The real estate investor’s toolkit

Should you manage your own property? When can you deduct mortgage interest? Here’s what every investor needs to know about buying real estate.

A major driver of economic growth, Canada’s real estate and housing market has been a hot prospect for buyers here and abroad for decades. And with good reason. Even with recent price hikes in some markets, Canada has shown a lot of underlying stability in comparison with other countries. Plus, our property laws to this point have generally favoured investors.

For those eager to get in on the action, take heed. Whether you’re a first-time buyer or a seasoned one, there are plenty of considerations to take into account when buying property for personal use or as an investment. Here’s a sampling.

HOW DO I DEDUCT MORTGAGE INTEREST?

Interest on mortgage loans in Canada can only be deducted on investment income. In other words, if you buy an investment property, 100% of the mortgage interest is deductible. But if the property serves as your principal residence and is not producing income, don’t expect any tax breaks. Of course, if you rent out part of your principal residence, you can subtract expenses incurred in maintaining it for rental. And the percentage of the mortgage interest that is attributable to the rental portion of the home will also be deductible.

If you’ve mortgaged your home to invest in an income-producing asset, you may benefit from a tax-saving strategy called the Smith Manoeuvre. Coined in 2002 by financial planner Fraser Smith, the strategy allows you to borrow against available equity in your home to invest in property or other assets. Even though you will be paying interest on your home-equity line of credit, it is 100% deductible for tax purposes. Of course, your new investment should provide a return that is higher than the interest rate on your loan.

WHO CAN FUND MY MORTGAGE?

Finding a competitive interest rate is key for most borrowers, but flexibility and customer service are important considerations, too. “Most people think shopping for a mortgage is all about rates but it’s more important to focus on your long-term goals,” says Angela Calla, host of The Mortgage Report on Global TV and a mortgage expert with Dominion Lending Centres in Port Coquitlam, BC. “Investors have to keep in mind that gas prices, inflation, government, even weather patterns, will have an impact on the economy, which, in turn, will affect mortgage rates.”

At Calla’s firm, brokers review inflation strategies with clients once a year to see if it’s time to make a shift in assets. “One of the biggest mistakes I see the middle class making is spending on depreciating assets (such as vehicles or furniture) and that reduces their ability to invest in real estate, if that’s one of their goals,” she says.

COMMERCIAL BANKS

Even with the greater variety of lending choices available these days, banks are still by far the biggest players in the mortgage market because they’re seen as stable and easy to access; they also benefit from brand recognition. However, they can be limited with their rates and wary about taking risks on any investors who don’t have an optimal credit rating or income. Online banks work much like other banks, although they might not offer as many options. Tangerine, for example, doesn’t provide second mortgages and will only finance properties zoned as residential with up to four units.

CREDIT UNIONS

These lenders fill in some of the cracks left by the big banks. They are regulated by the province where they are located rather than the federal government and are operated autonomously by their members as a cooperative (no shareholders involved). They are generally known for their good customer service and flexibility in tailoring mortgages to different customers. However, they may be limited in their rates and unable to offer large mortgages simply because they have less money to lend. Moreover, they might not offer some of the advantages offered by bigger lenders, such as bundled services.

MONOLINE LENDERS

These financiers focus solely on mortgages, but will only deal with clients via a mortgage broker. They tend to be smaller outfits without a brick-and-mortar presence. Since they have lower overhead costs than big banks do, they can offer more competitive interest rates and be a little more flexible when it comes to penalties and prepayment options. “If you qualify to work with a monoline lender, you will always have the best exit strategy clause on a mortgage if there is a divorce or if you want to flip the property quickly,” says Calla. “So it’s important to be proactive in figuring out how to optimize your credit and income beforehand so you can qualify for this type of mortgage.”

