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 Income Tax Implications of Selling U.S. Real Estate

Many Canadians own U.S. real estate, especially winter vacation properties. If you own such a property, the income tax consequences can be very complex. Some people erroneously think they are subject to double tax on the sale of their U.S. property, which is not true. Today I will review some of the issues

in relation to the sale of a U.S. property.

Let’s assume you purchased your U.S. vacation property for $200,000 USD several years ago when the exchange rate was $1.10. Thus ignoring legal and other acquisition costs, your Canadian cost base of the property is $220,000 Cdn. Let’s also assume you have just sold your Miami property for $325,000 USD or approximately $420,000 Cdn.

U.S. Withholding Tax Issues

I am not a U.S. income tax specialist, so if you are selling, confirm the following with a U.S. accountant. However, as I understand the process, one of the first things you need to do is obtain a US Individual Taxpayer Identification Number (ITIN), if you don't already have an ITIN or Social Security Number. The ITIN is obtained by filing a Form W-7, and the application is generally filed concurrently with the first U.S. federal tax form you are required to file, which could be either a tax return or a withholding tax form.

If you sell your vacation property for less than $300,000 USD and the buyer intends to use the property as a “residence” for more than half of the time it is used in the 2 years after purchase, you should be able to obtain an outright exemption from any tax withholding. The buyer would simply be required to sign an affidavit as to their intended use of the property.

If you sell for more than $300,000 USD, you will generally be subject to a 10% FIRPTA withholding tax on the gross proceeds. In this example, the tax would be $32,500 USD. But this is not the final determination of tax. A 1040NR U.S. non-resident tax return should be filed to report the actual gain. You can apply the $32,500 USD withholding tax against any tax owing or if your actual U.S. tax liability is less than the amount withheld, you may be entitled to a refund.

However, there is another means to potentially reduce or eliminate the withholding tax. On or before the closing date, one can file an application for a withholding certificate via Form 8288-B. This would reduce the withholding tax from 10% of the gross proceeds to 20% of the actual capital gain (which is the theoretically maximum amount of tax that could be owing). If the certificate is not received by the closing date, the transfer agent or lawyer handling the sale would hold the 10% default tax in escrow until such time that the certificate is received from the IRS, at which point the reduced withholding (if any) would be remitted to the IRS, and the excess funds would be released to the seller.

U.S. Tax Filing Issues

You must file a U.S. 1040NR to report the disposition of your property, regardless of whether or not income tax was withheld, or whether the property was sold at a gain or a loss. Continuing with our example, you would report a capital gain of $125,000 USD ($325,000 USD proceeds less $200,000 USD cost) on the U.S. tax return. If we assume the actual U.S. income tax owing is $15,000 USD (just an assumed tax number for this example), you would receive a refund from the IRS of $17,500 USD ($32,500 USD withholding less $15,000 USD tax owing).

As noted above, many Canadian think they are double taxed. That however is not the case. Any U.S. tax paid becomes eligible for what is known as a foreign tax credit (FTC) in Canada. The final result should be you never owe double tax, but that you are taxed only once, albeit at the higher rate of the two countries.

Canadian Filing Issues

As a Canadian resident, you are taxed on your worldwide income. For Canadian tax purposes, you would have a capital gain of $200,000 Cdn ($420,000 Cdn proceeds less $220,000 Cdn cost). Let’s assume the income tax on this capital gain is $50,000 Cdn. On your Canadian return you will claim a FTC of $20,000 Cdn (rounded equivalent of $15,000 USD actual US tax) against the $50,000 Cdn and as consequence, you will owe an additional $30,000 Cdn in Canadian income tax.

If you add the US tax paid ($20,000 Cdn) to the $30,000 Cdn actual Canadian income tax, you will note that you will have paid $50,000 Cdn in combined tax to the IRS and the CRA. The $50,000 Cdn in total tax is the same amount as the capital gains tax in Canada. So you have not paid tax twice, just once at the higher Canadian tax rate.

The sale of a U.S. property is very complex; please consult a US and/or Canadian tax advisor before you sell to understand the compliance procedures and income tax consequences of your property sale.

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.

20 Things I Don’t Understand About Income Tax

Rob Carrick recently wrote a great column in The Globe & Mail entitled, “20 things I don’t understand about personal finance”. The article caused me to smirk and chuckle several times. As they say, imitation is the sincerest form of flattery, so here are the top 20 things I do not understand about income tax:

1. Why can’t spouses file joint income tax returns as is permitted in the United States? It would equalize income tax rates, simplify our tax system, reduce the administrative time required to prepare and process personal income taxes and reduce the amount of paper the Canada Revenue Agency ("CRA") receives each year.

2. Why are parents only allowed a transfer of $5,000 of their child’s unused tuition, education and book credits? The parent is often the one who paid the costs of tuition, why is the credit transfer restricted. At a minimum, this cap should be re-evaluated in the wake of rising tuition costs.

