Ongoing low interest rates make it cheaper than ever to borrow to invest in rental property. However, one cost that investors may not be thinking about is property taxes.
While overall property taxes have been stagnant in the last few years (see “Average property taxes”), these costs have risen significantly over the last few decades. Between 1990 and June 2015, property taxes in Canada increased by 210%, according to a report by Royal LePage. (See “The mortgage isn’t the problem”.)
Unlike income taxes, the reason for the increase has nothing to do with the overall economy. “Each municipality needs to cover their expenses, so they look at their expenses for the upcoming year, then sets their property taxes,” explains Colleen Gibb, FCA, CFE, Gibb Widdis Chartered Accountants Professional Corporation.
Read: All you need to know about Vancouver’s foreign buyer tax, for more on recent changes and proposals in Metro Vancouver
You can help investors plan for these costs. Vern McClelland, associate broker, RE/MAX of Lloydminster, suggests investors look at similar rents in the same area to determine market value. Then, they should put aside 20% of rental income to pay for items like property taxes, maintenance and repairs. Also make sure clients are paying the right amount of tax. McClelland is “amazed at how many investors pay taxes without looking at their property assessments.” He advises looking at the assessed value and checking local real estate listings to see if it’s comparable to similar properties in the area. If your client’s assessed value seems too high, she may be paying too much tax and can take the issue to city hall. “Every municipality has an appeal process.”
Meanwhile, commercial property taxes can be as high as 4.5 times the rate of residential property. “But, if you’re investing in commercial, the tenant ends up paying for the property taxes due to the common area expenses,” says Gibb.
Say an investor has a building with three units. There’s a common parking lot, sidewalk and lawn. So the costs to cut the grass or shovel the snow, for instance, are split amongst all tenants. Common area expenses also include property taxes and utilities. The landlord will estimate those expenses at the beginning of the year and divide them by square foot, explains Gibb. The total rent per tenant is base rent plus common area costs.
At year-end, the landlord determines how much these costs actually were, she adds. If the tenants underpaid, they owe the additional funds to the landlord, and vice versa.
Tips for buyers
Experienced buyers should examine a property’s title before they purchase and see if the seller is up-to-date on his property taxes.
If the seller isn’t, it can actually be good news for the buyer. Why? It might mean the seller is in financial difficulty and, thus, more motivated to sell his property. This gives the buyer leverage to negotiate and get a better price.
McClelland once had a millionaire investor who had incurred a tax lien on a property he was selling. Since the investor wasn’t in financial hardship, McClelland advised him to pay his taxes to date.
The mortgage isn’t the problem
Index value of Canadian consumer price index, 1990=100
McClelland was also representing the buyer. “I explained I always pull title,” he says. “So when I ended up representing the potential buyer, the seller already knew we’d have looked at the title and seen the tax lien.”
This allowed McClelland to “negotiate harder” on the buyer’s behalf. “There was a pretty frank dialogue between the two and we got it done,” he says, adding that the seller has up until the date of transfer to pay any back taxes owing. (If he fails to pay up, the liability rests with him, not the buyer.)The experts note that most prudent investors account for property taxes. But what can overextend them, says McClelland, is leveraging their current properties to buy more. This can amount to high debt levels.
“I strongly recommend they do not use the equity in their existing properties to leverage the purchase of other properties,” says McClelland. “Equity does not pay your property tax. It does not pay the interest on your loan.” So ensure clients can afford the down payment and ongoing costs, including mortgage, insurance and taxes, before they buy.
And remind them the property could be vacant for months at a time. “If [an investor has] at least 20% to 25% of equity in [his] entire portfolio,” he adds, “it’s likely [he] can suffer some short-term vacancy because [he has] rents from other properties that’ll carry [him] through. Also, it doesn’t trigger the need to sell in a down market.”
Average property taxes
Residential (based on $1,000 of assessment)
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Commercial (based on $1,000 of assessment)
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Source: The Real Property Association of Canada