Hot Real Estate Market a Fertile Ground for Rentals

Renting out a property? Know the tax consequences? If not, this might be a good time for a tax refresher, especially if you are a rookie landlord or find yourself in this position quite by default! Income received from the rental of property is generally considered to be "income from property" rather than income from an active business, which means that it is considered to be "passive" rather than "active" in nature. The result is that tax deductibility of certain expenses can be restricted, and some special rules must be followed.

Those in the business of leasing boats or equipment, for example, would report earnings as income from a business. This would also be true where the rental of assets is a minor part of another larger business, or where the enterprise provides a myriad of services other than the rental of property, such as the business of running a hotel.

Income resulting from the rental of a home, apartment, condo, etc., is clearly rental income, however, and is reported on line 126 of the tax return. It is also reported in detail on Form T776 Statement of Real Estate Rentals. Unlike most unincorporated business ventures, which can generally choose a non-calendar fiscal period, net rental income must be reported on a calendar year basis. There are several other differentiating factors between the reporting of the two income types, as illustrated below:

  • Net profit from rental income does not qualify for Canada Pension Plan contribution purposes, as business income would.
  • Capital Cost Allowance (CCA) may be taken on capital assets related to rental property, as it can be on business property. The maximum CCA claim is subject to the regular CCA rules (i.e. half-year rule, etc.). However, there is a further restriction on the maximum CCA claim on rental properties. A rental loss cannot be created, or increased, by claiming CCA on rental assets. This rule applies collectively to all rental properties owned by the taxpayer, not to each individual property. Thus a taxpayer who has net rental income after CCA on one property may claim CCA on another property to create a loss on that property so long as there is no net rental loss on the properties collectively.

Buildings Costing over $50,000. There are some additional CCA rules pertaining to rental buildings that cost more than $50,000. Where these buildings were acquired after 1971, they must be placed in separate CCA classes. This means that when a rental building is disposed of, the undepreciated capital cost of another property cannot be used to shelter a recapture of CCA on the one sold. If each building was not required to be in a separate CCA class, recapture could be avoided by continuing to hold additional properties.

Terminal Loss. If a building suffers a decline in value, a terminal loss may arise. This occurs if a rental property is sold for an amount less than the remaining undepreciated capital cost (UCC). The underclaimed CCA must be deducted (as a terminal loss) in the year of disposition - however, note the additional restrictions below. For audit purposes, there must be a reasonable expectation of profit in the venture to allow rental loss deductibility against other income of the year.

Land. Land is not a depreciable asset, and so in the first year a property is acquired, the value of the land must be separated from the value of the building. This can generally be ascertained by looking at tax assessments or legal documents.

Sale of Land and Buildings

When the taxpayer disposes of a rental property, proceeds and outlays and expenses must be allocated separately to the land and to the buildings (and any other depreciable property). Capital gains may occur on the land and/or the building as well as recapture on the building. A capital loss may occur on the land and a terminal loss on the building.

However, a special rule applies when the proceeds allocated to the land exceed the cost of the land and the proceeds allocated to the building are less than the UCC of the building. In this case, the allocation is adjusted so that the lesser of

  • the gain on the land and
  • the loss on the building

is added to the proceeds from the disposition of the building and subtracted from the proceeds of disposition of the land. This rule is to ensure that the taxpayer is not able to include in income both a capital gain that is one-half taxable and a terminal loss which is 100% deductible.

Mortgage foreclosure

When a taxpayer purchases a rental property and subsequently loses the property as a result of a mortgage foreclosure, the balance of the outstanding debt is considered to be the proceeds of disposition of the property. The result will normally be a capital loss but in circumstances where debt, including accrued interest exceed the cost of the property, a capital gain may result.

Partnership vs. Co-ownership

When two or more taxpayers own a rental property jointly, it is necessary to determine whether they own the property as co-owners or as partners. Generally when two or more individuals, such as spouses own a rental property as an investment, they will be considered to be co-owners. The CCA restriction noted above applies separately to rental properties owned by a partnership and to rental properties owned by the taxpayer (either exclusively or as a co-owner). CCA on partnership property is claimed by the partnership, so that the income allocated to the partners is already net of any CCA deduction. Co-owners may each make different CCA claims in respect of the same rental property.

