Holding company

[Chad Friesen]

Hi can someone explain to me how a holding company works. I sat down with my mortgage broker yesterday and she told me after 4 doors i will need to put any more properties i buy into a holding company. 

I should have asked her more questions but the conversation went a different direction.

Im in Canada to so not sure the differences to the US

[Roy N.]

@Chad Friesen

Apologies for the delay in following-on, it's been a tumultuous week.

If you are purchasing residential (1 - 4 unit) properties on your own, or even with your spouse, holding the properties indirectly within a corporation or directly in your own name will have little bearing on the number of properties you can purchase using conventional financing.  Regardless of how you hold title to the property, the lender is going to require your personal pledge on the mortgage (if you hold the property in a company controlled by you, you will be required to guarantee the mortgage).

Secondly, there is no financing wall at four doors.  Different lenders will have their own internal guidelines.  Some have a fixed limit (RBC will lend until you have 5 mortgages); others will apply more rigorous underwriting criteria once you have 6-7 mortgages (CIBC, TD) and most will require you to have a ridiculous amount of readily liquid assets available once you have 10 or more mortgages.  Also note that the various lenders internal policies shift and change frequently depending on their mortgage/asset holdings and exposure risks.  Viz. A couple of years ago, TD was a great source of financing for rental properties, this year their offerings are not as aggressive and they have tightened their underwriting (even for those of us who have a proven track record).  Similarly, CIBC has decided they have too much variable-rate lending in their portfolio and their variable rate mortgage products are not competitive.

The limiting factor on how many mortgages you can obtain will be your Gross Debt Service (GDS) and household debt to income (DTI) ratios {Note that DTI is handled a little differently in Canada than most of what you will read here on BP, but the principle is the same}.

Another factor to guide your decision of holding properties in a holding company versus directly will be taxation.   Investment income (including rental income) is considered passive income in the eyes of the CRA.  If you hold rental properties within a Canadian Controlled Private Corporation (CCPC), the net income is considered passive (versus active).  Not only will the company not qualify for the small business corporate tax rate, but the passive income will be taxed at the highest corporate taxation rate (~44% in Alberta).

Conversely, if you hold the property directly, the net income is taxed in your hands - it is added to your income from other sources (salary / wages) and taxed at your marginal tax rate.  Unless you are in an upper tax bracket, your personal marginal tax rate is likely to be lower than the passive corporate tax rate.

You will also hear the argument for holding properties in a corporation being the mitigation of personal liability and the shielding of personal assets from creditors.

There is some truth to this, but not as much as one might think.   If you hold the properties in your own name, personal liability can be addressed via solid insurance coverage.   If you hold the properties in a corporation, you still need insurance.  It is true the directors and shareholders have limited personal liability - provided there has been no negligence or criminal conduct - but this extra protection is typically outweighed by the additional taxation and costs of operating as a company.

If you hold residential properties in a company, lenders will have required your personal guarantee on any mortgages - there is a reason the lenders require this and it is so they have recourse to your personal assets should the company default on the mortgage.

Now, there are valid, even necessary, reasons for holding property in a company.  It may be the easiest way to deal with sources of seed capital (this was our reason to start with a company) or to manage a small number of partners.  With larger, commercial. properties (say a 100 unit apartment complex), it also frequently makes sense to encapsulate them in their own business from both an operations, and eventual disposition, perspectives.

To decide whether (when when) a holding company makes sense in your personal situation, you would be best served to review your real estate objectives (near and mid term) and your present financial position (income, assets, debts) with an accountant who has real estate experience.

Hope this helps a little.