand the logic, and ask questions to your advisors at different stages of your business. We are going to use a corporation as an example to explain the following aspects:
Capitalized vs. current expenses
First, let’s look at the financial aspects of the developer business. Generally speaking, for a small developer, the turnover period can stretch to 3-5 years, depending on the size and complexity of the projects that they are involved in. As you know, a large amount of funds will be spent in purchasing the property/land and demolition at the beginning. So, it is reasonable to expect that the business will experience losses for the first couple of years until the property is sold. Would it be a huge “ loss” ?
Maybe. If you look at how the funds flow from a cash flow perspective, there would be a huge “ loss”. But if you look at it from a tax/accounting perspective, the answer may be a small loss. The tax rules are, during the development phase, there are many types of costs that are incurred. The majority of those expenditures are added to the capital cost of property or to the cost of inventory. CAPITALIZED! The capitalized item will be on the balance sheet instead of income statement, which is basically used to determine the taxable income. Therefore, it is not expected that a huge loss is experienced in the first few years as major expenditures are excluded in the income statement.
Then, the question is what can be deducted? Generally speaking, general and administrative expenses such as administrative expenses or accounting fees incurred can be deductible on the income statement if they are not related to the project. In addition, we refer to the costs as soft costs that do not have to be capitalized when the construction is complete or on the day that the building is substantially used. They include interest, legal fees, accounting fees and property taxes. For example, while the construction continues, interest incurred and property tax are required to be added to the cost of inventory or be capitalized. If the construction is complete, then they can be deductible as a current expense. And also, capitalized vs. current expenses is the area that the CRA auditors currently focus on. What they would do is to review income earned from business and property and expenses deducted in calculating that income.
By now, you can picture that, in the first couple of years, a small loss (in comparison to the funds flown into the capitalized property/inventory) can be claimed on the corporate tax return due to the majority of costs being capitalized. In the future, the business loss can still be carried back to offset the profit realized on the project.
Capital gain vs. business income
You may be confused why we need to understand the classification of the income generated from the business. The reason is simple as the tax treatment is different.
Business income is fully taxable (100%). Business losses are deductible against non-capital income. As compared, only 50 percent of capital gains and losses are taxable or deductible. What drives the difference then? It is based on specific facts. For example, the developer has an intention and has a pattern of making similar property sales. It is likely to be considered as business income. Generally, business income is earned “from a profession, a trade, a manufacture or undertaking of any kind, an adventure or concern in the nature of trade or any other activity [the taxpayer carries] on for profit”. We will always keep in mind that the CRA audits never go away. The CRA audits have a focus on reviewing real property sales to determine whether the income earned should be considered business income instead of a capital gain.
What if the developer buys a property outright and holds it for a number of years and then sells it for a decent gain?
Distribution of profit
We talk about the classification of income above. Then, logically we have to deal with the profit. In some cases, shareholders like to retain the profit for future business expansion. But for some, they like to split the profit once the project is completed.
In a corporation setting, shareholders can receive dividend as a return. Dividends are the after-tax dollars. What it means, after the corporation pays income tax on its taxable income, it can distribute the remaining earnings to shareholders. In a multiple-tiered corporate structure, the developer can pay dividends to another taxable Canadian corporation and such dividends do not attract corporate tax, as long as the recipient corporation is connected to the payor corporation. Sounds good?! Make sure the connected corporation falls into the definition of “connected corporation” under the Income Tax Act before paying out the dividends.
HST impact
HST impact is always a scary part to many businesses. Why? The application of the HST is very complex. These rules may apply to certain transactions in the business. You are strongly encouraged to seek professional advice to ensure you are in compliance with the law.
If you just start buying an outdated property in a good location and plan for redevelopment, it is quite common that you forget about registering for an HST account after being occupied with the startup for the first few months, sometimes a year. What would happen next? The CRA generally allows you to backdate the registration for 1 months only. So, the HST portion that you paid with various expenses at the start of the project may not be claimed back as a refund. What a loss! In addition, please make sure that all the receipts and slips are collected in a clean format and organized properly as the CRA will request those receipts for a review before releasing the refund,if the amount is significant.
Another confusion on HST is whether the sale price includes HST or not. Generally speaking, there is no HST charged when you personally sell your residential property. Does it mean no HST on selling properties as a developer. NO!!! When developers sell the property, the price listed should be subject to HST as it is a taxable sale under the Excise Tax Act. So, if you forget about the HST , the profit that you calculated may be incorrect. The HST portion should be excluded from the gross selling price to determine the profitability of the project. What it means to you as a developer – 13% loss ( in Ontario).Is it scary?
Let’s look at another case. A developer completes the development of a newly constructed building and takes over for his personal use. During the construction, he registered for HST account and claimed ITCs. Does he have an obligation in remitting HST when the property is delivered? The answer is NO. The reason is this developer has met the definition of a developer and has met his obligations by virtue of the self-supply, which applies when the developer uses the newly constructed building for personal use. However, since he has claimed ITCs, the self-supply rules do not apply.
We have looked at the situation that developers deal with redevelopment only. What if builders are engaged in the construction only. Does HST work differently? Yes. For example, in the construction industry, payments are subject to statutory holdbacks under provincial lien legislation. HST on the holdback amount does not become payable until the day the holdback amount is paid or the day on which the holdback period expires under the written agreement or applicable legislation, whichever is earlier.
Other stuff to be on your list
If you are a corporation involved in construction activities which provide your primary source of business income and you make payments to subcontractors for construction services, you must report amounts paid in T5018. If you don’t follow and the CRA finds out, the penalty for each failure is $25 a day, with a minimum penalty of $100 up to a maximum of $2,500. Furthermore, any contractor that plans with subcontractors to avoid tax by concealing underground activity could face criminal prosecution, with fines and penalties of up to 200% of the tax they tried to avoid.
We come to a final point on this topic. Nothing is straightforward, like any other businesses, planning ahead is the only tool to conquer the challenges and prepare for the success. If you need any help, please do not hesitate to contact us at 647-872–6656.
The information in this article is current as of the time it was written and considered as general guidance only. The article cannot be relied upon to cover specific situations and you are advised to consult with tax professionals for further guidance.
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