Mark Goodfield, CPA, CA, LPA, editor of the popular blog The Blunt Bean Counter, author of Let’s Get Blunt About Your Financial Affairs and a contributing editor to The TaxLetter, lays out some of the major considerations in purchasing and owning rental property.
Some people find the stock market hard to understand and thus have greater comfort owning alternative investments such as real estate, and in particular, owning rental real estate. While stocks and real estate each have their own risks, conventional wisdom suggests that both of these asset classes should typically be owned in a properly allocated investment portfolio. In this article, I will address some of the income tax and business issues associated with purchasing and owning a rental property.
Location, pricing and the current state of repair—or disrepair!—of a rental property are a book unto its own. So, in this article, I will just focus on the income tax issues you need to consider once you have purchased a rental property. (Note: I will not be discussing any GST/HST issues related to the purchase of real estate.)
Rental property ownership: Corporate? Personal/Partnership?
Your first decision when buying 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 most provinces (subject to the first federal Liberal budget), there is little to no income tax benefit to purchasing an investment property in a corporation. The corporate income tax rate for passive rental income is set to ensure there is typically no income tax incentive to utilize a corporation. When you include the cost of the professional fees associated with a corporation, in many cases, the use of a corporation does not make sense.
In addition, if buying an investment property personally, 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.
Buying in a personal, partnership or joint venture capacity
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 between land and building
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 typically be depreciated at four per cent (assuming a residential rental property) on a declining basis per year.
While most people do not have any hard data to support the allocation (the amount insured or realty tax bill may be useful), it has become somewhat standard to allocate the purchase price typically 75 per cent to 80 per cent to building and 25 per cent to 20 per cent to the land. However, since an arbitrary allocation does not have to be accepted by the Canada Revenue Agency, where you have some support for another allocation, you should use that allocation. For high-rise condominium purchases, the typical allocation is often either no allocation to land, or at maximum, an allocation of 10 per cent to land.
Repair and maintenance expense accounting
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 position set forth in archived 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 Canada Revenue Agency.
Capital cost allowance (CCA) for rental property
Capital cost allowance—or CCA, which, as noted above, is considered 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 rental property.
The downside of claiming tax depreciation
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 where they have such large recapture tax to pay that 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 your net position will be upon a sale and whether you are 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, then decide at some point 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.
Reasonable expectation of profit test
Previously, if a rental property historically incurred losses for a period of time, the Canada Revenue Agency may have challenged the deductibility of these losses on the basis that the taxpayer had no “reasonable expectation of profit”. Fortunately, the Canada Revenue Agency’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 its 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 judgment may have been less than competent.” Consequently, concerns previously held in respect to claiming losses from rental properties, even if the properties are not profitable for some period of time, are now mitigated.
Income tax considerations are a part of due diligence
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.
The information is not intended to constitute professional advice and may not be appropriate for a specific individual or fact situation. 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.
The TaxLetter, MPL Communications Inc.
133 Richmond St. W., Toronto, On, M5H 3M8, 1-800-804-8846