Last updated: May 14 2008
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:
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
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.
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.
The following checklist of common expenses should be carefully noted and all receipts retained in case of audit.
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.