Renting Your Property as an Airbnb - Beware of the Income Tax Issues

In the last few years, more and more people have begun to rent out all or part of their residence through

online services such as Airbnb or other rental vacation sites such as Tripping.com or FlipKey. Some will say it is for the unique opportunity to host people from a variety of backgrounds, others that it helps to cover the cost of the skyrocketing real estate/rental market.

Regardless of the reason, there are potentially detrimental tax consequences that can impact you in both the short- and long-term that I would suggest are unexpected to those renting.

Today, I discuss some of these tax consequences. Before I start, I would like to acknowledge the substantial assistance of Christopher Bell CPA, a senior tax accountant with BDO Canada LLP, in writing this post.

Sales Tax

The first thing that you will want to consider (which most laypeople would not) is whether your rental income is subject to GST/HST. You are required to register your business for GST/HST when your gross revenues from all of your commercial activities surpass $30,000 in revenue in a 12-month period. As a result, even if you only make $5,000 from renting your residence, if other commercial activities total $25,000 or more, you will be required to register to collect and remit sales tax. There is an important distinction to keep in mind when considering rentals. Long-term rentals (think of the rent you pay to your landlord) are exempt from GST/HST, while short-term housing rentals for periods of less than 30 continuous days are taxable for GST/HST purposes. There is a clear distinction here and Airbnb rentals, like hotels, are generally considered taxable for GST/HST purposes once you surpass $30,000 in a year.

You can claim back portions of the GST/HST you pay on expenses that are incurred related to the rental of the space in your home. Some items you might be able to recover GST/HST on are:

•  Housekeeping expenses
•  Professional/accounting fees
•  Advertising expenses

Note that there are some potentially significant impacts of improper planning when it comes to GST/HST. If you rent out your property for 90% of the time for rental periods of under 60 days, the property could lose its “residential complex” status, which would result in any future sale of the property to becoming subject to GST/HST. Good luck trying to explain that to any potential buyers!

If you decide to reduce or eliminate the rental of the property in the future, it may change status again, to either an exempt long-term rental or back to a personal residence. When this change occurs, you would need to pay GST/HST on the fair market value of the house at the time of this change. In some cases, you may be eligible to apply for a rebate on these taxes.

As you can see, the GST/HST issues of renting as an Airbnb are very complex. I strongly urge you to seek professional advice before you start renting. Note: I will not answer any questions on GST/HST as I am not an expert in this area. I am just making you aware of the issues you must consider.

Income Tax

Any income you earn from renting your home needs to be reported on your tax return and can be classified in one of two ways: rental income or business income. It is very important to always consider the impact renting can have on your Principal Residence Exemption. This is discussed in greater detail below. The characterization of your rental income is largely determined by the number and kinds of services that you provide to your customers. If you rent your home to someone and they only receive the “bare-minimum,” such as light, heat, parking, laundry, etc., this income would typically be deemed as rental income. If, however, you are offering additional services, such as meals, cleaning, or entertainment, you are more likely to be deemed to be carrying on business activities. As Chris told me, "if you want to keep the green, keep it lean".

You can deduct related expenses from the income earned on your tax return. Some of those items include the following:

1. Utilities (light, heat, water, etc.)
2. Maintenance (painting, small repairs, cleaning*)
3. Property taxes and condo fees
4. Internet and cable
5. Home insurance
6. Mortgage interest

*Note: you cannot clean or do repairs yourself and pay yourself $50 an hour for your hard work. Cleaning and repairs are typically only deductible if done by external service providers.

These expenses will need to be prorated based on the number of days of the year in which you hosted guests in the year against the total amount of time you’ve owned the home. Similarly, if you only rent out a portion of your home, you would need to prorate the expenses further to account for the proportion of the home that is used for rental purposes. The space can be prorated based on either the square metres/feet of the home you are renting or based on the number of rooms you rent out. I suggest you base the pro-ration on the square area to avoid any conflict with CRA, so get the measuring tape out!

Impact of renting as Airbnb on your Principal Residence

There are sometimes more significant amounts that you want to claim, such as large repairs or maintenance costs. Given the capital nature of these expenses, you may want to claim Capital Cost Allowance ("CCA"- you may know CCA as depreciation) on these repairs, or maybe on the property itself. While it is tempting to reduce your annual income by making a CCA claim, there are some long-term implications of doing so.

