My name is Mark Goodfield. Welcome to The Blunt Bean Counter ™, a blog that shares my thoughts on income taxes, finance and the psychology of money. I am a Chartered Professional Accountant and a partner with a National Accounting Firm in Toronto. This blog is meant for everyone, but in particular for high net worth individuals and owners of private corporations. The views and opinions expressed in this blog are written solely in my personal capacity and cannot be attributed to the accounting firm with which I am affiliated. My posts are blunt, opinionated and even have a twist of humor/sarcasm. You've been warned.

Monday, November 30, 2015

Should You Claim Capital Cost Allowance on Your Rental Property?


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”.

It should be noted that in general you are not allowed to create a loss for tax purposes with CCA. So continuing with the above example, if in year two you had net rental income of $15,000 before CCA, you cannot claim the $23,520 of CCA and create a loss of $8,520. You may only claim $15,000 of the CCA to bring your rental income down to nil. If you have more than one rental property, you can claim the maximum CCA even if it creates a loss on one property, if the net income of all rental properties does not become negative. For example, if in addition to the rental property above, you had a second property with net income of $9,000 after CCA on that property, you could claim the full $23,520 to create a loss of $8,520 on that property and net income of only $480 on both properties ($9,000-$8,520).

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.

38 comments:

  1. Hi Mark, great practical post! Would you typically recommend the same if the rental property(ies) are held in a corporation income? What about paying out rental profits as a wage to a lower income spouse rather than claiming CCA? I have done both in the past, and am interested on your thoughts on this... Thanks!

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    Replies
    1. Hi Anon

      It depends on whether your corp is a principal bus corp, personal tax rates and whether the wage paid to your spouse is reasonable. So no standard answer without reviewing the facts of the situation.

      Delete
  2. Hi Mark - what if your intention is to hold the property for a shorter period of time, say 1-5 years, would you still recommend to claim CCA?

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    Replies
    1. Hi Anon

      In that case it may not be the most tax efficient move, but would depend upon marginal tax rates and expected capital gain (assuming it would be considered capital)

      Delete
    2. OK - Thank you!

      Delete
  3. Hi Mark,

    Very helpful blog! I started reading one post and couldn't stop!

    I bought a house in 2014 for 330k while renting out 2/3 of it. One year later I had to sell my house at a slight loss of about 14k after all fees such as mortgage penalty, legal and land transfer tax. I am planing to claim both terminal loss on the building and capital loss on the land on the rented portion of the property. While I was reading the CRA's example "Calculation A – Land and building disposed of in the same year" I noticed that they used FMW of the property.

    My question is that should I used the actual sale price of the property in my claim? I suspect that the FMV could be a bit higher than my sale price since I did not use an agent.

    Thanks in advance!

    ReplyDelete
    Replies
    1. Hi

      Sorry Mfman, but this is a complicated provision and section and I cannot comment without doing the calc myself which I have no intention to do.

      Delete
  4. Hello Mark,
    Thank you for your blog. I bought a second house and lived it in for about a year and a half. I spent over 100,000 on renovations. I then moved abroad. Can I claim those renovations over time against my rental income?

    Also, I had new windows put in on the house ... this year. Would that be a capital expense? Can I claim it as a current expense?
    Thanks so much,
    David

    ReplyDelete
    Replies
    1. Hi David

      The fact you moved abroad could have/had a significant impact on your Cdn tax situation. I hope your received tax advice before doing so, if not you should do such.

      I cannot provide advice on whether certain expenditures are expenses or capital without a detailed review of situation. Again, you probably should speak to an accountant about any issues you had immigrating and in respect of your rental property.

      Delete
  5. Hello Mark,
    I used/took the equity from my primary house as the down payment to buy the rental property. Can I claim the equity loan interest as the expense for the rental property ?

    Appreciated,

    John

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    Replies
    1. Hi John

      Yes, however, if the equity comes from a line of credit and you are co-mingling it with other debt you will need to carve out the rental property debt as a percentage of the Line of credit.

      Delete
  6. Hi Mark,
    Very good post. I am going to hold the rental condo until retirement. At that time, I sell the condo. Since I claimed CCA during the last 10 years, I have accumulated CCA,e.g $30000, which becomes my income, plus capital gains, eg. $60000. My total income would be $60000. Since I want to avoid tax as much as possible, I will use my accumulated rrsp quota (I have 100k accumulated in the past 10 years) to buy $40000 rrsp. Thus, I pay little tax. Is this reasonable?
    Thanks a lot.
    Christina

    ReplyDelete
    Replies
    1. Hi Christina

      I do not provide personal tax planning on this blog. that being said, your plan may make sense dependent upon your marginal tax rate. Speak to your accountant or financial planner.

      Delete
  7. Hello Mark,

    Thank you for your article. I purchased a rental property 2 years ago and have not claimed CCA as of yet. Are those years lost, i.e. too late to apply? Or would it just be a matter of adjusting previous tax returns (which I wouln't care to do)?

    thanks.

