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As realtors, any fluctuation with the Interest Rate can seem very worrisome, wouldn’t you agree? Let’s begin with looking at the the recent realtionship between the ineterest rate and our government.
Rising Interest Rate & Canadian Government
In the past two years, the Canadian government has done two things to help fellow Canadians get through the pandemic.
- Lots of subsidies, grants, and benefits were offered to local businesses and fellow Canadians.
- Canadian interest rates had been lowered to the historic level at 0.25% to stimulate borrowing and investing.
Our government has been incurring a substantial amount of deficit year in and year out before the pandemic emergency relief measures. With the unprecedented amount of benefits and subsidies offered during the pandemic, the Federal government had increased their deficit by twelvefold, by $274.4billion in 2020.
If you combined the Federal government deficit with the provincial, territorial and local governments, the consolidated deficit was $325.5 billion for 2020.
Have you wondered how the Canadian government can afford to have this much deficit in one year?
The simple answer is that – they don’t, they borrowed. They borrowed from the Bank of Canada. They borrowed A LOT from the Bank of Canada.
The BOC, the Central Bank of Canada, purchased bonds, treasury bills, etc. from the Government of Canada. It then turned around and offered a portion of them to the private market including banks and security traders. The BOC kept the remaining portion without offering it to the public.
Because Bank of Canada is wholly owned by the Government of Canada, for those of you who know accounting, the portion that’s kept by BOC is essentially a digital entry that’s created to increase cash, i.e. asset, and increase liability.
This is how they increase money supply in the system, a simple journal entry in accounting term – by debiting cash, crediting liability.
Because of the amount of subsidies and grants offered by the government during the pandemic, we created an unprecedented amount of debt in 2020.
With an increase in money supply over the last two years, as well as low interest rates offered by the Bank of Canada, it isn’t surprising to see that inflation surpassed 5% in January 2022.
As realtors and real estate agents, you have all seen and experienced the unhinged real estate market, partly stimulated by cheap money being offered by banks.
One of the ways that the BOC could limit inflation AND control the overheated housing market was by increasing the prime rate.
And, so they did. They announced a rate hike of 0.25% at the beginning of March, and now they have raised it last week by half a percentage point to one percent last Wednesday in its latest move to rein in high inflation.
Now you may be wondering…
Can we expect to see more hikes?
We all knew that this was coming. We just didn’t know how much increase we would see over the next year or so.
The good news is that the gradual increase in interest rates over the year to help slow inflation does not mean buyers will stop seeking a home completely.
Together with the Federal government’s decision to ban foreign investors for the next two years, there will definitely be fewer bidding wars for home buyers to be in the middle of, maybe we can even see some rare stability in the market.
We may even see some price adjustments similar to the year 2017/2018.
You’ll be surprised how many realtors / real estate agents often ask me… as a buyer, should I go with a fixed-rate or variable rate mortgage in this fluctuating market?
Locking in with a Fixed interest rate mortgage
With a fixed-rate mortgage, your interest rate and payment stay the same over the mortgage term. A fixed-rate mortgage is tied to bond rate, not Bank of Canada prime rate.
With a variable-rate mortgage, the interest rate can move up or down according to the lender’s prime interest rate, which is also tied to the Bank of Canada prime rate.
With a variable rate mortgage:
- Your initial interest rate will most likely be lower than a fixed-rate mortgage
- If the prime rate falls and your interest rate falls accordingly, your monthly mortgage payments decrease (vice versa, as the prime interest rate has increased and is expected to continue to increase). If the prime rate rises and your interest rate goes up accordingly, your monthly mortgage payments increase accordingly as well..
- You can convert to a fixed-rate mortgage at any time (especially when you know there’s going to be an expected hike in interest rates)
What this means with a fixed-rate mortgage:
- From my experience, you can expect the initial interest rate to be higher than a variable-rate mortgage.
- You’ll know when you’ll be able to pay-off your mortgage, as the interest stays the same
- You’ll have the certainty to budget for mortgage payments, knowing exactly what you have to pay each month for the duration of the term
- Mortgage penalties can be substantial if you choose to break before the end of the term
The biggest downside of locking in a fixed-rate mortgage is the cost of penalty. Penalty is often calculated as greater of
- 3 months of interest or
- Interest rate differential between your existing mortgage or their advertised rate or posted rate
This could easily amount to tens of thousands of dollars in terms of penalty.