First of all, renting out your property regularly may result in you being considered to have changed the use of the property, which could result in some significant tax consequences. There is a deemed disposition of the property upon the change in use at the fair market value, and the property is no longer considered a principle residence.

Furthermore, claiming CCA against your income will potentially limit or outright prevent you from claiming the principle residence exemption on your home when you decide to sell it. Something to note would be that if you make significant structural changes and there is a significant change in use, CRA will deem the property as income generating.

Final Comments

It is vital that you understand the various complex income tax implications discussed above. I strongly urge you to obtain professional advice before you start renting in order to avoid some costly pitfalls.

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. Please note the blog post is time sensitive and subject to changes in legislation or law.

What Small Business Owners Need to Know - Eligible Capital Property Changes on the Horizon

In the 2014 Federal budget, the government announced it would begin public consultations (consultation is a code word for: we are making changes, but we will consider your thoughts on the matter) into repealing the rules that governed eligible capital property (ECP). They also proposed, subject to these consultations, that the ECP regime would be replaced by a new capital cost allowance (CCA) class.

Two years later, the 2016 Federal budget was released and not surprisingly, the legislation proposes the removal of the ECP regime and the introduction of a new CCA Class 14.1 effective January 1, 2017.

Many of you are probably saying to yourself, what the heck is ECP and why do I even care. Today, I will explain what ECP is and why you as a business owner should care about these changes.

What is ECP?

ECP is essentially “intangible assets” that do not qualify for the CCA rules (CCA is the tax word for depreciation). ECP also includes internally generated assets, such as goodwill, which are not reported on the balance sheet or tax return until there is a disposition of such. In addition to goodwill, some other common examples of ECP are:

• Incorporation expenses

• Customer lists

• Trademarks

• Farm Quotas

• Patents and Licenses with indefinite life

What are the main changes?

The most impactful change will be to Canadian-Controlled Private Corporation’s (CCPC) and how the disposition of ECP is treated subsequent to December 31, 2016, which I will address separately in a bit more detail below.

The way the ECP regime works now is; 75% of any expense for ECP is added to a pool, and each year 7% of the remaining pool can be deducted on a declining balance in the company’s return against income. When ECP is sold, there may be recaptured depreciation which is fully taxable, plus effectively 50% of any resulting gain which is taxable as active business income. The other 50% of the gain goes into the Capital Dividend Account ("CDA"), which can be distributed to the shareholders tax free. See my blog post on the CDA if you are not familiar with this account.

The new rules will allow 100% of any expense for ECP to be included in a new CCA class (14.1), and each year 5% of the remaining pool can be deducted. Rules that currently govern CCA such as the half year rule and recapture will apply to the new 14.1 CCA class. When ECP is sold after December 31, 2016 in excess of capital cost, the resulting gain will be treated as a capital gain (unlike the active business income treatment noted above), such that 50% of the gain is taxable and taxed at the high investment income tax rates. This change will have the largest impact of these new rules.

I know this discussion is technical and complicated, but I need to set forth the new rules. I have an example below that will hopefully bring everything together and clarify the issue.

There are a number of other transitional rules (e.g. pre 2017 dispositions for non-calendar year ends straddling January 1, capital cost determinations) which this blog will not cover due to the complexities involved.

The new rules will allow you to deduct immediately the first $3,000 of incorporation expenses, with anything above the $3,000 going into class 14.1. In prior years only 75% of the expense was allowed and it took years and years to get the tax benefit.

What happens to my current ECP pool after December 31, 2016?

In general terms, whatever your ending ECP pool balance (Schedule 10 of the corporate tax return) is on December 31, 2016 will become the opening balance of Class 14.1 on January 1, 2017. As noted above, there are separate transitional rules for companies that have year ends that straddle January 1, 2017 but in general terms the ending ECP balance will equal the opening Class 14.1.

For any ECP incurred before 2017, the company will be able to use a 7% CCA rate for 10 years, consistent with the deduction rate of ECP that is currently in place. After 10 years the CCA rate will revert back to the 5% rate applicable for Class 14.1. In addition, in order to allow any small balances of pre 2017 ECP to be written off quickly, the Class 14.1 CCA deduction for 10 years will be the greater of $500 and the amount otherwise deductible (i.e. 7% of the pool).