PRIVATE LENDERS

If you’re a higher-risk borrower with a poor credit rating, have an unconventional property to mortgage or just can’t meet the lending requirements of traditional banks, the private route may be your best bet. These lenders offer short-term loans funded by individuals or groups of investors. The interest rates on these mortgages are higher than average but monthly payments are lower because the loans are interest only (the payments do not pay down the principal). The loans are designed for borrowers who plan to have more income and/or improve their credit by the end of the loan term, at which point they would get a traditional mortgage. They can be ideal for investors who plan to flip a property for profit within a short time frame or who need bridge financing. Because private mortgages aren’t eligible for mortgage insurance and private lenders are on the hook if the borrower defaults, investors can expect additional costs for property appraisal, as well as legal, lending and mortgage broker fees.

IS IT BETTER TO INVEST IN RRSPs OR PAY DOWN MY MORTGAGE?

According to a recent Manulife Bank of Canada survey, average mortgage debt among Canadians was up 11% in 2016 to $201,000 — and millennials just entering the housing market saw the biggest increase. Plus, more than three-quarters of homeowners surveyed said being debt-free is a key priority.

Still, the experts are divided on whether tackling the mortgage should always be the top priority. If you have control of your RRSP and are getting a tax refund that you can then apply to your mortgage, going first for the RRSP might be the better route. “If you consider the question from an after-tax perspective, the majority of people would benefit more from investing in their RRSPs,” says George Dube, a partner at BDO in Kitchener-Waterloo, Ont. “If your mortgage interest rate is low, you can make a better rate of return on your RRSPs,” he says.

Mortgages are a “one-way street” where funds can’t be reclaimed unless you refinance or sell, adds Calla. “Putting your money into a mortgage can be a mistake if you could be generating additional income for yourself [through an RRSP] or if you’re going to need money down the road for something else,” she says.

On the flip side, Toronto-based financial expert Gordon Pape, publisher of the Internet Wealth Builder and Income Investor newsletters, says a key factor to consider is after-tax return over the longer term. While the initial tax return on an RRSP may be high, consider the rate of return on subsequent years and how that compares with having paid down a mortgage. “From a pure safety perspective, there is nothing better than paying off that mortgage even if the interest rate is low because you’ll guarantee that return with no risk,” he says.

HOW MUCH TAX DO I PAY ON CAPITAL GAINS?

Whenever you sell property (other than your principal residence) for more than its original cost, your profits are taxable. But contrary to popular belief, you’re not always taxed on all of the gain. Cherry Chan, a Toronto-based CPA specializing in real estate, says she encounters a lot of confusion among clients when it comes to taxes owed on profits from real estate transactions. “They think all the profit they make is taxed but there are many criteria to consider, such as intention of sale, profession and duration of ownership,” she says.

If you are a contractor flipping a property, for example, the profit would be 100% taxable, but if you’re planning to rent the property, it’s half that. Capital gains can also be offset with capital losses from other investments. And if you sell a piece of property for capital gain, but don’t expect to receive the funds right away because of the financing arrangements, you can sometimes defer the gain.

SHOULD I INVEST IN REITs?

Real estate investment trusts (REITs) provide an opportunity to invest in a portfolio of large-scale, income-producing properties (e.g., apartments, warehouses, shopping malls). They typically offer high distribution yields.

REITs in Canada tend to have longer-term leases and less tenant turnover. While this means steady cash flow with less tenant disruption, some experts say it provides fewer opportunities for landlords to raise rents. REITs are also sensitive to interest rates. As Pape explains, “People may be avoiding REITs because interest rates are going higher, making it more costly for the operators who will likely have to refinance at a higher rate when their loans come due.”

When investing in REITs, Pape advises diversifying not only in different segments of the market (residential, office, retail, industrial, etc.) but also in different geographical areas, including the US or Europe. It’s also important to understand the tax advantages for each investment, he adds. “Every REIT has a different set of parameters when it comes to calculating taxable implications each year,” he says.

DO I HAVE ENOUGH MONEY TO INVEST IN THE MARKET?

