bout de papier, Vol. 8, No. 2 (1991) — Spring 1991 // Printemps 1991, p. 33
There are sound reasons why high quality income-producing real estate should be part of any serious investment portfolio.
An investment in income-producing real estate can yield significant income tax advantage to investors. A positive cash flow, resulting from the excess of rental income over operating expenses and debt service, can be sheltered from the effects of income tax through deductions for capital cost allowance (essentially depreciation for income tax purposes). Even though the property may be increasing in value, the Income Tax Act permits a deduction for capital cost allowance to the extent of net rental income. Furthermore, proper structuring of the acquisition of the real estate investment can result in a loss for income tax purposes which is fully deductible against other income, such as salary or interest, even though the property actually earns a positive cash flow.
As with any investment, profits on the sale of the real estate will generally be treated as a capital gain for income tax purposes. The accompanying chart illustrates the marginal tax rates imposed on capital gains compared with those imposed on salary and interest income:
1990 MARGINAL INCOME TAX RATES
Annual Net Income ($000s)
$0 to $28 $28 to $56
Salary/Interest 27% 43%
Capital Gains 20% 32%
(These are the approximate marginal tax rates for an Ontario resident, including federal and
Ontario surtaxes.)
Thus, the maximum tax rate on profits from the sale of a capital property, for example a real estate investment, is 35% compared with 48% on salary and interest income, a difference of 13%. This difference is even more pronounced if one can take advantage of the lifetime $100,000 capital gains exemption.
In addition, as the property increases in value, the increased equity in the property can be used as security for additional borrowing, with the higher cash flow from the property being available to service the increased debt. The real estate investment does not have to be sold to obtain funds for The result is that an investment in high quality income-producing real estate, for example a well-maintained rental plaza, office building, industrial warehouse, multiunit apartment complex or mixed-use project, can yield a pre-tax profit and cash flow in excess of 25% per year.
The reasons for this above-average performance are straightforward, and can best be illustrated through an example. Assume that a shopping plaza can be purchased by a group of investors for $3 million, with a 20% downpayment of $600,000. If the value of the property increases by 6% in the first year, perhaps from higher income or the effects of inflation, the property would then be worth $180,000 more. This increase of $180,000 on an initial downpayment of $600,000 is a potential profit of 30% in one year. This profit would be in addition to any cash flow and income tax savings resulting from the real estate investment. With a maximum tax on capital gains of 35%, this would produce an after tax return of 19.5% in one year, plus any cash flow and income tax savings.
In this example, if the property earns additional income of $100,000 after three years of operation, and if prevailing interest rates permit the refinancing of an additional $600,000, the investors could receive a $600,000 lump sum entirely tax free. Rental income earned from the property will service the additional debt without the investors having to contribute on an ongoing basis. In this situation, the investors will have received all of their initial investment plus $100,000 in three years, entirely tax free, without having sold the property.
This significant profit level and record of performance can be earned through the careful analysis and acquisition of high quality income-producing real estate. By pooling their financial resources, individual investors of diverse financial backgrounds can acquire superior large-scale properties in partnership, and can earn an immediate positive cash flow and income tax savings.
In some cases, no initial down payment is required. Individual investors, with a minimum annual family income of $60,000 and a family net worth of $100,000, can finance their equity contribution to the partnership by borrowing the entire amount from any financial institution. The investment loan is generally amortized over twenty-five years which, after the monthly loan payments are made, creates a significant positive cash flow from the investment.
Individual investors can thus enjoy the benefits of owning high quality income-producing real estate, with no disruption to their monthly disposable income. In almost every case, disposable income increases significantly. The benefits of owning this type of investment include:
• cost-effective professional property management and leasing expertise;
• regularly distributed cash flow earned from the tenants of the property, with automatic deposits to each individual investor’s bank account;
• tax free distribution to each individual investor of the proceeds of additional refinancing in future years;
• no requirement for day-to-day involvement in the investment, which is of particular interest to foreign service officers on posting abroad;
• immediate positive cash flow and income tax savings; and • long term pre-tax rates of return in excess of 25% per year. These results are certainly achievable with any large scale well-managed real estate investment. However, as with any proposed investment, potential investors should conduct careful analysis prior to investing. In addition, they may want to consult with professional advisors who are well-versed in real estate issues.
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Originally published in bout de papier, Vol. 8, No. 2 (1991) — Spring 1991 // Printemps 1991, p. 33. Read the rest of this issue →