Dispositions of ECP After 2016

As mentioned above, the biggest change going forward for CCPC’s is that for a sale prior to January 1, 2017, the gain is taxed as active business income, and for a sale subsequent to this date, the gain will be taxed as a capital gain. This is best reflected by using an example. So, let’s assume an Ontario CCPC sells goodwill that results in a $200,000 gain.

If the sale takes place on December 31, 2016, $100,000 (50% of the gain) will be taxable to the company as active business income, resulting in taxes owing of $15,000 if the small business deduction can be applied against the income, or $26,500 if the company’s income for the year is already over $500,000.

If the sale takes place on January 1, 2017, $100,000 (50% of the gain) will taxable to the company as a capital gain, resulting in taxes owing of $50,170, a portion of which would be refundable only after a taxable dividend is paid to the shareholder. The immediate taxes owing on this sale are $23,000 - $35,000 higher than if the sale had occurred one day earlier. It is important to note this is essentially a loss of a tax deferral, not an absolute tax cost; as the deferral of tax by retaining funds from the sale in the company is essentially lost under the new rules.

In both of the above scenarios, the other half of the 50% gain is still added to the Capital Dividend account of the company, and available for distribution to shareholders tax free, so no change in that regard. One small advantage to the new rules will be be the date you can make the tax free payment out of the capital dividend account. For sales of ECP before January 1, 2017 you would have to wait until the first day of the following tax year to pay out the capital dividend, whereas the new rules will allow the payment of the capital dividend as early as the day after the sale. 

Asset sales that include ECP will likely prove to be more difficult to negotiate after 2016 due to the higher tax cost, as the seller will be looking for a higher purchase price to cover the additional tax.

It may be prudent, in situations where your current accountant would not have this information, to begin compiling the following information:

• Original cost and date of purchase of any ECP purchased in the past

• Any ECP pool deductions taken from the time of purchase on any assets identified above

This information will assist your accountant in determining the gain on a disposition of ECP that occurs after January 1, 2017.

What planning can be done?

If your CCPC is planning on selling its business in the future via an asset sale or hybrid sale (versus a sale of shares), or selling any ECP of the company, serious thought should be given to completing this sale before January 1, 2017.

If your CCPC has a significant amount of internally generated goodwill, and no external method of sale is available before January 1, 2017, it may be possible to complete an internal reorganization to take advantage of the current ECP rules. This is extremely complicated and before you consider undertaking this type of transaction, you must speak with your accountant/tax advisor to determine if this is a viable option.

With less than 3 months until the transition date, if you think your company may be adversely affected by the new rules, now is the time to speak to your advisors.

I would like to thank Colin Sirr, Manager, Tax, for BDO Canada LLP for his extensive assistance in writing this post. If you wish to engage Colin for ECP tax planning, he can be reached at csirr@bdo.ca

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. Please note the blog post is time sensitive and subject to changes in legislation or law.

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. Please note the blog post is time sensitive and subject to changes in legislation or law.

The Best of The Blunt Bean Counter - The Income Tax Implications of Purchasing a Rental Property

This summer I am posting the "best of" The Blunt Bean Counter while I work on my golf game (or more accurately, my golf game in rain conditions). Today, I am re-posting my most read blog of all-time; a post on the income tax implications of purchasing a rental property. This post has over 300 comments; so many that I have stopped answering questions on this topic. As there are many excellent questions within the 300 comments, I posted a new blog a few months ago highlighting those questions. I called that post, Rental Properties - Everything You Always Wanted to Know, but Were Afraid to Ask.

The Income Tax Implications of Purchasing a Rental Property

Many people have been burned by the stock market over the past decade and find the stock market a confusing and complex place. On the other hand, many people feel that they have a better understanding and feel for real estate and have far more comfort owning real estate; in particular, rental real estate. While both stocks and real estate have their own risks, some proportion of both these types of assets should typically be owned in a properly allocated investment portfolio. In this blog, I will address some of the income tax and business issues associated with purchasing and owing a rental property.

