Investment property could cause some tax complications for small business owners, beginning in 2019. A new formula, recently announced in the 2018 federal budget, will be applied to weigh the passive income that Canadian-controlled private corporations (CCPCs) earn on investments not related to their principal active business against the small business deduction that CCPCs with less than $15 million of taxable capital currently enjoy. This could either deplete the amount of operating revenue that qualifies for the small business rate or bump businesses entirely into the corporate tax class.
Mid-sized to large landlords will not be affected — their earnings would be classified as operating revenue generated in their principal business and/or they are already wholly taxed at the corporate rate — but the new rules do capture the demographic of investors who own small low-rise residential or mixed-use commercial-residential buildings as a sideline to their main business ventures. Many such landlords are now in line for a tax hit they didn’t foresee when they purchased their properties.
“They could lose the ability to claim the small business rate, which will be 9 per cent in 2019, on the operating income in their original business and will, instead, be taxed at about 26 per cent,” observes David Mason, a tax partner with Deloitte Private. “It will make people think carefully about how they are earning their investment income.”
For small landlords, that scenario is most likely to play out when they sell and realize the gains on their investment property. (Taxable capital gains from the disposition of active business assets — if, for example, a dentist sells the building that houses his or her practice — are excluded from the calculation of passive income.)
Under the new rules, passive investment income of up to $50,000 annually will not impede a qualifying corporation’s eligibility for the small business tax rate on the first $500,000 of annual net operating revenue. From there, an incremental offsetting formula will be applied to reduce the allowable deduction by $5 for every $1 of investment income in excess of $50,000. Once passive income hits $150,000, the small business deduction will be completely negated.
No added tax on investment income
The 2018 budget affirms there will be no changes to the existing tax on investment income, refundable taxes or dividend tax rates — a step back that Mason calls “less onerous and less punitive” than the proposal for an added tax on investment income found in last summer’s contentious consultation paper on tax reform. “During the period of consultation, the Government heard that its proposals could be very complex and add significant burdens on businesses,” the budget document acknowledges.
However, the pledge that “no existing savings will face any additional tax upon withdrawal” falls short of other concessions that business representatives advocated. The new approach does not offer: grandfathering of passive income from investments made prior to announcement of the new rules; an exemption for investments made with funds not tied to small business revenue, such as the business owner’s inheritance; or a mechanism to spread gains over a longer period than the tax year in which they occur.
“Let’s say you buy a small rental building for $1 million and every year you more-or-less just break even until you sell it for $1.7 million. All of a sudden, you’ve got $700,000 in passive income. There is no averaging of that income over a number of years,” Mason explains.
Compounding reluctance to sell
The new tax measure won’t be official until the budget is formally adopted into law, but it is slated to take effect for the 2019 tax year. That could push some investors to cash out now or, alternatively, it could compound the tax aversion already seen as a significant factor in the persistent low supply of rental housing properties offered for sale.
“Some small landlords might sell off in 2018,” Mason speculates. “They might try to trigger a gain in 2018 or they might just try to hang on.”
“There are already two critical tax issues that discourage a lot of people from selling their properties now,” concurs Christopher Seepe, a landlord and broker with Aztech Realty Inc. and president of the Landlords Association of Durham Region. “Number one: capital gains. That can be huge for someone who has held the property for 30 or 40 years. The second one is capital cost allowance — also known as depreciation. You can take depreciation on your building every year and reduce your taxable income, but, when you sell, you have to pay it all back. That can take a substantial chunk out of the proceeds of the sale.”
As a course instructor for prospective investors in rental housing, Seepe characterizes the new tax measure as another example of the sector’s complicated and sometimes intimidating regulatory terrain.
“You really need to surround yourself with people who know real estate,” he advises. “You need a real estate lawyer, a real estate accountant and a real estate bookkeeper.”
Barbara Carss is editor-in-chief of Canadian Property Management.