Rental Property Income and Losses
You are planning to purchase [or have purchased] a rental property and anticipate incurring negative cash flows for a number of years. We recommend that we sit down and review together how the rental property will affect your income and deductions.
Generally, subject to certain special rules discussed below, you will incur a rental loss if your rental expenses exceed your gross rental income. Your rental losses can be deducted against your other sources of income, including employment income and other investment income. To the extent that you have any unused rental losses after reducing taxable income to nil in a particular year, the loss may generally be carried back three years or forward 20 years to apply against taxable income in those years, thereby generating a refund (i.e. to the extent of taxes paid on the reduced taxable income).
Rental income must be accounted for on an accrual basis (i.e. rent receivable must be included in income). The following typical expenses are generally deductible from rental income in the year they are incurred:
Accounting and legal fees (other than fees associated with the acquisition of the property);
advertising;
commissions paid to agents to collect rents;
condominium fees;
insurance on the property relating to the period of operation;
interest on money borrowed to acquire the property or to fund operating costs or property improvement costs (you can also deduct interest charges you paid to tenants on rental deposits);
landscaping of grounds around property;
lease cancellation payments;
property taxes;
utilities;
repairs and maintenance (except significant renovations that must be added to the total cost of the property and deducted over-time in the form of CCA (i.e. tax depreciation));
amounts paid or payable to superintendents, maintenance personnel, and others you employ to take care of your rental property;
office supplies;
travel costs;
reasonable motor vehicle expenses if you receive income from only one rental property that is in the general area where you live, you personally do part, or all, of the necessary repairs and maintenance on the property, and you have motor vehicle expenses to transport tools and materials to the rental property. You cannot deduct motor vehicle expenses you incur to collect rents as these are considered personal expenses by the CRA. The motor vehicle expenses the CRA considers to be reasonable depend on the circumstances of your situation.
[Multiple properties: reasonable motor vehicle expenses if you personally do part, or all, of the necessary repairs and maintenance on the properties, and you have motor vehicle expenses to transport tools and materials to the rental properties. Also, you can deduct reasonable motor vehicle expenses you incur to collect rents, supervise repairs, or manage the properties (this applies whether your rental properties are located in or outside the general area where you live). The motor vehicle expenses the CRA considers to be reasonable depend on the circumstances of your situation.]
Expenses you cannot deduct include:
Land transfer taxes, which are instead added to the cost of the property for tax purposes;
repayments of principal on your mortgage on the rental property;
any penalties shown on your notice of assessment or notice of reassessment issued to you by the CRA;
the value of your own labour (for example, if you do repairs or renovations on the property).
Certain other common expenses with special rules for tax purposes are highlighted below.
Soft Costs
Certain expenses that you may incur during a time that the rental property is being constructed or renovated, including interest, legal fees, accounting fees, and property taxes, are referred to as soft costs for tax purposes. Soft costs are generally only deductible as a current expense up to the amount of rental income earned during that period (amounts in excess of the rental income are treated as capital expenditures).
Lease Cancelation Payments
If in a future year you pay an amount to a tenant to cancel their lease, the available deduction is computed as follows: 1) if you made the cancellation payment in the year: Cancellation payment × (Number of days to the end of the year when payment is made)/(Number of days left on the lease), 2) if you made the cancellation payment in a previous year: Cancellation payment × (Number of days in the year left on the lease)/(Number of days left on the lease). For this calculation, the life of the lease (including all renewal periods) cannot be longer than 40 years.
Example: Sarah is a landlord. She paid her tenant $1,000 to cancel a lease on August 18 of the current tax year. The lease was due to expire on December 31 of the following year. When she made the payment, there were 135 days left in the current year and 500 days left on the lease. For the current tax year, Sarah deducts $270 ($1,000 × 135/500), and in the following year, she deducts $730 ($1,000 × 365/500).
Financing Fees
If you make a lump-sum interest payment or incur a fee to re-finance your mortgage at a lower interest rate, the expense must be prorated and deducted over the original term of the mortgage or loan. For example, if the term of your loan or mortgage is ten years and in the third year you pay a fee to reduce your interest rate, the fee is treated as a prepaid expense and is deductible over the remaining term of the loan or mortgage. Similar treatment applies to a penalty or bonus paid to a financial institution to pay off your mortgage loan before it is due.
