What form of Property Ownership is Right for You?
Before you buy a real estate investment, considering the type of property ownership is an important part of your strategy – as well protecting your assets and understanding your tax implications. In my experience, each ownership type has specific strategies to improve your long term success.
I want to offer an overview of the different types of property and present information which can help you decide which property ownership is right for you.
Property Ownership Types
Generally speaking, property can be acquired and owned in a range of different forms – directly as an individual, joint venture, or indirectly through a limited partnerships, or Real Estate Investment Trusts (REITs). In Canada, investors can also consider investing indirectly via providing private mortgages or in a more structured way through a Mortgage Investment Corporations (MICs).
Within each of these groups, there are several liability and tax considerations. Let’s look at these in further detail.
If you own a rental property as an individual owner, you must consider the income or loss from the property for each calendar year.
A key advantage is that you enjoy the benefit of capital appreciation and profits as your investment is held within your portfolio. Also, according to CGA-Canada, if you own rental properties, unlike corporations, you are not faced with a capital tax on a federal level.
However, for individuals in a higher tax bracket, once you are generating additional income, it can push you towards higher taxation. In addition, due to the unlimited liability factor – you can be exposed to legal claims by third parties, as a final consideration.
Joint Venture | Corporate Ownership
Joint venture ownership in real estate is created between parties to realize a financial benefit. Unlike a partnership, where each partner is entitled to share in allocated profits, joint assets are typically managed in undivided co-ownership. For real estate investors, joint ventures can offer greater affordability and offer significant tax savings. Also, if there is a mortgage involved usually one, two or all of the owners may have to guarantee the mortgage.
On the other hand, if you are investing is with friends or family, your joint venture agreement should be drafted by a lawyer in advance of your first purchase. As I have said before … “Life happens!” You need consider what will happen if one of the investors goes bankrupt, pass away, get divorced, sell their shares, or interrupt the partnership.
Unlike direct ownership, the following property ownership vehicles fall under the securities act. As an informed investor, take the time to read and understand the entire offering memorandum or prospectus.
Each investment opportunity has a different perspective regarding investor distributions – both in timing and the form of dividends or interest income – which can be an important distinction to clarify.
When you invest in real estate through Limited Partnerships (LPs), you purchase LP shares which can provide cash flow and tax deductions, while sheltering you from the cost and liability typically associated with individual property ownership. Limited partnerships allow many of the deductible expenses to be shared with investors, while you receive possible cash flow distributions and appreciation. However, as they are held for a set period of time and are not publicly trade, they can be illiquid.
My experience has shown that although Limited partners enjoy economies of scale, they also rely on a General Partner in an executive role to be accountable for operations. This means that as an investor, you have significantly less control over the direction of your investment.
Real Estate Investment Trusts (REITS)
Real Estate Investment Trusts (REITS) are created to combine the funding of a large number of investors with the intention of obtaining income producing real estate assets.
Like LPs, REITs typically issue units which allocate a pro rata share of the income and losses of the trust. Unlike LPs, many REITS are publicly traded on the stock market, which offers greater liquidity.
REITs provide tax advantages, improved access to equity markets and regular stable income distributions with the potential for high yield capital growth for real estate investors.
One of the disadvantages of REITs is a narrow focus on one sector of real estate. In my experience, putting all of your eggs in one basket is a risky choice.
Another consideration is the location of the REITs investment. If there are other projects underway in the same area, oversupply can damage your investment performance.
Mortgage Investment Corporations
Mortgage Investment Corporations (MICS) is an investment fund that combines investors’ money by buying shares in a pool of mortgages. In North America, these particular investment vehicles are unique to Canada. The group of mortgages is constantly managed, to ensure that invested share capital, and the earnings of repaid mortgages are being employed to finance new mortgages.
Generally held for a set period of time, MIC’s are regulated by the Securities regulator of the province, FICOM and CRA. MIC’s are legally obligated to annual independent audits – so as an investor, you get the annual results up front.
One of the key advantages for MICS is that they act as a non taxable entity. All income amounts are flowed directly as dividends to the investor group. Not only do investors get tax advantages, MICS shares are also eligible fore RRSPs and RPPs. Tax is paid only when a plan is collapsed and a beneficiary receives funds from the MIC.
Although you MICs offer a large pool of capital, the management group is responsible for determining which mortgages are approved. Inherently, residential mortgages come with some risk. Through strict lending practices, these risks can be mitigated.
Now that we’ve looked at the different types, we also need to consider two other elements before you make your choice.
As I mentioned in earlier newsletters, understanding the “why” can help direct the “what” of your real estate investments.
For some, using a different real estate investment vehicle will create greater tax benefits. For investors with a larger portfolio, different forms of property ownership can spread and potentially reduce the risk of real estate investing. Determining what forms that best suit your objectives will be an important step.
For other investors, creating a legacy through real estate investments is a key element for their portfolio. Passing an investment on to the next generation of investors impacts which investment to consider. This consideration will require that you determine the exit ahead of time to minimize tax implications.
Liability and tax considerations are the primary reason to consider a variety of real estate investment vehicle. In my experience, each element is a moving target and your choice really comes down to your values and motivation.
The Final Analysis
Each property ownership type offers different advantages and disadvantages.
As you weigh your choices I highly recommend that you consult with your lawyer and accountant. In fact, invite them to join you for a planning meeting – so you can all be in the same room at the same time. Although this may seem like overkill, each professional can offer you a different perspective – giving you the clarity and a clear approach to how to approach your investing strategy across different real estate sectors.
The end result is diversity in your real estate investments and better protection against potential risks in one sector or area.