Before you make the plunge into property ownership, experts say you should know how big an impact it will have on you financially. “It’s about making sure you understand all the costs associated with owning a property (such as property insurance and monthly maintenance) and figuring out if you’re going to be cash-flow positive or way under water,” says CPA Terry Hawes, based in Port Moody, BC. “I tell my clients they need to be able to sleep at night and I’ve walked away from a deal myself for that very reason.”

Chan says real estate is a great investment if you follow the rules. “Make sure the fundamental economics are there: buy in the right area and operate it properly and your asset will appreciate,” she says. “If you’re bleeding every month and aren’t comfortable putting extra into the property every time there is an additional expense, buy something safer that’s not eating up your regular savings.”

It also helps to seek advice from advisers who are investing in the market themselves so they can draw from their own experiences.

DO I QUALIFY FOR A PROPERTY TRANSFER TAX EXEMPTION?

Most buyers are required to pay land transfer tax when a property title is registered. The tax is generally based on the purchase price of the property, although fair market value can also be used in some situations. The rate differs from province to province. For example, in Manitoba no land transfer tax is paid on the first $30,000. In BC, 1% is charged on the first $200,000, and 2% on amounts above that. The rate goes up to 3% for the portion above $2 million. This year, Ontario raised its rates to 2.5% from 2% on amounts exceeding $2 million.

Fortunately, a few types of transactions are exempt or carry a reduced rate for Canadian citizens or permanent residents, and again, the rules vary by province. Generally, first-time buyers and their partners/spouses do not have to pay the full tax; the same applies in some circumstances to those who are transferring property within a family. For the latter, either the transferor or transferee must generally have lived on the property for a certain time depending on province.

DO I REALLY NEED A REAL ESTATE AGENT?

No one is required to use a real estate agent when buying or selling property and they don’t have to accept any offers even when they have signed with a listing agent. Technically, if you breach your contract by selling or buying the property yourself or with another realtor, you could be on the hook for commission to the first agent. However, Chander Chaddah, a broker with Toronto-based Sutton Group-Associates Realty, says this has never happened to him in the 30 years he has been in the business, although he has “fired” clients when he found out they were also looking with other agents.

Chaddah advises choosing good agents for all real estate deals simply because they are the experts. “You wouldn’t operate on yourself or draft your own will — and if you only do a few real estate transactions in your lifetime, how could you possibly know what’s important in the sea of information out there?” he says. “That’s why a good agent is worth the money.” (Commissions across Canada vary but the listing and selling agent each receive about 2% to 2.5% on average.) Staging can be a good investment as well, and the expense is often covered by the agent if it’s negotiated into the arrangement.

Once the deal is done, a lawyer or notary prepares your final conveyance documents. Having a CPA look over the paperwork, especially if it’s an investment property, is also a good idea. Hawes says clients should do their due diligence when choosing a notary in order to avoid potentially costly mistakes. He recalls one case in Vancouver where the notary failed to learn that a property owner was a nonresident and should have remitted more than $600,000 in withholding taxes to the CRA. After the sale, the purchasers were hit with the tax bill, although they later successfully sued the notary.

SHOULD I MANAGE MY OWN PROPERTY?

Despite the horror stories about delinquent tenants, managing your own property can provide a greater sense of control over your overall finances. Before you opt for landlord status, however, you should find out exactly what you’re taking on, advises Victoria Vladimirova, owner of Vicole Real Estate Management & Consulting in Montreal. “You have to know the tenant/landlord laws really well and you have to expect you’ll be taking calls 24/7 to deal with all kinds of issues.” In such cases, patience really is a virtue, she says.

For residential properties in particular, Vladimirova says it’s critical to establish good relationships with tenants if you want to receive the rent on time. “Whenever you have a personal approach to your property it will generate money, but it takes time,” she says.

Even for those who prefer to pass the headaches along to someone else to manage, Vladimirova says not to focus solely on the finances. “Go visit the property and see who lives there before buying. And bring along someone with experience in renting who will know what to look for when it comes to potential problems.”