When you commit to a fixed-rate mortgage, make sure you are not planning to 1) sell or 2) refinance within the term of your mortgage.
Here’s the little hack that I normally do – commit to variable, pay fixed-rate mortgage amount
If I were to borrow $800K from the bank to purchase a rental property, I would opt for a variable rate.
Variable-rate at 1.60% means that my monthly payment amount = $2,797.46
Fixed-rate at 2.69% means that my monthly payment = $3,234.26
If you want peace of mind, here’s what I would do…
Sign up for a variable rate mortgage, pay your monthly mortgage payment amount to the fixed-rate amount.
In my example earlier, with an $800K mortgage, the bank requires me to pay $2,797.46 if I go variable.
I would instruct the bank to make a fixed-rate mortgage payment of $3,234.26 instead – so I am already used to paying a higher monthly amount.
The extra $437 payment that I make goes toward my outstanding mortgage principal on a monthly basis.
At the end of one year, my mortgage outstanding amount is lowered by $5,306 as compared to opting in for the fixed mortgage.
My cash outflow is exactly the same, but the extra goes straight to my mortgage principal, which also carries a compound effect on my monthly mortgage payment.
By the end of the second year assuming there is no rate increase, my mortgage outstanding is lowered by $10,757 cumulatively.
If you are concerned, go for a variable-rate mortgage, but pay as if you’re committed to a fixed-rate mortgage, assuming you have an option. As you know, sometimes, we don’t have a choice but to commit to a fixed-rate mortgage.
How to Prepare for a higher Interest Rate Environment?
- Invest in cash flow positive properties
If the rental income isn’t enough to cover all expenses on its own, you should think twice before investing in the property. As a minimum, you need to generate enough cash flow from your overall portfolio to support this cash flow negative investment.
With this principle, even if there’s a rate hike, your overall portfolio can still sustain itself, without further cash flow injection from you.
Yes, you can still find cash flow positive properties. After all, you’re a realtor! I’m sure if you look hard enough and be more creative, even in this scarce market, there’s something for you out there.
We bought a couple of properties in 2017/2018 just before the “market downturn”. We bought at the peak that year. I remember questioning why we committed to purchase these properties when they were priced at the top.
Thankfully, they have been cash flowing positive from day 1, even though we bought them at the “peak”.
- Restructuring debt to seek out the lower cost of financing
Never stop finding the lower cost of borrowing.
As we speak, we’re in the middle of refinancing 3 of our investment properties. We just completed one round of refinancing on these properties in early 2021. Now we’re on our way to refinance again.
Instead of paying a blended mortgage payment, line of credit allows us to pay interest only, lowering the monthly debt carrying cost.
If the plan goes well, we’re hoping to switch the B-lender financed properties to line of credit as well. Imagine, switching from a B-lender mortgage to a line of credit with interest only payment. We can easily increase our cash flow by $1,000 per property or more.
We’ll still use the excess cash flow to pay down our debt, but we get to choose the amount we pay.
Even if interest rates go up, we get the flexibility to pay less into our principal payment, maintaining the same level of cash outflow monthly.
Make sure you constantly look out for a lower cost of borrowing to minimize the biggest item in your rental operation.
- Take advantage of the dip
You have probably heard about the quote by Warren Buffet, “be fearful when others are greedy and be greedy when others are fearful.”
When there are multiple hike increases, we expect to see an adjustment in the real estate market. Coupling with the ban on foreign investors for the next two years, I’m definitely expecting to see a dip.
This can be the perfect opportunity for capable investors to enter the market, take advantage of the downturn.
Remember the market downturn in March 2020 when nobody was buying properties? Well, this is your chance to score some hidden gems while you still can! As a realtor, you may even know exactly where to find them.
- Relax, rates will remain low… for a very long time
From the narrative on Statistics Canada’s website regarding 2020’s government debt level, “Our debt charges (the Government of Canada interest expense) remain low despite record debt levels. This is a result of increasing money supply, encouraging lending and investment and keeping short-term interest rates close to zero. This allows our government to finance the unprecedented deficits generated during the pandemic at low cost and to refinance maturing debt at lower rates.”