    ReplyDelete
    Replies
    1. Hi Adam

      Since you dont want to adjust the CCA in prior years, you will just start claiming CCA when you determine you wish to do so. However, when you start you can only claim the CCA for the current year, you cannot catch up past years in the year you decide to start claiming CCA.

      Delete
    2. Hello Mark,

      Great and to the point blog post. If one starts claiming CCA in this context (start when you wish to do so) on has to continue claiming CCA in the following years till the property is sold?

      Delete
    3. Hi Anon

      No CCA is discretionary each year, you do not have to claim.

      Delete
  8. What if the sales proceed after two years is 700000, resulting in a capital loss of 64480, still need to recapture the full CCA of 35520 and pay tax on it?

    ReplyDelete
    Replies
    1. Where there is a loss on the property as a whole, there will likely be a reduction or elimination of the recapture and maybe even a terminal loss depending upon all the facts. You would need your accountant to run the numbers.

      Delete
  9. Thank you! Am i right to say that the same rules (capital gain tax, CCA recapture and elimination of recapture..) apply for canadian tax residence holding foreign rental properties?

    ReplyDelete
  10. If I have claimed CCA for past years on a rental property, and if my income is very low in the present year, can I repay the CCA taxes this year while I am in a lower tax bracket?
    Can I borrow and repay the CCA whenever I want or would I be required to only pay it when the property is sold?

    ReplyDelete
    Replies
    1. Hi Anon

      You cannot repay CCA when you want. It is only taxable upon the sale of the property. If your income is low, it may make sense not to claim CCA and thus reduce the amount you eventually have to repay. Speak to your accountant or get advice.

      Delete
  11. Thanks - this is really useful! A quick question on rental properties owned overseas, so if one is owned in Canada and another one is owned in the UK - assume that the CCA would only be relevant against the Canadian property. Even though I am declaring the UK income the tax basis in the UK would be applied when doing a tax return there, and it is almost irrelevant that it is rental income for the means of the Canadian one??

    ReplyDelete
    Replies
    1. Hi Unknown

      Incorrect. While the original cost will be the same in both countries for capital gains purposes (subject to FX exchange), the depreciation/CCA can be different in both countries and result in far different taxes upon sale. The tax rules of each country guide the year by year rental income/loss claims.

      Delete
  12. This is very helpful. Thank you. I am contemplating the sale of a rental property and had assumed that any difference between sale price and UCC + original value of the land would be treated as capital gain. Obviously not. You explained how to deal with the recapture very well.

    ReplyDelete
  13. Thanks for the excellent article. I'm wondering if you have a guideline for determining the building portion of a property? I have a typical condo in a 4-floor building of 97 condos. How to determine the percent of the value that would be building vs land?

    ReplyDelete
    Replies
    1. Hi Jon

      Many accountants allocate 80 or 90% to building and the rest to land for condos. However, that does not mean the CRA will accept such.

      Delete
  14. We bought a house 4 years ago and renovated the basement last year into a self-contained suite, which is now being rented out (it is about 1/3 of the house and we live in the other 2/3). Can we use 1/3 of the original purchase price of the house as capital cost?

    ReplyDelete
    Replies
    1. Hi Niki

      You should engage an accountant to review you situation. Once you claim CCA 1/3 of your house is not your principal residence. That may be the result anyways once reviewed, but you need to have someone explain to you the tax implications of the 1/3 rental so you can make an informed decision re the CCA.

      Delete
    2. Ok, thanks I think I will do that. One other thing though, if I claim rental income and expenses, would that also make 1/3 of the house not our principal residence, or is it just CCA that would trigger that?

      Delete
    3. The CRA folio on principal residence says this:

      "It is the CRA’s practice not to apply the deemed disposition rule, but rather to consider that the entire property retains its nature as a principal residence, where all of the following conditions are met:

      a) the income-producing use is ancillary to the main use of the property as a residence;
      b) there is no structural change to the property; and
      c) no CCA is claimed on the property."

      speak to your accountant to review your situation in lieu of the above

      Delete
  15. Great article and good analysis. Question: if I sold one of a few rental properties (all in the same class) in 2016, have been claiming CCA on all these properties in the past years and now have a gain from sale of that rental property; then on my 2016 tax return, must I take a recapture of CCA taken on the sold property, or can the negative UCC of the sold property be lumped with UCC of the few unsold rental properties (all in same class)?

    ReplyDelete
    Replies
    1. Hi Joseph

      Each rental property over $50k must be in its own class, you are doing this wrong if your properties cost more than $50k which I assume they do.

      Delete
    2. Thanks for your timely reply. Yes, I have calculated CCA for each of these rental properties (each over $50K) separately on separate CCA form. I just were not sure if a recapture of CCA taken in the past must be done on the one property sold in 2016.

      Delete