A purchaser of real estate has the choice of a number of legal structures under which to acquire the property. Most commonly used real estate acquisition vehicles include sole proprietorships, partnerships, joint ventures, corporations and trusts. The determination of which legal form is most appropriate will involve considering a number of commercial and legal issues with the ultimate choice having impact on the liquidity, return on investment, tax and liability of the venture.
Acquiring commercial real property as an individual is generally not the ideal option as it places unlimited liability onto the owner. While it does allow the individual to set off the losses generated by the real property from other sources of income there are two key provisos: First, the losses on an income producing property claimed by an individual are limited to the net rental income derived from all rental properties in their name. Secondly, there are restrictions on the deductibility of carrying costs on vacant land and construction period soft costs by an individual.
Despite the unlimited liability and possibility of realizing on the losses flowing from the real estate, acquiring the property as an individual allows a degree of flexibility as the owner is able to subsequently change the form of ownership by transferring the property to a partnership or a corporation on a tax deferred basis. In contrast, property that owned by a corporation cannot be transferred out to the individual owner on a tax deferred basis.
Real estate can also be acquired through a partnership, whereby the partnership will hold title to real property with partners having either equal or unequal interest in the real estate. Whether a general partnership or limited partnership, the partners do not have a separate interest in the property and are therefore obligated to treat the partnership property as joint property. This is often a deterrent to some commercial real estate owners or investors who value the freedom to deal with their undivided interest in the property as would be permitted under a co-ownership arrangement.
As between the two types of partnership, general and limited, due to the joint and separate unlimited liability for all its partners, general partnerships are typically avoided by commercial real estate owners, investors and developers. In fact, great efforts are made to ensure that the arrangement is characterized as a limited partnership.
Where a limited partnership is used to acquire real property, the owner of the is the general partner, who’s liability is unlimited for all of the liabilities of the partnership, on behalf of the limited partnership. The benefit of real estate acquisition through a limited partnership is material for the limited partners whose liability is restricted to the amount that each limited partner has contributed to the limited partnership, plus each partner’s share of any undistributed income.
In order to insulate the limited partners from unlimited liability, the general partner must be solely responsible for the management and operation of the partnership business. The limited partners cannot participate in the management or operation of the business. A limited partner who breaks this critical rule and takes part in the control, management or operation of the business of the limited partnership, including signing any documents on behalf of the partnership in its own capacity as a limited partner, risk being exposed to unlimited liability.
Aside from limited liability for its limited partners, partnerships offer two key benefits. First, they are easily to create and offer considerable flexibility, in that sellers can “roll in” real estate into the partnership and take back units of the partnership on a tax deferred basis.
In terms of taxation of real estate held by a partnership, under the Canadian Income Tax Act a partnership is not itself a taxable entity. As such all revenues and expenses, assets and liabilities of the partnership flow through to the partners. For this reason, a partnership may be the optimal structure for estate venture where losses are expected in the initial stages allowing the partners to utilize losses flowing from the partnership, thereby increasing the net present value of the investment. The singular exception to the flow-through nature of partnerships is capital cost allowance, which is calculated at the partnership level.
Co-ownership which includes joint tenancy, tenancy-in-common and co-tenancy, describes an arrangement whereby two or more parties own real estate. In contrast to partnerships however, each co-owner has a separate interest in the property and is therefore unrestricted in dealings with their interest in the property. While there is a presumption of freedom with respect to each co-owner deal with their share of the property, it may be restricted by the agreement governing the co-ownership.
In addition to each co-owners’ rights to deal with the property, co-ownership agreements typically deal with liability of the co-owners. While such agreements will limit each co-owner’s liability to their interest in the property, the risk of exposure to joint and several liabilities remains high as a court may categorize the arrangement as a partnership for liability purposes and attribute joint and several liabilities in some cases. Most notable are instances where the co-ownership agreement limits the co-owner’s ability to sell or otherwise transfer her interest in the property. Equally dangerous are instances where the co-ownership agreement calculates profit and losses as if a partnership had been created versus allotting gross revenues and expenses directly to the co-owners. Co-ownerships should be particularly vigilant and obtain sound legal advice in order to reduce the potential of liability.
From the tax perspective, acquiring real estate through a co-ownership allows each co-owner to reports his or her share of income or loss from the property independently of other co-owners. As such, co-ownership allows investors to claim a capital cost allowance and other discretionary deductions independently of other co-owners.
Perhaps the most common legal form used to acquire and hold commercial real estate property is through a corporation. The overriding benefit of using a corporation is that recourse against a corporation is limited to its assets, without the possibility of piercing the corporate veil to hold the shareholders liable. Another benefit is that a corporation whose main business is leasing of real estate owned by it is not subject to restriction that capital cost allowances on rental property cannot be claimed in excess of the net rental income.
From a tax perspective corporate income, losses and capital cost allowances do not flow through to the shareholders. Therefore corporations are suitable for more mature operations with net income exceeding the available capital cost allowance deductions but where losses are anticipated, especially in the early stages of the venture, a partnership may be a more suitable vehicle allowing losses to flow directly to the members of the partnership.
The last of the widely used legal structures in real estate acquisition are trusts, which are arrangements whereby registered title to real estate is transferred to a trustee, who holds and manages the real estate for the benefit of and on behalf of parties specified in a trust agreement, called beneficiaries. As with a corporation, recourse against a trust is limited to its assets however if a trust holds title to multiple properties, it exposes all of them to liability that may arise from only one property.
Trusts are taxable entities and are taxed similarly as individuals however graduated rates of tax do not apply to inter-vivos trusts. Although losses realized by a trust do not pass through to the beneficiaries, income paid to the beneficiaries is deducted from income of the trust and taxed in the hands of the beneficiaries.
This article should not be relied upon as legal advice - the comments may not be applicable to you and may not be up to date. If you have any questions, you should contact a lawyer.