The flip side of this narrative is that when the Bank of Canada increases its prime rate, coupled with the stop of quantitative easing, means that the government will have to finance their future deficit and refinance their current debt at higher rates.
Remember, when the BOC increases its prime rate, it’s also increasing the interest expense that the Government of Canada is paying.
The Government of Canada has about $2,852 billion of total liabilities as of 2020. A rate change is going to increase the cost of financing, not just for us, but for our government as well.
Yes, the rate is likely going to increase again.
No, Bank of Canada won’t have a substantial increase like back to 23% in the 1980s, or even back to 8% in the 1990s…or else our governments will go broke.
Hope this article helped you understand how the Bank Of Canada’s rising interest rate can help you as a realtor and investor!
Until next time,
Cherry Chan, CPA, CA
Your Real Estate Agent Accountant
PAYABLE ON COMMISSION INCOME
Before you learn how to calculate your income tax, you must first understand how the Canadian tax system works.
The Canadian personal income tax system is a progressive tax system. This means that the more you make, the more you get taxed on.
The chart below shows the marginal tax rates for Canadians residing in Ontario in 2022:
|Income range||Marginal tax rate|
|$0 – $11,141||0%|
|$11,141 – $14,398||5.05%|
|$14,398 – $46,226||20.05%|
|$46,226 – $50,197||24.15%|
|$50,197 – $81,411||29.65%|
|$81,411 – $92,454||31.48%|
|$92,454 – $95,906||33.89%|
|$95,906 – $100,392||37.91%|
|$100,392 – $150,000||43.41%|
|$150,000 – $155,625||44.97%|
|$155,625 – $220,000||48.35%|
|$220,000 – $221,708||49.91%|
Marginal Tax Rates
I have simplified the above chart to summarize all major marginal tax rates. However, there are additional income ranges and marginal tax rates. There are also basic personal tax credits that everyone is entitled to.
The best way to explain this system is to use an example.
In this example, we’ll assume the Realtor earns a net commission income of $80,000. To calculate the tax payable, we have to go through the entire list of marginal tax rates.
Here’s how it works:
Between $0 and $11,141, you get taxed nothing.
Between $11,141 and $14,398, you get taxed at 5.05% Ontario tax rate.
= ($14,398 – $11,141) x 5.05% = $164.48.
Between $14,398 and $46,226 you get taxed at 20.05%.
=($46,226 – $14,398) x 20.05% = $6,381.5
And so on.
We have to go through the above calculation for someone who nets $150K in business income. Then, add them all up in the tax payable column, and we will come up with a total tax payable of $44,642.
See the table below:
However, this person’s overall tax rate is different. Your income is taxed at a different marginal tax rate depending on how much you make.
There are two main concepts here: the average tax rate and marginal tax rates.
Average Tax Rate Vs. Marginal Tax Rate & Income Tax
Average Tax Rate
To calculate the average tax rate, you divide your total tax liability by your taxable income.
The average tax rate for a single person who makes a taxable income of $150,000 and pays
$44,642 in 2022 in Ontario is:
= 29.76% ($44,642/$150,000).
Marginal tax rate
The marginal tax rate is the tax rate applied to your highest chunk of taxable income.
A Realtor who nets $150,000 commission income may decide to close one extra deal before the end of the year.
Let’s assume the realtor makes $10,000 in commissions.
This additional $10,000 is then taxed at the marginal tax rate of 48.35%.
The realtor’s total overall tax liability = $46,642 + $4,835 = $51,477.
The realtor’s new average tax rate = $51,477/$160,000 = 32.17%.
Yes, an extra deal of $10K will only give you an after-tax pay of 52% – the government keeps $4,835, you keep $5,165.
Essentially, if you net $150K already, you are splitting this extra deal 50/50 with the government.
What if you contribute to your Registered Retirement Saving Plans (RRSPs)?
Similarly, all contributions are considered a tax deduction when you contribute to your Registered Retirement Saving Plans (RRSPs). But, again, this tax deduction gets taken off from your top marginal tax rate.