The determination of a property’s location and the issue as to what is a fair price to pay for any rental property is a book unto its own. For purposes of this blog, let’s assume you have resolved these two issues and are about to purchase a rental property. The following are some of the issues you need to consider:

Legal Structure

Your first decision when purchasing a rental property is whether to incorporate a company to acquire the property or to purchase the property in a personal/partnership capacity of some kind. If you are purchasing a one-off property, in most cases, as long as you can cover off any potential legal liability with insurance, there is minimal benefit of using a corporate structure. 

In 2011, in Ontario, there is no tax benefit to purchasing the property in a corporation given the fact that the corporate income tax rate for passive rental income is identical to the highest personal marginal income tax rate, 46%. Given their is no income tax incentive to utilize a corporation, when you include the cost of the professional fees associated with a corporation, in most cases, the use of a corporation does not make sense.

In addition, if the property is purchased in one’s personal capacity, any operating losses can be used to offset other personal income. If the property runs an operating loss and is owned by a corporation, those losses will remain in the corporation and can only be utilized once the rental property incurs a profit.

If you decide to purchase a rental property in your personal capacity, you must then decide whether the legal structure will be sole ownership, a partnership or a joint venture. Many people purchase rental properties with friends or relatives and/or want to have the property held jointly with a spouse. Where it has been determined that the property will be owned with another person, most people fail to give any consideration to signing a partnership or joint venture agreement in regards to the property. This can be a costly oversight if the relationship between the property owners goes astray or there is disagreement between the parties in terms of how the rental property should be run.

One should also note that there are subtle differences between a partnership and a joint venture. This is a complicated legal issue, but for income tax purposes if the property is a partnership, the capital cost allowance (“CCA”) known to many as depreciation, must be claimed at the partnership level. Thus, the partners share in the CCA claim. However, if the property is purchased as a joint venture, each venturer can claim their own CCA, regardless of what the other person has done. This is a subtle, but significant difference.

Allocation of Purchase Price

Once the rental property is purchased, you must allocate the purchase price between land and building. Land is not depreciable for income tax purposes, so you will typically want to allocate the greatest proportion of the purchase price to the building which can be depreciated at 4% (assuming a residential rental property) on a declining basis per year. Most people do not have any hard data to support the allocation (the amount insured or realty tax bill may be useful) so it has become somewhat standard to allocate the purchase price typically 75% -80% to building and 25% - 20% to the land. However, where you have some support for another allocation, you should consider use of that allocation. Typically for condominium purchases, no allocation or, at maximum, an allocation of 10% is assigned to land.

Repairs and Maintenance

If you are purchasing a property and it is not in a condition to rent immediately, typically, those expenses must be capitalized to the cost of the building and depreciation will only commence once the building is available for use. When a building is purchased and is immediately available for rent or has been owned for some time and then requires some work to be done, you must review all significant repairs to determine if they can be considered a betterment to the property or the repairs simply return the property back to its original state. If a repair betters the property, the Canada Revenue Agency’s ("CRA") position set forth in Interpretation Bulletin 128R paragraph 4, is that the repair should be capitalized and not expensed. This is often a bone of contention between taxpayers and the CRA,

CCA

CCA (i.e. depreciation for tax purposes) is a double-edged sword. Where a property generates net income, depreciation can be claimed to the extent of the property’s net income. Generally, you cannot create a rental loss with tax depreciation unless the rental/leasing property is a principal business corporation. The depreciation claim tends to create positive cash flow once the property is fully rented, as the depreciation either eliminates or, at minimum, reduces the income tax owing in any year (depreciation is a non-cash deduction, thereby saving actual cash with no outlay of cash). Many people use the cash flow savings that result from the depreciation claim to aggressively pay down the mortgage on the renal property. The downside to claiming tax depreciation over the years is that upon the sale of the property, all the tax depreciation claimed in prior years is added back into income in the year of sale (assuming the property is sold for an amount greater than the original cost of the rental property). This add-back of prior year’s tax depreciation is known as recapture.

People who have owned a rental property for a long period, sometimes reach a point in time where they have such large recapture tax to pay, they don’t want to sell the rental property. Personally, I do not agree with this position, since it is really a question of what will be your net position upon a sale and are you selling the property at a good price. However, recapture is always an issue to be considered, especially for older properties that have been depreciated for years.

