Wednesday, March 14, 2018

Real Estate Investing Tax Traps

I was at a great seminar last week. One of the speakers, a super knowledgeable tax guru and ex-CRA-auditor, shared several tips about potential tax traps real estate investors can fall into.

Taxes can get pretty fat, so it's always great to learn some ways to keep them skinny. Posting my notes here just in case you'll find them helpful.

Tax Trap #1 - House Flipping

Suppose, the following flip scenario: we buy at 400K, renovate for 100K and sell for 650K. This results in 150K capital gain, half of which is taxable.

Let's say our tax rate is 50%. We'd then pay 37.5K in taxes and pocket 112.5K of after tax profit.

DANGER: Flip with incorrect Tax on Capital Gain calculation -
larger profit than in reality


Most people don't realize that per Canadian Income Tax Act, there are two distinct categories of property:

1) Inventory, which creates business income or loss

2) Capital, which creates capital gain or loss.

The distinction is based on whether or not a property is acquired and used on account of income or capital.

Taxes Payable - Personal Name

It turns out that, when you purchase a property with the intention to renovate and flip, you put yourself into a business income situation.

Capital gain is not applicable since you have a clear intention of selling the property. In this case, your property is your inventory. So sales proceeds are your income. You have to pay tax on 100% of your income. You cannot take advantage of the 50% capital gain tax inclusion rule.

In the scenario above, if you purchased the property in your personal name (not under a corporation), your taxable income is 150K, tax is 75K and your actual after tax profit is 75K (not 112K).

If you are not aware of this tax trap, there is a HUGE risk of spending 112K profit and then being stuck with a large tax debt of 37K.

REALITY: Flip with Tax on Income - much lower profit

Please note that purchasing in corporate name can save you a lot of taxes. So this example and tax trap would not be applicable, if you manage your corporate taxes well.

Tax Trap # 2 - Condo Flip

On condo flips, investors can fall into an even deeper tax trap.

First, as in the previous example, all of earned income is 100% taxable since condo is considered to be inventory.

In addition, investor must repay GST, if he/she had received it when purchasing the condo from the builder. Even though GST repay is just a return of the money recently received, the danger is that one would have already spent it by the time they'd need to pay it back.

The next catch is that HST is applicable on new properties. Investor would have to pay 13% HST.

Lastly, as per the linked article, CRA is on top of improper tax payments (ie. capital income vs. business income issue) and would apply a penalty up to 50% of tax payable for tax avoidance to anyone who reports tax incorrectly on their new condo flip.

All in all, a condo flip may end up being a loss rather than a profitable deal, once all these adjustments are applied.

For example, if we purchase a new condo for 400K (including tax rebate) and sell it for 500K. Applying capital gain tax only, you might erroneously think that you'd only pay tax on 50% of 100K capital gain, which would result in 75K profit.

DANGER: New Condo Flip with Incorrect Tax Calculation
- looks like a profitable deal

In reality, after we apply all the adjustments that an investor might have missed, we end up with a loss of 12K.

REALITY: Loss on a New Condo Flip due to Taxation Error

Bottom Line

The bottom line is that many new investors might not know about these potential tax traps and might lose money. 

The only way to avoid these tax traps is to keep educating yourself and find a way to get advice from knowledgeable accountants and tax advisors, who have applicable experience and know exactly how to navigate around these and other potential tax traps.

Hope you find this post helpful. Please share, like or forward to your friends and fellow newbie investors if you did!!!


Tuesday, March 13, 2018

Me vs The Door. I win!

Old Patio Door - Brrrr! cold
Hurray! The door issue is finally resolved. I was VERY frustrated with it! Here's the story.

Mid November, a tenant notified us that they had very severe draft coming from under the front door and also from under the patio door at the back of the living room.

Within a day or so, we  had our contractor come out to the house to look into it. It turned out that there was an easy fix for the front door, but the patio door was too old to be repaired. It had to be replaced. The wind was hauling through and around every inch of the door surface.

Tenant is Freezing! Let's Replace The Patio Door

The contractor called and reported his findings. He had an estimate prepared and went over it with me over the phone. I roughly knew how much it would be to replace the door since we completed a similar project several months ago at another property. The estimate sounded reasonable and within what I expected. We agreed to go ahead with a new patio door!

The contractor ordered a new door at the local hardware store. The new door was supposed to be delivered to his shop within the next couple of days. He called and explained new door specs to me in a lot of detail! He was super excited that the new door was 3-panel and talked extensively about how warm the house would be, once the new beautiful door is installed.

And at the end of the call, he also asked for a payment. I often pay for materials up front and labour upon completion. So this wasn't a surprise.

I thought I knew the contractor well. He finished a couple of jobs for me before. All of them went great - work done quickly and well. Tenants were happy with the quality.

So, without thinking too much into this, I sent the payment for the new door and asked the contractor to schedule work dates directly with the tenant as soon as possible.

Mistake #1 - I have no idea what I bought...

I paid money for a phantom door without doing ANY due diligence to check that there was actually a door purchased on my behalf. I paid simply because I thought the contractor was a good guy based on  the two times he worked for me before.

