Meet Michelle, a real estate agent wondering “what is the hype about PRECs”?
Michelle is a hardworking real estate professional with annual household expenses of $70,000 and hoping to buy an investment property within five years. She is currently a sole proprietor with average annual compensation from her brokerage of $220,000. After business expenses of $70,000, she has $150,000 of taxable income remaining. Michelle pays approximately $50,000 in personal taxes leaving her with after-tax personal income of $100,000.
Since Michelle’s after-tax income of $100,000 greatly exceeds her personal expenses of $70,000, she should consider setting up a Personal Real Estate Corporation (PREC).
This would allow her to take advantage of opportunities for tax deferral and provide flexibility in managing finances that can help her achieve her personal and professional goals (i.e. buying that investment property).
Check out the “What is a Personal Real Estate Corporation (PREC)” section below to see how much Michelle could save annually!
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October 1, 2020 was a historic day for Ontario’s 80,000 Realtors, as per Ontario Real Estate Association (OREA) President Sean Morrison. Why, you ask?
According to OREA, the journey to allowing Ontario Realtors (also known as real estate salespersons and brokers) to operate their business through a corporation has been ten years long, and it is finally here. Regulatory changes have now been made to the Trust in Real Estate Services Act, 2020 (TRESA) that finally allowed this to happen.
At AMLB, we work with several high-performing real estate professionals who have asked about the implications of these changes, so we have put this article together to cover the following questions:
What is a Personal Real Estate Corporation and why does it matter?
What are the benefits and drawbacks of incorporating specifically for a real estate services professional?
What are the corporate tax and personal income considerations a real estate services professional should keep in mind?
How do real estate agents get started?
What is a Personal Real Estate Corporation (PREC) and why does it matter?
A PREC affords real estate agents the benefits of professional corporations like accountants, lawyers and doctors. Essentially, it provides income tax planning opportunities that help you and your family members build net worth faster given the significantly lower corporate tax rates compared to rates on personal income.
Real estate agents in Ontario are faced with marginal income tax rates of approximately 53.5% on earnings greater than $220,000, while income earned through a PREC would be subject to corporate tax rates of 12.2% until net income reaches $500,000. Income above this amount is taxed at 26.5%. As you can see, the rates for corporate tax are significantly lower than personal tax, which results in tax planning opportunities.
Setting up a PREC will not be right for every agent but it becomes increasingly useful as your income grows and exceeds your expenses. This allows you to leave savings received from the brokerage in the PREC, resulting in a tax deferral on these funds.
Back to Michelle. If she sets up a PREC, and with all else being equal, she would have $132,000 after-tax corporate income. She would withdraw $80,000 – enough to cover her personal expenses of $70,000 – leaving her with $52,000 in after-tax corporate income. This leaves her with approximately $22,000 savings due to the tax deferral of funds left in the corporation.
What are the benefits and drawbacks of incorporating for realtors?
As with any decision to do business as a sole proprietor vs a corporation, there are benefits and drawbacks to be evaluated to arrive at a decision that is right for you. As a real estate professional reaches the point of earning more than he or she needs to cover personal and family living expenses, establishing a corporation begins to make sense.
Tax deferrals
the most significant benefit of incorporation for real estate professionals is tax deferral. In Ontario, availability of a Small Business Deduction means that the first $500,000 of active business income (e.g. income paid to you from a real estate brokerage) is taxed at the lowest corporate rate of 12.2%, compared to the highest personal tax rate of 54%. So, for whatever funds that remain in the corporation, you will be paying a much lower tax rate, which means more funds available in the corporation to invest back in your business or other assets to meet your business and personal financial goals. Once these funds are ultimately withdrawn from the corporation – typically as salary or dividends – they are taxed based on personal income tax rates. This means you are eventually paying the same tax as you would have without a corporation but you now have flexibility on when and how much you want to withdraw to optimize your after-tax situation.