Certain fees you may have incurred to obtain a mortgage or loan are deductible over a period of five years. Fees subject to this rule include, for example: mortgage applications, appraisals, processing, and insurance fees; mortgage guarantee fees; mortgage brokerage and finder’s fees; and legal fees related to mortgage financing. The amounts are deductible over a five-year period regardless of the term of the loan. Thus, a 20% deduction may be claimed in the year the expenses are incurred, and 20% in each of the following four years. If you repay the loan before the end of the five-year period, you can deduct the remaining financing fees at that time.
Interest
Interest expenses you incur will generally be deductible to the extent that the borrowed funds are used to purchase/fund rental operations. Interest on loans to cover personal expenses are not deductible.
Example: Robert owns and rents a property. During the year, Robert refinances the property to increase the mortgage because he needs money for a down payment on a personal-use cottage. Robert cannot deduct the additional interest on the mortgage against his rental income since the funds are being used for a personal use.
There are various strategies we should discuss that can be employed to maximize the amount of deductible, versus non-deductible, interest you pay.
Renting below fair market value
Expenses/losses are only deductible to the extent that they are incurred to earn income. If, for example, you incur losses because you rent a property to a person you know for less money than you would to a person you do not know, you generally will not be able to claim a rental loss (in particular, the CRA may challenge whether your rental operation is a source of income as opposed to a personal endeavor). You can, however, claim a rental loss if you are renting the property to a relative/friend for the same rate as you would charge other tenants provided you expect to make a profit. If there is any personal element to your rental operation, we should discuss measures that should be taken to ensure that losses may be claimed.
Capital Expenditures and Capital Cost Allowance (CCA)
The cost of your rental property, and cost of certain other items such as furniture and fixtures for the property, are considered “capital” expenditures for tax purposes. You cannot deduct the initial cost of capital expenditures in the calculation of your net rental income for tax purposes. Rather, since these properties wear out over time, you are permitted to deduct the cost over a period of several years; this deduction is referred to as capital cost allowance (CCA) for tax purposes. CCA is akin to the concept of depreciation expense for accounting purposes. The rate of CCA you may claim depends on the type of property and when it was acquired. Capital properties are grouped into different CCA classes, and a specific rate of CCA applies to each class. Normally, similar properties are pooled together in the same class. As an exception, the cost of each individual rental property (i.e. if you purchase a second property) must be included in a separate CCA class.
For most assets, the declining balance method is used to calculate deductible CCA each year. Under this method, the applicable CCA rate is applied to the capital cost of the property, and over the life of the property, the rate is applied against the remaining balance. The remaining balance declines each year that you claim CCA. In the year a property is acquired, you can only claim CCA at half the normal rate (referred to as “the half-year rule” for tax purposes).
Example
Last year, James bought a rental building for $500,000. On his tax return for that year, he deducted CCA of $10,000 in respect of the building in computing his rental income ($500,000 × 4% × 50%). This year, James can deduct $19,600 of CCA on the remaining balance of $490,000.
You do not have to claim the maximum amount of CCA available in any given year. This may be relevant, for example, if you do not earn income from other sources in a particular year.
If you sell your rental property in a future year for more than you paid for it, in the year of disposition, you generally have to include an amount in your rental income equal to all previous CCA deductions claimed on the property (the so-called “recapture” rules are designed to ensure that a taxpayer includes in income and pays tax on any CCA that the taxpayer might previously have claimed as a deduction from income but which is “recovered” upon the disposition of the asset). Also, to the extent that the net proceeds from the sale exceed the amount you paid for the property, half of this gain is taxable (such a gain is referred to as a “capital gain” for tax purposes).
In addition to the cost of acquiring your rental property, the cost of repairs and renovations to the building may either be deductible in the year incurred as a current expense, or may be classified as a “capital” expenditure for tax purposes. Capital expenditures are added to the cost of the property and available deductions are limited to those provided for under the CCA rules. Very generally, renovations and repairs that extend the useful life of your property or improve it beyond its original condition are considered capital expenditures. The question of whether a particular expenditure is capital in nature or is currently deductible can be complex. If you are unsure of the nature of an expense incurred, I can send you some general guidelines for distinguishing between a capital and current expense. Before incurring a large expense, we should discuss the expected tax consequences.
