The year was 2016, but we never realized the tax mistake until 2017.
2015 was a huge turning point for us. We had paid off our mortgage in 2014 and then decided to invest in real estate. In 2015 we bought our first rental property, in fact, we bought our first 4 rental properties that year.
Then in 2016 we bought our fifth rental property and made a huge tax mistake
Debt Repayment Strategy
One of the strategies we used when paying off our mortgage was to put a chunk of our savings into RRSPs (registered retirement savings plans) and then put the tax refund directly towards paying off our mortgage. That way we were diversifying our investments slightly.
Part of our money went into our primary residence – although you could argue, and I would agree, that your home isn’t really an investment, more of a forced savings plan. And part of our money went into our RRSP.
We were a high-income family at the time so every dollar we invested in our RRSP resulted in 42% of it coming back to us as a tax refund.
In 2015 we were all in on real estate. Someone gave us the (misguided in my opinion) advice to not invest in our RRSP so that we could have more money for rental properties.
Here’s why that is good advice
On the surface, that seemed like sound advice. If every property you own is cash flowing, then the more properties you own, the more cash flow you have every month. Also, the more properties you own, the more tenants you have paying down your mortgages, the more your net worth increases.
In this case, if one is good, five, or ten must be better. If you can afford the properties of course, which at the time we could, hence why we bought 4 that first year. And by 2016 we now had 5 little property income streams.
Here’s why that is bad advice
Yes, every property was providing us with cash flow, great, more money in our bank account. But from a CRA (Canadian Revenue Agency) perspective, it’s also more income, and more income means more tax. Oh yeah, and remember that higher tax bracket we were in? That meant that every dollar we made form real estate was taxed at that higher amount.
And when you buy rental properties, nobody is holding back your taxes at the source as your employer does. You need to consider this and either a) lower your tax burden somehow, b) make installment payments towards your taxes throughout the year or c) face a huge tax bill come tax time.
The Big Tax Mistake
When we filed out taxes for 2015 nothing seemed out of the ordinary. At the end of the day, we ended up owing a few hundred dollars each, not a big deal.
But what we didn’t realize at the time and definitely do now, is that first year of owning those 4 properties there were a lot of write-offs that offset our profits. When you included legal fees, appraisals, and property inspections into all the expenses, our properties were not that profitable that first year.
Problem was, we didn’t have those expenses the second year of owning the properties. And in 2016 we only bought one property. Add that to the fact that our first 4 were very cash flow positive that year and we naively did not contribute to our RRSPs again that year and we were saddled with a massive tax bill.
The Effect of the Tax Mistake
How big of a tax mistake did we make? Our tax bill was $13,603.61 to be exact. And we were not prepared for it at all.
We had some money saved up that we could put towards this bill, but we didn’t have enough. We ended up taking out a short term loan to cover the difference.
Thankfully we did not have a mortgage on our primary residence at the time so we were able to save a large portion of our income every month. It still took us a few months to pay back the loan. The interest we paid could have been put to much better use.
How We Fixed Things Going Forward
That tax bill was a really hard pill to swallow, and a tax mistake we vowed never to make again.
So in 2017, after paying our massive tax bill, we went back to our debt repayment strategy that had helped us pay off our mortgage in the first place. For half of the year, we saved and invested that money into our RRSPs, and for the other half of the year, our savings went towards our real estate investments.
Although this substantially decreased the speed in which we could grow our real estate portfolio, it eliminated our need to pay taxes come tax time. If anything, we now contribute more to our RRSPs than we need to, and put the refund towards our debt.
For years, we were earning income without really contributing to our RRSPs which resulted in a carryover of a lot of RRSP room. We should be able to continue with our current debt repayment strategy for a few more years without running out of contribution room.
How this applies to you
Okay, right now maybe you are thinking, well I don’t have rental properties, so this tax mistake doesn’t apply to me. But in fact, it probably does.
Our mistake wasn’t buying rental properties; it was not understanding the math behind our taxes.
Canada, and every province and territory, has a marginal tax rate system. What this means is that every dollar of income is not taxed the same.
Canadian Federal Marginal Tax Rates (2020)
|$48,535 – $97,069||20.50%|
|$97,069 – $150,473||26%|
|$150,473 – $214,368||29%|
So, depending on your tax bracket, contributing to an RRSP can have varying impacts. The benefit of an RRSP is that that money can grow tax-deferred, meaning it is not taxed until you begin to withdraw from it.
Maybe contributing to an RRSP right now isn’t the best strategy for you. But the point is to be aware and have a strategy.
Not sure what your strategy should be? Check out this RRSP refund calculator. Plugin your annual earnings (can be found on your final payslip of the year) and then play around with the RRSP contribution amount. You can easily calculate the “return” on your contribution.
Remember to put in the correct province, as each one has its own marginal tax rates.
Our Tax Mistake – Final Thoughts
Arrogance and ego have a lot to do with our $13,000 tax mistake. Because we didn’t have any tax issues with our 2015 taxes, we were arrogant in thinking that we never would. Our egos lead us to believe that we knew everything and didn’t need help.
Had we asked for help or done a bit of tax planning we could have saved ourselves thousands of dollars.
Now, instead of paying at tax time, our strategy enables us to come out even or get a refund. The added benefit of this is that our RRSP strategy helps us to grow our net worth, instead of owing at tax time. And that tax refund? We promptly put it towards our debt.
What about you, what’s your biggest tax mistake?