bout de papier, Vol. 6, No. 4 (1989), p. 34
For most of us, an investment in real estate, whether it be a home, a cottage or some form of rental property, is our single biggest investment. It’s something we know about — we can see it, walk through it, fix it up or treat it with benign neglect. The date of our monthly mortgage payment is etched on our mind — unless we have pre-authorized payments out of our bank account, and only have to remember each month to cover that cheque! Given the many different forms of real estate, it will be no surprise to anyone that real estate taxation is a wide and varied subject. In this article, I’ll try to cover some of the general tax rules applicable to the purchase of a single rental property by an individual. Thus, the special rules for real estate developers, tax shelter investors, owners of MURB’s and purchasers of a business property will not be discussed.
The purchase of a rental property should generally be compared to other forms of “passive” investment. It is not a “business”: It has more in common with investment in stocks, bonds and so on. Therefore, the main questions that you should ask yourself include:
- How will this property stack up over time as an investment compared to other uses of my money?
- What is the risk?
- What kind of cash flows can I expect while I own the property? Can I afford the cash shortages likely in the early years when the rents don’t cover costs?
- When I sell, will my expected gain provide me with an overall yield higher than I could have obtained in other investments?
- How will my investment be taxed, at purchase, during ownership, and upon disposition?
Purchase In general, all costs associated with buying the property and putting it into rentable condition must be capitalized (i.e. they are not deductible in the year you buy the property). This will include legal fees and expenses, service connections, land transfer taxes, major additions and renovations prior to renting, and so on. The total cost should be allocated between land, building, and equipment (appliances — not the furnace, central air, etc., as these are part of the building). This allocation should be made by you on a fair market value basis that you can sustain with Revenue Canada later on.
Prior to tax reform, the costs of negotiating and obtaining your mortgage (such as appraisal fees, legal fees, standby or mortgage brokers fees, bank fees) were deductible in the same year. From 1988 on, you may only write them off at 20% a year. Good records are essential!
Ownership Period Any rental profits during the ownership period will be taxable to you; conversely, any losses will be deductible from other income.
a) Carrying costs — interest on your mortgage or any other financing you use to acquire or improve the property will be deductible from the rents. If you borrowed, but used only part of the funds on the property, you will have to pro-rate the interest. Property taxes and insurance will also be deductible. If you re-finance, any deduction will be restricted to 20% of financing costs as noted above. Principal payments on your mortgages or loans are not deductible.
b) Operating expenses — utilities, repairs and maintenance, advertising for tenants, property management fees and so on will all be deductible in the same year. Remember that you should report rents as earned and expenses as incurred, not on a cash basis. For example, a three year insurance premium paid at the start of the policy must be pro-rated over the years in question.
c) Capital costs — how do you decide what is capital and what is current (i.e. deductible as repairs and maintenance)? Don’t look to the Income Tax Act — there’s no definition of either! Revenue Canada’s guide to rental income says that “capital expenditures are outlays which usually provide a benefit lasting beyond the current year”. Does this mean that a patching job which you expect to solve your roof leak for three years is not deductible? Of course it’s deductible — and a case can be made that a completely new roof of the same quality as the old one is also a deductible current expense! There is no single rule, and each case must be decided on the particular circumstances.
d) Non-deductible expenses — these would include most travel to and from your property, an office from which to “manage” your single property, or expenses such as personal occupancy of part of your building.
Capital Cost Allowance (“Depreciation”) Buildings acquired after 1987 can only be depreciated at 4% per year. You may not create or increase a rental loss by claiming capital cost allowance. You can, however, reduce a rental profit to nil by claiming capital cost allowance. Capital cost allowance on furniture and equipment leased as part of the property is similarly restricted.
Sale of Your Property When you sell, you could have a capital gain or loss and recaptured depreciation or a terminal loss. While we now have a limited exemption to cover capital gains, any recaptured depreciation will be taxable in the year of sale. You may be able to claim a reserve against capital gains if you had to take back a mortgage or for some other reason didn’t get the full sale price right away. In calculating any capital gain, the adjusted cost base will be the original cost plus any capital costs you were not able to deduct during the period of ownership. Real estate commissions and legal fees on the sale will reduce your capital gain. However, rental losses incurred after 1987, as well as any other carrying charges you have claimed on Schedule 4 in excess of investment income (collectively all these amounts are known as cumulative net investment losses) could reduce your entitlement to the capital gains exemption when you sell. The capital gains exemption is not available to non-residents (deemed residents are acceptable here) and special rules apply to require a prepayment of any capital gains tax.
Conclusion Owning a rental property should be a rewarding experience – in every sense, financial and otherwise! If anxiety about collecting the rents or about what your tenant may be doing to the property is going to keep you awake at night, think again. Perhaps you should invest in bonds or GIC’s instead!
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Originally published in bout de papier, Vol. 6, No. 4 (1989), p. 34. Read the rest of this issue →