3. Why people are so consumed with saving income tax that they buy tax shelters of dubious nature? There are numerous shelters or schemes out there that purport to reduce income taxes significantly. People are so hungry to reduce their taxes that they forgot their common sense – if it sounds too good to be true, it probably is.

4. Why child care expenses must be claimed by the lower income spouse? The motivation behind the child care deduction is to get people with children back to work to help drive the economy. Who’s to say which spouse was the spouse that was enabled to head back into the work force by hiring child care?

5. Why so many people ask for their RESP tax deduction receipt? Receipts aren’t necessary since the contributions are not tax deductible.

6. Why when one spouse has a tax refund and the other owes money, you can’t net the refund and tax payment against each other? Again, this would simplify our tax system and reduce the administration and paper work for the CRA.

7. Why people are loathe to realize a capital gain on an investment because they will have to pay income tax on the gain (which by the way, will be subject to tax at maximum rate of 23%)? Often individuals wait too long before selling and end up converting what would have been a capital gain into a capital loss (case in point: individuals who held shares of Nortel too long because they did not want to pay the income tax on the inherent gain). I have a whole blog on this topic upcoming.

8. Why do so many people think they can contribute the maximum RRSP limit to both their spousal RRSP and their own RRSP? It is one RRSP limit per person, regardless of the number of RRSPs contributed to.

9. Why people complain about income tax preparation fees, which help reduce the risk of costly potential future re-assessments, yet they are willing to "blow" thousands of dollars on investments in ridiculous companies or options trading they heard about on the radio without blinking an eye? 

10. Why don’t people who can deduct their car expenses, not note their odometer reading on January 1st and December 31st of each year. This would provide them with at least the total km driven in a given year, even if they are not willing to keep log books? The CRA has relaxed their administrative position concerning log books recently, but I still think there is no substitution for a log book and at minimum, noting your odometer readings at the beginning and end of each year.

11. Why the withholding taxes on RRSPs are graduated? Withdrawals up to $5,000 are subject to a 10% withholding tax; withdrawals between $5,001 and $15,000 are subject to a 20% withholding tax; and withdrawals of $15,001 or greater are subject to a 30% withholding tax. These graduated rates often cause significant income tax owing in April since the size of the withdrawal has no correlation to the taxpayer’s marginal income tax rate. All withdrawals should be subject to higher withholding rates (or withholding at the highest marginal tax rate) to prevent this issue.

12. Why does the CRA constantly send information requests for documentation to support child care claims in relation to nannies? Taxpayers are required to report the nannies social insurance number when claiming a child care expense. All that is required by the CRA is to match the social insurance number to the T4 filed by the employer for the nanny. The CRA has other programs which match items in a person’s tax return to a T-slip, why can’t they include this?

13. Why do people pay no attention to the RRSP contribution limit information on their income tax assessments when planning their RRSP contributions for the year? An individual’s RRSP contribution limit for the upcoming year is printed right on the Notice of Assessment for the prior year. It is also available on-line assuming that you register for on-line access on the Canada Revenue Agency’s website.

14. Why don’t people create a file folder for charitable donations they make during the year? If a donation is made online, they can print out the confirmation at the same time and replace the confirmation with the actual online receipt when received. Alternativey, if a cheque or pledge is made, make a copy and replace that copy when the actual receipt is received in the mail. By doing such, at year end it will be clear which donation receipts are missing and have to be chased down.

15. Why do people have money in non-registered accounts but yet they have not fully funded their TFSAs? Just transfer $5,000 each year, non-taxable is always better than taxable.

16. What do post-secondary aged children have against printing out their T2202A tuition receipts for their parents without being admonished? They are now at the age where they are supposed to be considered responsible adults – they should act like one.

17. Why do people who buy stocks not create a spreadsheet to track the cost (adjusted cost base) of the stocks purchased? In addition, when stocks are inherited from parents or grandparents, why not note the value reported on the parent’s or grandparent’s terminal income tax return so the cost base is not lost. You wouldn’t believe the number of times that shares have been passed down from one generation to the next where the recipient has no idea of the actual cost base.

18. Why do people transfer assets to try and save probate taxes without understanding the consequences for income tax. See my blog on probate taxes for a discussion of some of the possible detrimental income tax consequences when tranfers are made blindly for probate purposes.

19. Does the public transit credit or the children’s fitness/activity credit really incentivize anyone to use public transit or put their child in a sports/activity program? The tax benefit from these credits is so small. If the government really wanted to advocate these behaviours or activities there are better ways to do this than offer petty tax credits.

20. Should the labour sponsored funds tax credit be more appropriately called the convert $5,000 and turn it into a $1,000 credit? Enough said.

I am sure I could come up with another list of 20 plus things I don’t understand about income tax, but I will leave that for another blog for a rainy day.

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.

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.