Issue(s): The availability of affordable residential real estate has become a concern in many local communities and is now a priority for both our provincial and national governments. Likewise, small business owners rely on the availability of commercial real estate, which has increased in value in many of our communities. An opportunity exists for the federal government to support private corporation investment in both commercial and residential real estate rental projects. However, the opposite has happened. The Income Tax Act (“ITA”) deems income earned from the rental of real estate to be “income from property” or “passive income” rather than business income, subjecting it to a different tax treatment that may create a disincentive for investments in real estate assets that can contribute to housing solutions and economic growth.

Background

Income earned from the rental of real estate (“rental income”) is generally deemed “passive” under the ITA unless it meets certain criteria to be “active business income”. Active real estate assets or “active” income generally includes: 

• Provision of other goods or services with the real estate – for example, a hotel, B&B, etc.; 
• Use in an active business operation – for example, office, factory, retail store, warehouse; 
• Property that meets the exclusions of “specified investment property”, for example, where more than 5 full time employees are employed by a corporation involved in commercial real estate management or development; and 
• Rental of real estate to an “associated” corporation – deemed as active. 

Unfortunately this definition can lead to significant differences in how real estate income will be taxed in situations that are not fundamentally different to warrant a different treatment. For example: 

• the 5 employee requirement is problematic as it creates a size test that is not relevant, nor can it be met even in a large company if that company chooses to contract out all of its services or hire part time employees rather than employ full time staff, or if it needs to structure its affairs to manage risk (for example – one property per company) 
• the same piece of real estate can be classified differently from passive to active or vice versa, with or without changes in ownership of the real estate or whether corporations are “associated” for tax purposes. The TABLE below illustrates some common examples.

From an economic and policy perspective, these situations should not be the determinant of whether real estate is considered to be used in a business. In fact the definition of a business is quite broad and can include any situation where goods and services are or are intended to be exchanged for consideration – a definition that would include property rental. It is time to remove the passive treatment in the ITA to encourage more investment in real estate, to increase supply of both housing stock and commercial real estate, which in turn should improve affordability for both employees and employers and make it easier to attract and retain labour, and to manage the cost of business succession. 

Treating net rental income as business income in all circumstances will have the following tax benefits to private corporations: 

• Simplify the tax treatment and provide clarity and fairness of how the income will be taxed 
• Eliminate the 4% added tax cost of flowing passive income through a corporation 
• Eliminate the need to “dividend” out passive income to trigger the “dividend refund”, which is currently necessary to offset the refundable tax and maintain the tax cost at 4% 
  • Cash retained can be used for necessary debt servicing or new investments 
• Effective for 2019 and future years, avoid a grind down of the small business tax rate where passive income exceeds certain thresholds (currently set at $50,000 based on a notional 5% return on $1,000,000 in assets, with a prorated grind down between $50,000 - $150,000, and a full loss in excess of $150,000)
  • These thresholds are too low and do not reflect the current value of real estate in many Canadian markets or the rental yield they may earn

Recommendations

That the Federal Government

1. Remove net rental income from passive income, making it subject to normal corporate taxation rates for business income 
2. Until this change happens, specifically exclude net rental income from investment income subject to the thresholds that grind a private corporation’s access to the small business tax rate. 
3. If it is necessary to include net rental income as part of the passive investment income subject to the new proposed thresholds, then: 
   1. Significantly increase thresholds to reflect economic reality and debt servicing requirements; 
   2. Provide exclusions for investments that provide access to affordable residential housing or subsidized employee housing; 
   3. Provide exclusions for commercial real estate that is connected to or attached to an operating business, or subject to a business succession plan; and 
   4. Provide more appropriate criteria around what is active vs. passive as the “deemed as active” rules are not able to (nor intended to) identify real estate ownership situations and changes in circumstances that should qualify as active