Say with this new deal; you now net $160,000 commission income. You want to save some taxes by contributing $10,000 to your RRSP.
This $10,000 contribution is coming off the top marginal tax rate. This means you can save $4,835 tax payable.
Why are these two definitions important?
As a Realtor, your net commission income is subject to tax.
From the example earlier, for someone who already nets $150,000 commission income, doing one extra deal and adding an extra commission income of $10,000 results in an additional $4,835 of tax liability.
The marginal tax rate from $155,625K to $220K is 48.35%.
The new tax liability is now $51,477.
The new average tax liability is 31.08%.
You cannot simply take your income tax paid at the end of the year and divide it by how much your net taxable income is to come up with your tax rate. You get taxed more than your average tax rate!
Recognizing the marginal tax rate on the additional commission income allows you to make an informed decision on whether you should set up a Personal Real Estate Corporation or not.
CPP – You Pay Double
Now, on top of the personal income taxes you have to pay, as a self-employed realtor, you’re also required to contribute to the Canada Pension Plan (CPP), similar to all other Canadians.
The only difference is that because you are your own employer, you’re required to contribute to the employee and employer portion of CPP.
CPP is calculated as 5.70% of your net earning with a basic exemption amount of $3,500 in 2022. Both employer and employee are required to contribute 5.70%.
In 2022, self-employed realtors who net more than $64,900 in 2022 are required to contribute a maximum of $3,499.80 as an employee and another $3,499.80 as an employer. That is a combined total of $6,999.60!
What if you incorporate?
Well, this is a topic for another day.
As a minimum, if you incorporate, you can choose not to contribute double amount of CPP by paying yourself a dividend.
As a minimum, you can choose to retain as much profit as possible in the corporation which has a tax rate of 12.2% in Ontario, instead of the 50% that you see above.
If you need help setting up a PREC for income tax purposes, CLICK HERE to book a 30 minute one on one consultation with one of the professional Accountants on my team.
Until next time,
Cherry Chan, CPA, CA
Your Real Estate Agent Accountant
Harmonized Sales Tax (HST) is a combination of federal and provincial sales taxes on goods and services in Canada.
Last week, we spoke about how realtors could deduct commission rebate, and some of you asked me about calculating your HST in the first place. So let’s get right into it…
As a Realtor, the services you provide to your clients are subject to the Goods and Services Tax (GST) or the Harmonized Sales Taxes (HST) in Ontario.
In Canada, if you make over $30k annually from all your combined commercial activities, you must charge HST to your customers on behalf of CRA. However, CRA considers you a small supplier if you make less than $30k from all of your combined commercial activities on a rolling 13 month basis. This means you may be able to get away from not charging HST.
Practically speaking, most real estate brokerages require their agents to register with the government to collect HST. I have yet to see a real estate agent client that is not registered for HST..
Most real estate brokerages require realtors to provide their HST numbers, whether they make over $30K commission or not. Once you get your HST numbers, you are required to charge HST on the commission you collect, regardless of the amount you earn.
Some brokerages charge HST on behalf of their realtors. Then, they deposit the commission income, together with HST collected, into the Realtor’s bank account.
Most new Realtors do not understand that even though the HST money passes through your bank account, it doesn’t belong to you. You are only collecting it on behalf of the government.
This means you must keep track of the HST you collected on behalf of the government. Then you subtract the HST paid on all the services/products used for business purposes. Afterwards, you remit the net difference to the CRA at the end of the filing period.
Traditional Method Of Calculating Harmonized Sales Tax (HST) Payable
Let’s illustrate with an example…
If you make a $100,000 commission income for the year, in Ontario, you must charge 13% HST on behalf of CRA. So, you receive a total of $113,000 from your clients through the brokerage.
Note that you’re only eligible to claim the deductible portion of the HST you paid on meals & entertainment and the business use portion of the HST you paid on automobile expenses.
For example, only 50% of the HST you paid on meals & entertainment can be claimed against the HST you collected.
If you use the vehicle 90% of the time for business use purposes, only 90% of the HST you paid on vehicle expenses would be claimed against the HST you collected.
