Strategy essentially uses a business loan instead of mortgage

In this current real estate market, finding the home you have always dreamed of may not be a challenge, but paying for it could be a little tricky. I offer for your consideration the case of Peter and Monica. They have been watching a particular listing for the past year, ever since they first toured a beautiful estate home and agreed it was the house they wanted. Apparently, they were not the only ones finding the $1.7-million price tag unaffordable. Eventually, they received word from their realtor that the vendor was getting desperate and would entertain a cash offer of $1.2 million. Not wanting to pass up the deal of a lifetime and the opportunity to make their dream home a reality, Peter and Monica began to think seriously about how they could structure the purchase.

Here are the relevant facts:

• Peter, 34, is an emergency physician with a net income of $250,000. He loves his work and is not incorporated.

• Monica, 32, is a part-time legal secretary who makes $30,000 annually.

• They have one daughter, two years of age.

• They live in a condominium with a current value of $450,000, which they purchased four years ago for $250,000. It has an outstanding mortgage of $50,000, and ideally they would like to keep it as a rental unit.

• Peter’s old condo has been rented for the last four years. It has a value of $350,000, a tax cost of $200,000 and no mortgage.

• Monica’s mother, who is 59, lives in Ontario and has no income.

• If they can swing the deal, their goal is to use all the available cash resources to pay down the mortgage.

The plan

This is the plan I would set in motion to assist Peter and Monica in achieving their goal.

1. Set up a medical corporation with a family trust. This allows them to maximize income splitting by paying dividends to the beneficiaries, who include Peter, Monica and her mother. Note that dividends cannot be paid to their daughter until she turns 18.

2. Sell the current residence to the corporation for $450,000. The company then assumes the $50,000 mortgage, and borrows an additional $400,000 to pay for the balance of the purchase price. The interest is deductible against rental income. To get 100% financing, Monica and Peter will need to offer personal guarantees and possibly a collateral mortgage against the new home.

3. Peter sells his condo to the company. This gives him $200,000 cash from a corporate loan, which is equal to the tax cost.

4. Borrow the remainder. Peter and Monica will need an additional $600,000 personally to complete the $1.2-million purchase.

5. Use practice surplus against mortgage. All available practice surplus in the corporation is distributed via the trust and applied against the mortgage, deferring RRSP contributions and savings.

Here’s why the plan makes sense.

1. As a result of transferring the real estate to the corporation, Peter and Monica effectively convert a personal home mortgage into a $600,000 business loan. The benefits of this approach are the interest deductibility and the fact that the principal is repaid with cheap after-tax corporate dollars. Paying off a corporate loan requires only a pre-tax cash flow of $700,000, while you need $1,000,000 to repay a $600,000 personal debt (assuming a corporate- and personal tax rate of 15% and 40%, respectively).

2. There are no tax implications in transferring the real estate to the corporation. The apartment is the principal residence, and Peter can file a special tax election to avoid paying tax on a capital gain of $150,000 on the transfer of his condo.

3. With the real estate fully financed, the interest expense will likely create a rental loss, which can be fully offset against medical income in the corporation.

4. If you live in a province such as British Columbia, which imposes a property transfer tax applicable on the transfer of legal title, you can avoid the extra cost through a bare trust agreement. This one-page document basically states that you hold the property in trust for the corporation and that you will transfer legal title when requested by the corporation. The Canada Revenue Agency cares about the beneficial rather than the legal ownership, so you should make sure you have a purchase and sale agreement in place that transfers the beneficial ownership.

5. As Peter is removing all cash from his corporation, income splitting is crucial, and allocating dividend income to his mother-in-law saves thousands of tax dollars. For instance, a $50,000 dividend reported by her rather than by Peter reduces the tax bill by about $14,000.

6. Assuming Peter and Monica don’t mind interest rate fluctuations, they should choose a variable rate rather than a locked-in mortgage, thereby allowing them to benefit from the lower interest payments. In comparing a 2.5% variable to a 4% fixed mortgage of $1,200,000 with a 25-year amortization, the savings total a significant $1,000 a month, for a total savings of $300,000.

Using these financial strategies will help Monica and Peter get their dream home with significant savings in interest and tax costs. And that means more money in their pockets!  

Manfred Purtzki, a chartered accountant, is the owner of Purtzki & Associates with offices in Vancouver and Nanaimo, B.C. You can e-mail him at manfred@purtzki.com.