It has been my experience that minimizing income taxes is typically the number one objective for many of my clients. Yet, some clients instruct me to not claim depreciation (the technically correct term for income tax purposes is capital cost allowance or “CCA”) on their rental property(ies), which results in a higher income tax liability.
I am further confounded when clients who have claimed CCA in prior years will not sell their rental property because they will owe income tax on both their capital gain and recaptured CCA (see detailed discussion below). Today I try and breakdown the reasoning for these counter-intuitive income tax positions.
A discussion as to whether or not one should claim CCA can become extremely complex when you consider inflation, purchasing power, discount values and present values. In an effort to not over complicate the issue, I will essentially ignore most of these factors; however, one must always be cognizant of them. For the purposes of today’s blog post, I will work under the assumption that you hold your rental property for 20 or so years and a dollar today is worth a heck of a lot more than a dollar 20 years from now.
When someone purchases a residential rental property, they can claim CCA at the rate of 4% on the building portion of the property (non-residential property may be entitled to a 6% claim). The land portion cannot be depreciated. In the year of purchase, only 50% of the CCA may be claimed.
For example: if you purchase a residential building for $800,000 in 2015 and you determine that 75% of the property related to the building and 25% related to the land, you will start claiming CCA on $600,000 ($800,000 purchase price x .75%). The allocation may be determined through negotiation with the seller and is reflected in the purchase and sale agreement, by appraisal or based on an insurance policy or other relevant information.
In the first year you can claim CCA to a maximum of $ 12,000 ($600,000 x .04% CCA rate x 50% rate allowed the first year).
In year two you can claim CCA of $23,520 ($600,000 -$12,000 CCA previously claimed x 4%). In all future years, the CCA claim is equal to the original cost of $600,000 less CCA claimed in all previous years x 4%. Technically, the remaining amount to be depreciated is called Undepreciated Capital Cost or “UCC”.
Thus, to the extent you can claim CCA; you have absolute income tax savings or a tax shield equal to the CCA you claim times your marginal income tax rate. Consequently, one wonders why anyone would not claim CCA if their marginal income tax rate was say at least 35% and they plan to hold the property long-term.
The reason some people do not claim CCA is a concept known as recapture. When you sell a building or rental property for proceeds equal to or greater than the original cost of the building, any CCA claimed since day one is “recaptured” and taxed as regular income. Thus, say you purchased the $800,000 building in the example 25 years ago and over those 25 years you claimed $350,000 in CCA. If you sell the land and building for $1,000,000, which is more than the original purchase price of $800,000, you would have to add $350,000 in recapture to your income and report a capital gain of $200,000 ($1,000,000-800,000).
At this point I could get into a technical discussion of the present value of the CCA tax savings over multiple years versus paying recapture 25 years later, however (1) I think it causes unnecessary confusion for purposes of this discussion and I don’t think most people even take this into account and (2) even though I am an accountant, I hated doing PV calculations in school, so if I tried to do them, I would probably get them wrong. But seriously, I have never had a client ask about the present value of their deprecation tax savings; they know intuitively a dollar saved today is typically worth far more than a dollar in tax paid in the future.
We can now discuss the second issue that confounds me in regard to CCA, that being some people are not willing to sell for the $1,000,000 we use in the example above because of the recapture they will owe.
Say Judy Smith purchased the property initially for $800,000 and she is in the 35% marginal tax bracket. If Judy sells the property, she will have to pay income tax on $350,000 of recapture and a $200,000 capital gain. The additional income tax that results from the sale for Judy will be approximately $220,000 (because she moved into the higher marginal rates).
Judy will thus net $780,000 ($1,000,000 proceeds less $220,000 tax), $20,000 less than her original cost. If Judy is like some people, she may not want to sell the property because she does not feel she made any money on the property. I have trouble understanding this position, since she would have benefited from the tax shield on $350,000 of CCA, which at a tax rate of 35% was worth approximately $125,000 and would have grown to between $200,000 (using a 4% return on the after-tax savings) and $260,000 (using a 6% return on the after-tax savings) and still broke even on her investment. If Judy did not want to sell because she feels the property still has large upside, or her tax rate would be lower in a future year and/or she cannot find another investment that can provide the same returns, that is another issue.
If Judy had purchased the property in 1990, she would need approximately $1,280,000 to purchase the property today (See bank of Canada inflation calculator).
In summary, I will typically recommend that a client claim CCA on their rental property. I also generaly tell them to not let the income tax due on recapture cloud a potential sale decision. In the end analysis, tax savings today are almost always worth more than taxes paid in the future, unless the purchase to sale period is very short.
This site provides general information on various tax issues and other matters. The information is not intended to constitute professional advice and may not be appropriate for a specific individual or fact situation. It is written by the author solely in their personal capacity and cannot be attributed to the accounting firm with which they are affiliated. It is not intended to constitute professional advice, and neither the author nor the firm with which the author is associated shall accept any liability in respect of any reliance on the information contained herein. Readers should always consult with their professional advisors in respect of their particular situation.