Common Rental Expenses

Most expenses in order to earn rental income will be deductible in the year paid. However, some exceptions apply.

  • Expenses must be matched to the rental income. For example, if the taxpayer pays insurance in advance, only that portion of the insurance that relates to the rental period may be deducted.
  • Repairs that improve the property beyond its original condition or the addition of new appliances or equipment are considered to be capital expenditures and must be deducted over the life of the asset created using Capital Cost allowance.

The following checklist of common expenses should be carefully noted and all receipts retained in case of audit.

  • Advertising ñ Amounts paid to advertise the availability of the rental property are deductible.
  • Insurance ñ Cost of insurance coverage for the year is deductible. If the insurance is paid in advance, claim only the portion that applies to the rental year.
  • Interest ñ Interest on a mortgage to purchase the property plus any interest on additional loans to improve the rental property may be deducted. However, if an additional mortgage is taken out and the proceeds are used for some other purpose, the mortgage interest is not deductible as a rental expense. If the mortgage funds were used for another investment, then they may be deductible as carrying charges. Other charges relating to acquisition of a mortgage are not deductible in the year paid but amortized (under S. 20(1)(e)) over a five-year period starting at the time they were incurred.
  • If the interest costs relate to the acquisition of depreciable property, the taxpayer may elect under S. 21(1) to add the interest to the capital cost of the asset rather than deduct it in the year paid.
  • Maintenance and Repairs ñ The cost of regular maintenance and minor repairs is a deductible expense. For major repairs, it must be determined if the cost is a current expense or capital in nature.
  • Management and Administration Fees ñ If the taxpayer paid a third party to manage or otherwise look after some aspect of the rental property, the amount paid is deductible.
  • Motor Vehicle Expenses ñ If the taxpayer owns only one rental property, then motor vehicle expenses to collect rent are not deductible. CRA considers these to be a personal expense. However, if the taxpayer personally makes repairs to the property then the cost of transporting tools and materials to the property may be deducted.
  • If the taxpayer owns rental properties at two or more sites away from the taxpayer's place of residence then CRA will allow motor vehicle costs to collect rent, supervise repairs or otherwise manage the properties.
  • Office Supplies ñ supplies needed to earn rental income are deductible
  • Legal, Accounting and Other Professional Fees ñ Legal fees to prepare leases or to collect rent are deductible. Legal fees to acquire the property form part of the cost of the property. Legal fees on disposition are outlays and expenses which will reduce any capital gains on the sale. Accounting fees to prepare statements, keep books, or prepare the tax return are deductible.
  • Property Taxes ñ Property taxes applicable to the period when the rental was available for rent are deductible.
  • Travel Costs ñTravel costs do not include the cost of accommodation, which CRA considers to be a personal expense.
  • Utilities ñ The cost of light, heat, water, etc. paid by the landlord and not reimbursed by the tenant are deductible. Amounts charged to tenants are deductible if the amount paid by the tenants is included in rental income.
  • Other ñ the following are some miscellaneous costs that may be deducted:
  • Landscaping costs may be deducted in the year paid;
  • Lease cancellation payments ñ deduct that portion of the payment that relates to the period of the cancelled lease in each year;
  • Condominium fees applicable to the period when the rental condo was available for rent may be deducted;
  • Renovations made or equipment purchased to make the rental property accessible to individuals with a mobility impairment may be deducted.

Capital vs. Current Expenditures

If an expenditure extends the useful life of the property or improves upon the original condition of the property, then the expenditure is capital in nature. A repair that returns the property to its original state, such as replacing the carpet, is a current expense. Expenditures that are capital in nature must be added to the undepreciated capital cost of the asset improved.

Rentals to Family Members

S. 18(1)(a) of the Income Tax Act precludes the taxpayer from deducting any expense that is not made for the purpose of gaining income from business or property. Therefore, when a taxpayer rents a portion of his or her home to a family member for a nominal rent and the purpose of the arrangement is not to earn income, then the taxpayer may not claim a rental loss by deducting expenses. In this case, the taxpayer need not include the rent in income.

The article above was excerpted from The Knowledge Bureau's EverGreen Explanatory Notes. When it comes to questions about taxes, we make you smarter!© To subscribe, click here.