Also, if you have taken tax depreciation on a property and you decide at some point in time to move into the property, you will not be able to defer the gain under the “change of use” rules in the Income Tax Act. I discuss these "change of use" rules in a guest blog "Your principal residence is tax exempt" I wrote for The Retire Happy Blog.

Reasonable Expectation of Profit Test

Previously, if a rental property historically incurred losses for a period of time, the CRA may have challenged the deductibility of these losses on the basis that the taxpayer had no “reasonable expectation of profit”. Fortunately, the CRA's powers with respect to the enforcement of this test have been severely limited. The test has been reviewed by the Supreme Court of Canada and their view is that where the activity lacks any element of personal benefit and where the activity is not a hobby (i.e. it has been organized and carried on as a legitimate commercial activity) “the test should be applied sparingly and with a latitude favouring the taxpayer, whose business judgement may have been less than competent.” Consequently, concerns previously held in respect to utilizing losses from rental properties, even if the properties are not profitable for some period of time, are now mitigated.

Purchasing a rental property requires a considerable amount of thought and due diligence prior to the actual acquisition. Having a basic understanding of the income tax consequences can assist in making the final determination to purchase the rental property.

Bloggers Note: I will no longer answer any questions on this blog post. There are over 300 questions and answers in the comment section below. I would suggest your question has probably been answered within those Q&A. Thanks for your understanding.

The blogs posted on The Blunt Bean Counter provide information of a general nature. These posts should not be considered specific advice; as each reader's personal financial situation is unique and fact specific. Please contact a professional advisor prior to implementing or acting upon any of the information contained in one of the blogs. Please note the blog post is time sensitive and subject to changes in legislation or law.

The Income Tax implications of purchasing a rental property

Many people have been burned by the stock market over the past decade and find the stock market a confusing and complex place. On the other hand, many people feel that they have a better understanding and feel for real estate and have far more comfort owning real estate; in particular, rental real estate. While both stocks and real estate have their own risks, some proportion of both these types of assets should typically be owned in a properly allocated investment portfolio. In this blog, I will address some of the income tax and business issues associated with purchasing and owing a rental property. For a discussion of some of the non-tax issues you should consider in purchasing a rental property, The Wealthy Canadian has posted the first of a two part series on rental properties titled Tangible Assets .

The determination of a property’s location and the issue as to what is a fair price to pay for any rental property is a book unto its own. For purposes of this blog, let’s assume you have resolved these two issues and are about to purchase a rental property. The following are some of the issues you need to consider:

Legal Structure

Your first decision when purchasing a rental property is whether to incorporate a company to acquire the property or to purchase the property in a personal/partnership capacity of some kind. If you are purchasing a one-off property, in most cases, as long as you can cover off any potential legal liability with insurance, there is minimal benefit of using a corporate structure.

In 2011, in Ontario, there is no tax benefit to purchasing the property in a corporation given the fact that the corporate income tax rate for passive rental income is identical to the highest personal marginal income tax rate, 46%. Given their is no income tax incentive to utilize a corporation, when you include the cost of the professional fees associated with a corporation, in most cases, the use of a corporation does not make sense.

In addition, if the property is purchased in one’s personal capacity, any operating losses can be used to offset other personal income. If the property runs an operating loss and is owned by a corporation, those losses will remain in the corporation and can only be utilized once the rental property incurs a profit.

If you decide to purchase a rental property in your personal capacity, you must then decide whether the legal structure will be sole ownership, a partnership or a joint venture. Many people purchase rental properties with friends or relatives and/or want to have the property held jointly with a spouse. Where it has been determined that the property will be owned with another person, most people fail to give any consideration to signing a partnership or joint venture agreement in regards to the property. This can be a costly oversight if the relationship between the property owners goes astray or there is disagreement between the parties in terms of how the rental property should be run.

One should also note that there are subtle differences between a partnership and a joint venture. This is a complicated legal issue, but for income tax purposes if the property is a partnership, the capital cost allowance (“CCA”) known to many as depreciation, must be claimed at the partnership level. Thus, the partners share in the CCA claim. However, if the property is purchased as a joint venture, each venturer can claim their own CCA, regardless of what the other person has done. This is a subtle, but significant difference.