Instead I should have:

  • Asked for a receipt
  • Asked for a picture of the door that I was buying
  • Checked patio door prices on

Now, when the door issue is behind me, I have to admit that I paid $1,275.77 for a new patio door. If you check at Home Depot, patio doors start at $565 + HST. There are 30 different doors that are cheaper than $1,275.77 and another 170 doors that are more expensive.

So, to this day, I don't know if I paid more than I should've... Was the door too fancy for my needs? Did I pay too much? Did I get a great door that will now last another 50 years? I will never know because I have no idea what I actually bought.

Mistake # 2 - Winter is NOT a good time to replace patio doors

No door - bad idea during Canadian Winter

Now, we had to wait for the weather to cooperate. This winter was brutal, especially in December and January. It was very cold and snowy. Contractor advised that we couldn't take out the door and keep the house open for a day or two when it was -30C outside.

In addition, the selected dates had to work both for the contractor who was always super busy and our tenant, who insisted on being present at all times personally. The tenant wouldn't agree that I come by and oversee the contractor instead, if they can't be home.

Eventually, after 3-4 weeks, everything got aligned: the weather, a couple of open days on the contractor schedule, and our tenant’s schedule.

Series of Unfortunate Events

Unfortunately, our contractor had a mild heart attack just a couple of days before the scheduled date. Obviously, health and life take precedence before the draft under any doors. Tenant was understanding of the situation. Luckily, our contractor recovered and got back on his feet over a few weeks.

Winter weather was still nasty! Once health issue was behind us, we all started watching the forecast waiting for a couple of warmer days. Finally, we scheduled the work. Yay!

On the day of the appointment our tenant had something urgent come up. They couldn't be home and asked to reschedule.

We now waited and watched the weather for the third time in a row... Finally, all good again: decent weather, tenant at home, and contractor is in good health and available. The new dates were scheduled! We set 3 days aside to make sure there is ample time to get the job done.

Mistake #3 - Don't Assign More Work When Previous Load isn't Done

Just  a couple of days before the appointment, the tenant got in touch. They asked us to take a look at several new items at the house:

  • A few outlets had no power on the main floor
  • Shower tap got broken and tenant (including their kids) had to use pliers to turn the shower on and off
  • A pipe leaked in the basement when they were using the washer

Since the contractor would be at the house anyway, I asked him to scope out these issues and let me know a quote.

The contractor called me back and explained that broken power outlets were a SAFETY concern and had to be addressed ASAP. Apparently, wires inside the electrical box were lose and several of them had signs of burning. He had to replace fuses, do some re-wiring, etc. I agreed that he should go ahead and address the safety issues, thinking that eliminating the risk of fire is a much higher priority than getting rid of the draft.

What I didn't expect was that these safety issues would take up ALL OF THE THREE DAYS. So by the end of the slotted time period, all of the new issues were addressed, but the contractor didn't even start on the door.... 

It turned out, that since the heart attack, the contractor wasn't aloud to drive a car. So the work took him longer than normally, because he had to take a bus to and from hardware store during the day every time when he needed some parts. His partner drove a truck, and gave him a lift when possible, but still capacity limitations became apparent. Tenant observed that the contractor only spent 2-3 hours a day working, while I was under the impression that he spent 3 full days onsite.

Anyways. New issues got resolved very fast! Old issue was still not started. 

We were now watching the weather again. Tenant started getting quite frustrated. The house was cold and they were concerned about really high heating bills. It was the end of January - 2.5 months have already gone by.

Mistake # 4 - Always be in Control. Excuses will NEVER end.

And for the fourth time, we scheduled several days. By this time the tenant was extremely anxious. They shared with me that they expected the contractor would find an excuse not to show up.

And he did.

Three days before the appointment, the contractor called me. He politely explained that, as he was preparing for the appointment and unpacked the door, he realized that the new patio door turned out to be welded rather than bolted. As a result, it would not go through the entrance door since it can't be taken apart. And since the front door is the only way to access the backyard in this town house, we'd have to postpone the appointment.... 

Well. This is when meditation practice comes in handy.

I counted 5 breathes in my mind before asking what he thought our options to overcome this hurdle would be... There were two options: 1) get a new bolted door which might be problematic, since manufacturer now makes all doors welded and we'd have to look for an older model; or 2) find a way to bring the door in through a neighbour's backyard.

I explained in detail that it was very important to finish the project and install the new door as soon as possible and that the tenant was not happy and I really needed all his help to get to a conclusion on this. I was offering help and asking if there was anything I could do to help. 

The contractor started calling hardware stores and by the end of the day he found an old model of the door, which could potentially be delivered early next week. Great! Let's do it. 

As a backup plan, we agreed that if there would be a hiccup or delay and the new door wouldn't be delivered early next week, we would implement a backup plan. 

Backup Plan

My husband and I went to check if there was a way to bring the door in through the back yard. We found out that one of the fences at the end of the backyard was only about 4 feet high. We thought that it would be possible, with enough man power, to bring the door in over that fence.