The amount of CCA that may be claimed on rental properties is restricted. The limit is intended to prevent taxpayers from sheltering other sources of income with losses created by CCA on a rental property. Per this special rule, you cannot deduct CCA that would otherwise be available if the amount claimed increases your rental loss for a year.
Example
During the current tax year, Amy bought a house to use for rental purposes. For CCA purposes, the building is classified as Class 1, which has a depreciation rate of 4%. It is her only rental property. The total cost was $390,000 (the sum of the $375,000 total purchase price plus $15,000 total expenses connected with the purchase). The details are as follows:
Building value (Class 1) $ 285,000
Land value + $ 90,000
Total purchase price = $ 375,000
Expenses connected with the purchase
Legal fees $ 5,000
Land transfer taxes + $ 10,000
Total fees = $ 15,000
Amy’s rental activity is reported on a December 31 year-end basis. Her rental income was $16,000 and her rental expenses were $12,000. Therefore, her net rental income before deducting CCA was $4,000. Amy wants to deduct as much CCA as she is permitted.
Before Amy can determine the total amount of available CCA, she must calculate the capital cost of the building. Since land is not depreciable property, she has to calculate the part of the expenses connected with the purchase that relates only to the building. To do this, she uses the following formula:
Part of the fees Amy can include in the building’s cost = Building value × Expenses
Total purchase price
= $ 285,000 × $ 15,000
$ 390,000
= $ 10,962
This $10,962 represents the part of the legal fees and land transfer taxes that relates to the purchase of the building. The remaining $4,038 relates to the purchase of the land. Therefore, the capital cost of the building is:
Building value (Class 1) $ 285,000
Related expenses + $ 10,962
Capital cost of the building = $ 295,962
The cost of the land for tax purposes (referred to as the “adjusted cost base”) is $94,038 ($90,000 + $4,038) (Note that + $15,000 - $10,962).
Amy purchased the rental property during the current year. Therefore, she is subject to the so-called CCA “half-year rule”.
Her net rental income before CCA is $4,000. Amy cannot claim CCA for more than $4,000 because she cannot use her available CCA to create a rental loss. This is the case even though she would otherwise be entitled to claim $5,919 [($295,962 × 50%) × 4%]. Therefore, she claims CCA of $4,000, reducing her rental income to nil.
[Since you own more than one rental property, you are required under the tax rules to calculate your overall net income or loss for the year from all your rental properties before claiming CCA. Combine the rental income and loss from all your properties, even if they belong to different CCA classes. This also applies to furniture, fixtures, and appliances that you use in your rental building. You can claim CCA for these properties, the building, or both. However, you cannot use CCA to create or increase a rental loss ]. This limit is intended to prevent taxpayers from sheltering other sources of income with losses created by CCA related to rental property.
Example
Jack owns three rental properties. Two of these properties are Class 1 buildings and one is a Class 3 building. All the buildings contain Class 8 appliances. Jack’s net rental income from these properties is as follows:
Net rental income
Building (or loss)
1 (Class 1) $ 10,000
2 (Class 1) + $ 2,000 (Class 1 includes most buildings acquired after 1987)
3 (Class 3) + ($ 14,000)
Total = ($2,000)
Jack has an overall net loss of $2,000. Since he is not allowed to increase his rental loss by claiming CCA, he cannot claim any CCA on his rental buildings or appliances.
Forms of Rental Property Ownership [If the property has not yet been purchased]
We should sit down and discuss the structuring of your planned rental property purchase, including from a financing [See Letter GYTDCPA.com-Interest Deductibility - Rental Properties] and ownership perspective.
For example, you may want to consider possibly owning the property jointly with another person, such as your spouse or child. Such an ownership structure would allow for significant tax savings through income splitting. Notably, the CRA has indicated that it will not apply the punitive Tax on Split Income (TOSI) rules to rental income earned on a rental property (or to capital gains realized on the disposition of such properties) that is held by related individuals in co-ownership in cases where the TOSI would apply if the property were instead held through a corporation, partnership, or trust. Thus, joint-ownership may provide for a means of income splitting, which can lead to significant tax savings depending on the circumstances.
For more information, please contact info@gytdcpa.com or 1 844-GYTD-CPA
GYTDCPA.com-Rental Property Income and Losses
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