Allocation of Purchase Price

Once the rental property is purchased, you must allocate the purchase price between land and building. Land is not depreciable for income tax purposes, so you will typically want to allocate the greatest proportion of the purchase price to the building which can be depreciated at 4% (assuming a residential rental property) on a declining basis per year. Most people do not have any hard data to support the allocation (the amount insured or realty tax bill may be useful) so it has become somewhat standard to allocate the purchase price typically 75% -80% to building and 25% - 20% to the land. However, where you have some support for another allocation, you should consider use of that allocation. Typically for condominium purchases, no allocation or, at maximum, an allocation of 10% is assigned to land.

Repairs and Maintenance

If you are purchasing a property and it is not in a condition to rent immediately, typically, those expenses must be capitalized to the cost of the building and depreciation will only commence once the building is available for use. When a building is purchased and is immediately available for rent or has been owned for some time and then requires some work to be done, you must review all significant repairs to determine if they can be considered a betterment to the property or the repairs simply return the property back to its original state. If a repair betters the property, the Canada Revenue Agency’s ("CRA") position set forth in Interpretation Bulletin 128R paragraph 4, is that the repair should be capitalized and not expensed. This is often a bone of contention between taxpayers and the CRA,

CCA

CCA (i.e. depreciation for tax purposes) is a double-edged sword. Where a property generates net income, depreciation can be claimed to the extent of the property’s net income. Generally, you cannot create a rental loss with tax depreciation unless the rental/leasing property is a principal business corporation. The depreciation claim tends to create positive cash flow once the property is fully rented, as the depreciation either eliminates or, at minimum, reduces the income tax owing in any year (depreciation is a non-cash deduction, thereby saving actual cash with no outlay of cash). Many people use the cash flow savings that result from the depreciation claim to aggressively pay down the mortgage on the renal property. The downside to claiming tax depreciation over the years is that upon the sale of the property, all the tax depreciation claimed in prior years is added back into income in the year of sale (assuming the property is sold for an amount greater than the original cost of the rental property). This add-back of prior year’s tax depreciation is known as recapture.

People who have owned a rental property for a long period, sometimes reach a point in time where they have such large recapture tax to pay, they don’t want to sell the rental property. Personally, I do not agree with this position, since it is really a question of what will be your net position upon a sale and are you selling the property at a good price. However, recapture is always an issue to be considered, especially for older properties that have been depreciated for years.

Also, if you have taken tax depreciation on a property and you decide at some point in time to move into the property, you will not be able to defer the gain under the “change of use” rules in the Income Tax Act. I discuss these "change of use" rules in a guest blog "Your principal residence is tax exempt" I wrote for The Retire Happy Blog.

Reasonable Expectation of Profit Test

Previously, if a rental property historically incurred losses for a period of time, the CRA may have challenged the deductibility of these losses on the basis that the taxpayer had no “reasonable expectation of profit”. Fortunately, the CRA's powers with respect to the enforcement of this test have been severely limited. The test has been reviewed by the Supreme Court of Canada and their view is that where the activity lacks any element of personal benefit and where the activity is not a hobby (i.e. it has been organized and carried on as a legitimate commercial activity) “the test should be applied sparingly and with a latitude favouring the taxpayer, whose business judgement may have been less than competent.” Consequently, concerns previously held in respect to utilizing losses from rental properties, even if the properties are not profitable for some period of time, are now mitigated.

Purchasing a rental property requires a considerable amount of thought and due diligence prior to the actual acquisition. Having a basic understanding of the income tax consequences can assist in making the final determination to purchase the rental property.

Bloggers Note: I will no longer answer any questions on this blog post. There are 294 questions and answers in the comment section below. I would suggest your question has probably been answered within those Q&A. Thanks for your understanding.

The blogs posted on The Blunt Bean Counter provide information of a general nature. These posts should not be considered specific advice; as each reader's personal financial situation is unique and fact specific. Please contact a professional advisor prior to implementing or acting upon any of the information contained in one of the blogs. Please note the blog post is time sensitive and subject to changes in legislation or law.