The neighbour was not home and we left him a note with our phone #. We also left our # and information with other neighbours. No response. Contractor told us that he also stopped by and left his card. No response. My husband and I went there again the next day at a different time of the day - no one home and no call back.

Contractor said that he wouldn't carry the door without the neighbour's permission since that would be trespassing. 

My husband and I made a decision that we would personally trespass and carry the door in, through the back yard. We clearly communicated this to the contractor: please, just bring the door, we will get it in for you, then please install it. We spent time on the phone re-iterating this plan. It seemed we all were on board with this backup plan.

Contractor assured us that he felt backup wouldn't be necessary since he already scheduled the delivery of a bolted door for Tuesday. Awesome! Even better.

By this time, tenant refused to pay rent. They explained that they paid hundreds of dollars for heating month after month after month and they were fed up with it. This was the first time ever when a tenant yelled at me. I hung up and submitted a court hearing application. I was very offended by the yelling. Draft or no draft, rent must be paid... However, I decided to find out how much extra heating costs my sloppy implementation of door replacement was causing.

Do You Know What Happened Next Tuesday?

You would not believe it. It was now mid February and winter started fading away. +7C outside. 

8:30 AM. 30 minutes before the appointment. Contractor calls. He'd have to postpone the appointment because it is pouring rain. It is very dangerous to work with power tools in the rain and since he'd be using power tools as he'd be installing the door, he can't proceed. He cannot risk his life and show up.

This time I was not even mad. I've become immune and emotion free. Having said that, all my dreams over the past few nights were strictly about patio doors.

I called the utilities company and found out that my tenants' actual heating consumption was super low through the winter. The service desk could only provide general averages to me, but it became obvious that if my tenants' bill was several times higher than average WHILE their consumption was several times lower than average, they hadn't paid their bills for a while. 

I no longer felt guilty. I knew that I just had to get to the end of this whole door situation. At the same time, it was obvious that I didn't have to worry about my tenants' high heating bill and reimburse them for extreme consumtion. Phew!

Grand Finale

I called the contractor a day later and realized that he still didn't have a new bolted door. Still, the biggest issue was that we couldn't carry the welded door in. Why I asked? I thought that a bolted door was supposed to be delivered back on Tuesday. Oh no - he thought that I didn't want it because I asked him to carry the welded door through the back yard.

Alright. I insisted that we schedule a day when he'd bring the welded door to neighbour's drive way. My husband and I would take full responsibility for trespassing and we'd have the door carried in.

In my mind, I set a deadline of the following Friday giving it final 9 days. I decided that if I wouldn't see a door by then, then that door probably didn't exist and most likely I had bought air for $1,275.77 . I already started asking my friends for trustworthy contractor referrals, so I could quickly find a replacement and start all over again. It wouldn't be the first time when I lose a deposit.

I discussed the situation with the tenants. We agreed to give this operation the last chance. We also discussed utility costs and rent payments and came to an agreement. Our court hearing was scheduled for March 26, just in case our verbal agreement wouldn't go as planned.

The End

Love the new door!
Super thick, 4-panel, warm home next winter :)
Drum roll!!! The following week, on Wednesday a new bolted door was delivered. The Contractor carried it in through the front door. He installed it and finished by Friday.

Somehow, there was a missing part on the lock of the new door, but at this point I was not going to worry about it. The contractor came up with a work around for it, so the door locked.

The bolted door, apparently, was $400 more expensive than the welded one. I asked the contractor to show me receipts for both doors and explained that I couldn't pay any additional money without seeing a receipt. He said that he'd gladly eat that cost given how many problems we ran into along the way. I told him that I appreciated it.

The contractor's computer mysteriously crashed and he wasn't sure how much labour costs we originally agreed to. The numbers in his journal were $200 higher than what my notes said. He agreed to go with the numbers I wrote down. I thanked him for that as well.

Door installed. After 3.5 months of struggling it was a Happy End after all. I am grateful and happy about it!

PS Lessons Learned

In future I will ALWAYS require:

  • a written work estimate including timeline and cost
  • a written agreement for full money refund if project doesn't get done by a pre-agreed upon date
  • receipts and a proof of purchase for all major purchases/materials before I pay for them 
  • invoice before I pay for the work done
  • myself to know market prices and key parameters of the most costly parts of a project.
I realize now that the best course of action would have been to use a specialized Doors/Windows company rather than a General contractor for this project. If someone changes doors every day, I'm sure they'd know about welded vs. bolted doors and how to deal with them. Even though this seems obvious, this realization only came to me after a couple of months of weather checking. 

I wish I could also make sure that no one ever gets sick and the weather is always great, but since that isn't an option, I'd just say that for all external work, I'd notify the tenants that they might have to wait till Spring. If I set expectations correctly, all the re-scheduling would've just been a part of the original plan.

You never know how the circumstances will play out and all the various factors that may work against you. So you need to have a planned way out of an existing engagement in case it fails. You shouldn't be making yourself a hostage of a contractor and/or a series of unfortunate events.