Toonie Newsletter has been written and published almost every week since September 2020, which is a complete surprise to me — I never thought I'd be this consistent for this long.
But it turns out, writing about personal finance is a lot of fun.
Especially in this newsletter format.
Newsletters are all the rage right now (and have been for quite some time) — if you're writing, you better be writing a newsletter.
There are many opinions about why newsletters are successful, so I may as well share my own: I think newsletters are great because they feel extra personal. I'm not writing a "blog" or producing a "vlog" here. I'm writing a letter. To be delivered into your precious inbox. And that's personal.
Because I've enjoyed writing Toonie so much, I decided to give it a bit of a face lift, give it it's own domain, and move everything over to Ghost.
This is the first issue of Toonie Newsletter delivered on the new Ghost platform. My pal Josiah graciously created a droplet in Digital Ocean and we're now running Ghost on an efficient, modern, and fun new platform. I'm excited for the change.
Henceforth, Toonie Newsletter can be found at Toonie.News. I can't wait to see where this goes.
Now, back to regularly scheduled programming. This week, I want to give pause to those who think they should incorporate their rental property business. It's not worth it until you make a lot of money.
Active Business Income and Aggregate Investment Income
In Canada, there are two common types of income earned by corporations: active business income (ABI) and aggregate investment income (AII). ABI is taxed at a very low rate and AII is taxed at a very high rate (at least upfront). In general, Canadian business law would prefer you used a corporation to produce ABI rather than AII.
The Canadian Income Tax Act defines ABI as any income that is not specified investment business income or personal services business income.
So... that's not very helpful.
The best way to think of ABI is to consider the types of jobs it produces: As the business grows, does the business require more employees to complete the work of producing goods and services?
If the answer is "Yes", the income earned is likely ABI and can be taxed at that ultra-low rate (currently 9% federally).
If the answer is "No" — which can be interpreted as a business that can grow in size but doesn't require more employees, such as real estate investment businesses — the income is generally considered AII.
AII is not eligible for the small business deduction (which reduces corporate tax to 9%) and even has an extra 10 2/3% extra tax applied to ensure integration of the taxation system.
Without getting too nerdy, ABI is your standard business income and, in Canadian-controlled private corporations, is taxed at a low 9% (plus provincial tax, if applicable). AII is your standard investment income and, in Canadian-controlled private corporations, is taxed at at least a 50.17% rate upfront.
That is a massive, massive difference in tax rates.
Please note: AII generates refundable dividend tax credits that reduce the amount of overall corporate tax paid when a dividend is issued to shareholders. This system ensures there is very little tax advantage to holding investments in a corporation — at least until your personal marginal tax rate exceeds the AII tax rate.
Rental Properties Don't Jive with Corporations
There are so many factors and considerations when talking about investments, corporations, businesses, and more. It's impossible to cover them all. So I'm going to address the one I see the most and the one most of my colleagues consider: rental properties.
It seems by the day, rental properties produce less and less cash and more and more gains. As material prices increase, as interest rates dip, and as the supply of homes wanes, real estate's overall purchase price has skyrocketed. Rental rates haven't kept up to the increase in the underlying value of the property and have resulted in less overall cash returns.
Essentially, you have to sell a rental property to get any cash out of it. And during ownership, it feels like all you do is dole out cash to fix problems.
Entering the real estate market is extra difficult right now. To enter the market, you have to put down enough cash to meet the inflated property price (at least 20% down), and you have to be prepared to see rental rates that don't fully cover your operating costs.
The area where you gain is the principal portion of the mortgage payment. Each month, you make a mortgage payment, of which part is principal and the other interest. That principal paydown is one of only two ways to truly earn in the rental business (the other being price growth).
The principal component of a mortgage payment is not deductible for tax purposes. Repairs, insurance, and mortgage interest are all deductible on your tax return, but the principal component is not. Which means you have to actually produce net rental income to get ahead of the mortgage, otherwise you'll need to inject cash to keep the rental property spinning.
Put another way, you generally have to recognize net rental income on your tax return to pay down the rental property's mortgage. (You can use depreciation to defer tax, but that's another discussion for another day.)
Numbers time: You have net rental income of $5,000 in the year, but the principal component of the mortgage payments was $5,000 during the year. You have to pay tax on $5,000, but you don't have any cash in the bank account to pay for the tax. If you hold the rental property personally, you'll pay your marginal tax rate (generally 35% or 40%) on that $5,000 of net rental income — so about $1,875 of income tax.
Now, let's put that rental property into a corporation. You have $5,000 of net rental income but no cash because you had to make the mortgage payment. Because of the extraordinarily high AII tax rate, your tax bill is going to be at least $2,508 — $633 higher. You'll generate refundable dividend tax credits for the corporation that you can get back later, but you have to pay that corporate tax bill now.
That $633 makes life a lot easier when the rental property produces nil or even negative cash flow.
Smart tax people know tax is not a matter of "if", but a matter of "when" — if you pay the tax upfront, you don't have to pay as much later, and vice versa.
But the beauty of those ultra-low ABI corporate tax rates in Canada means you can keep 91% of net income in your business, producing more jobs, better services, and better products.
The exact opposite happens with investments in a corporation — you can only keep 49% of net income in the business, and you'll likely have to supplement the cash account to keep the business spinning.
Unless you're under very specific circumstances, I don't see much benefit in incorporating a business to hold rental property investments.
This was a bit of a geeky introduction of the Ghost platform, but I wouldn't have it any other way — when talking about personal finance, you have to get into the math and understand at least some of the mechanics.
Thanks for sticking things out with me this week. I hope you and your family have a wonderful weekend and a prosperous (and warm) week ahead.
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