Flexibility in financial and estate planning
Funds kept within the corporation can be used in various ways to help you reach your financial goals. A common use of funds by realtors is the purchase of rental properties. Other uses are investments, life insurance or an Individual Pension Plan. Also, if you withdraw funds from your corporation in retirement, this will typically be at a lower rate than your personal tax rate today. In terms of estate planning, you can organize the affairs of the corporation such that its shares transfer to your beneficiaries in a cost-effective way.
Income splitting
If your spouse or other immediate family member works in the business, you may be able to compensate them resulting in additional tax savings through a concept called income splitting (keeping in mind the Tax on Split Income rules).
Reducing Canada Pension Plan (CPP) payments
If you are a real estate agent with income above $58,700 in 2020, you would have to pay CPP of approximately $5,800. One of the benefits of incorporation is the ability to pay yourself dividends, which would eliminate this cost. However, there could be scenarios under which you would want to pay yourself via salary and contribute to CPP. The decision to pay yourself a salary vs dividend should be made as part of your overall financial plan.
The main drawback of incorporation is the extra administration costs. For example, there are legal and accounting costs to incorporate the business, create agreements and, on an ongoing basis, to take care of annual corporate and tax filings.
What are the corporate tax and personal income considerations a real estate services professional should keep in mind?
Here are a few questions you should ask yourself when considering incorporation:
1. Is the average annual income you receive from the brokerage greater than your annual living expenses and if so, by how much?
2. Do you expect your projected income from the brokerage over the next 3 to 5 years to increase at a greater rate than your living expenses?
3. What are your personal financial goals, including anticipated major purchases, retirement, and legacy creation?
If you answered ‘yes’ to questions one and two above, you will likely gain greater flexibility in achieving your goals by establishing a corporation to receive income from the brokerage.
Summarized below are five key points from the new regulations (see link below) to keep in mind when setting up a PREC:
- The controlling shareholder must be employed by a brokerage to trade in real estate and cannot receive payment for trading in real estate other than from the PREC or brokerage.
- The PREC is not a brokerage, does not trade in real estate other than providing the services of its controlling shareholder to the brokerage and does not hold any money or other property of a client, customer or other person in connection with trading in real estate.
- The controlling shareholder must own all equity shares of the PREC and be the only director and officer of the corporation.
- Non-equity shares of the PREC must be owned by either: a) the controlling shareholder, b) a family member of the controlling shareholder, or c) trustees for children who are minors and beneficiaries of the controlling shareholder.
- A written agreement must exist between the PREC, the controlling shareholder and the brokerage governing these relationships. This agreement needs to include specific terms that ensure the PREC will: a) not hinder the brokerage, b) assist the brokerage in complying with the Act and regulations, and c) ensure that the controlling shareholder is complying with the shareholder’s duties under the Act and regulations.
How do real estate agents get started?
AMLB can help you evaluate this opportunity to see if it makes sense for your specific circumstances and goals. We have designed a process to quickly get you set up so you can benefit immediately from these recent Bill 145 developments. We also work closely with partners who can help you develop diversified real estate and investment portfolios so you’re growing your new asset base to achieve your goals.
We start with a discovery call to understand your business and personal finance goals. If there’s a good fit, we can take care of it all: initial corporation set-up, advice to optimize your tax situation, bookkeeping and annual filings.
Want to find out if a PREC is right for you? Feel free to drop a comment or contact us here.
Sources:
Ontario Regulation 536/20: PERSONAL REAL ESTATE CORPORATIONS: https://www.ontario.ca/laws/regulation/r20536
Government of Ontario news release: https://news.ontario.ca/en/release/58624/ontario-removing-hurdles-for-real-estate-professionals-and-addressing-consumer-concerns
OREA news release: https://www.orea.com/News-and-Events/News-and-Press-Releases/Press-Releases/October-1-2020
Note that this material has been prepared for informational purposes only. It is not intended to provide, and should not be relied on for, tax, legal or accounting advice. You should consult your own tax, legal and accounting advisors before engaging in any transaction.