HST or PST you paid on insurance are not eligible to be claimed against your HST collected.
Assuming you spend $20,000 on goods and services as a business expense and pay 13% HST ($2,600) to the vendors, you would have paid $22,600 in total.
At the end of the filing period, you need to file an HST return and remit the net difference between what you collect and what you pay to the government.
In our example, it is $13,000 – $2,600 = $10,400.
CRA recognizes how much work is involved in filing an HST return, so it offers taxpayers another way to file HST returns more quickly and accurately.
This is called the Quick Method.
The Quick Method of calculating Harmonized Sales Tax (HST) payable
For Realtors to qualify for HST filing using the Quick Method, they have to meet the following conditions:
- The Realtor’s annual commission income must be below $400,000
- The Realtor must make an election to file the Quick Method or NOT revoke an election under the Quick Method.
- You are not a taxpayer such as accountants, bookkeepers, public institutions, etc.
Now that we have established the conditions required to qualify for HST filing using the Quick method let’s dive into how this method works.
In Ontario, Quick Method Remittance rates for service providers is 8.8% on gross income received (inclusive of HST), while for resale of goods, it is 4.4%.
As a Realtor, you are also eligible to claim 1% on the first $30,000 eligible supplies as a credit.
This means you would apply 8.8% to your income and subtract the 1% credit for the first $30,000 eligible supplies.
Using the same example above, you collected $100,000 income plus $13,000 HST from your clients. Ie. Gross income inclusive of HST = $100,000 + $13,000 = $113,000 in total for the year.
The Net tax payable under Quick method = $113,000 x 8.8% – $20,000 x 1% = $9,944 – 200 = $9,744
Recall that in the example above, if you were to file HST under the traditional method, our Net tax payable using the traditional method = $10,400.
This means you get to SAVE $656, which you will have to add to your income and pay the tax on it.
Even if you are at the top marginal tax rate in Ontario paying 54% tax, you will still net $302 after tax!
The Quick method is great, especially for businesses that are labor intensive with low expenses.
Benefits for filing using Quick Method
There are a few benefits using Quick Method for your HST filing:
- If your expenses are low in relation to how much you have collected, this can provide some tax savings, as illustrated with the example above.
- If you want to have certainty in terms of how much HST you have to pay, the Quick method provides a quick and easy calculation for you to set aside the amount for payment. For example, if you earned $100,000 commission, collected $113,000 from your brokerage, and you wondered how much you need to set aside.
With the Quick method, all you need to do is take the amount deposited in your bank account, multiply it by 8.8%, and you have the exact amount you need to remit to CRA.
In our example this would have been $113,000 x 8.8% = $9,944.
This helps with cash flow management and you know exactly how much you would need to set aside.
- Simple calculation – as illustrated in our example, the HST payable calculation can be as simple as taking the gross commission income and multiplying it by 8.8%. You don’t need to complete your entire set of bookkeeping before knowing what you have to pay.
No adjustments required for the non-deductible portion of meals and entertainment required. No adjustments for the personal use portion of your car expenses. All you need is your gross commission income, inclusive of HST x 8.8%.
Downside of using Quick Method
With its simplicity, it comes with a few disadvantages:
- If your expenses are high, using Quick Method to file your HST may cost you money. You’ll lose out on claiming extra HST that you pay on your high expenses.
- You can’t make a change easily. If you want to revoke your election to use Quick Method to file HST, you have to revoke the election by the due date of the HST return for the last reporting period for which you want to use the quick method.
We have a client who has been consistently late with his HST filing. By the time he recognized the HST implication and would like to revoke his election, it was too late.
- Quick method is only available for realtors who make less than $400,000 commission income. If you make more than that amount, you are not qualified to use the Quick Method for filing.
Deadline to file elections
For an annual filer, your deadline to file the election is the first day of the second quarter.
If you file your HST return quarterly or monthly, you simply need to make the election by the due date of the filing period that you start using the Quick Method.
You must file an election BEFORE you can use the Quick Method to report Harmonized Sales Tax (HST).
In other words, more incentives to file more frequently.
Until next time,
Cherry Chan, CPA, CA
Your Real Estate Agent Accountant