Real estate has been a hot investment area in Canada for quite some time now due to favorable economic conditions, immigration, and historically low interest rates. Canadians who have taken advantage of these conditions are sometimes confused about the measures they can take to reduce their tax burden.Here are some tax tips addressing several typical areas of confusion:
To depreciate or not to depreciate
Depreciation, or for income tax purposes Capital Cost Allowance (CCA) can be an effective way to shelter your real-estate income from current taxes by transferring your obligation to future tax years. CCA works by amortizing a portion of the cost of your rental property against your rental income, generally 4% of your building’s cost on a declining basis year over year.
CCA is an election, meaning that it is the taxpayer’s choice whether or not to use it. The drawback to CCA is that it is recaptured in the year you sell your property, meaning that the historical CCA you’ve taken will be added back on income account to your tax return if you sell the property for anything more than your current un-depreciated capital cost (i.e. the cost of your property less the CCA claimed on prior tax returns).
This recapture can have a negative impact on your taxes in the year of sale so some planning around this election is required. Generally, if you plan on holding the income property for a very long period of time then taking CCA to reduce your rental profits to zero will almost always be advisable.
However, if you plan on selling your property in the near future you should attempt to estimate if your potential recapture will push you into a higher tax bracket, thereby reducing the current effectiveness of the CCA claim. You may also want to consider forfeiting CCA in years where your overall taxable income is low thereby allowing you to claim higher CCA in subsequent years when your marginal tax rate is higher. For more information on CCA see the CRA’s Guide T4036, Rental Income.
Documents, documents, documents
As far as the Canada Revenue Agency is concerned, if your expense transactions are not documented then they may as well not exist. When you own an income generating property it is your responsibility to keep adequate records and supporting documents in an organized fashion. Records would be the accounting information supporting the final reporting on your tax returns. Supporting documents would provide evidence of the transactions that make up your final accounting records.
Contrary to popular belief, simply maintaining banking and credit card statements is not always considered adequate supporting documentation. Original contracts, purchase receipts, and other documents should be maintained. In addition, if you are claiming auto related expenses a detailed log of your driving should be maintained outlining the dates of travel, the kilometres travelled, and the reason for travel (it must be to support the production of your rental income). My suggestion is always: If in doubt, save it. The more detailed your back-up, the more likely it will pass the scrutiny of a CRA review or audit. For more information on keeping records and allowable expense see the CRA’s guides: RC4409 Keeping Records andT4036 Rental Income.
Flipping a Property for Capital Gains?
Thinking of flipping a property and reporting the profit as a capital gain? You may want to think again. Capital gains are generally favorable to business or property income for tax purposes because of the fact that only half of your capital gains are subject to income tax. While the sale of a property held for the purpose of generating rental income would normally be considered a capital gain, this is not always a black and white scenario.
Use the analogy of an apple tree: An apple farmer purchases an apple tree in order to grow and sell apples. The apples are her inventory, while the tree is her capital property. When the farmer sells the apples she is generating business income, but if at some point down the road she decides to sell the tree, she is selling a capital property. If she makes a gain on the sale of the tree that would be a capital gain and taxed at only half her marginal tax rate. The same can be said for an income producing property. If you were to buy an income producing property, rent it out for a decade, profit during that rental period, then eventually sell the property at a gain, the rental profits would be taxed at the full rate and the gain on sale would most likely qualify as a capital gain (taxed at half your marginal rate).
The same cannot be said for short term property flips. When buying or selling a property on a short term basis for a profit (say buying, renovating, and then flipping) the CRA may consider the gains to be a type of business income rather than capital, thereby taxing the full gain at your marginal tax rate. Why is this? The law distinguishes between properties explicitly bought to generate rental income and those bought to profit on a sale. The former would normally be considered capital property to the taxpayer while the latter would be considered a type of business related inventory or more specifically an “adventure in the nature of trade.” While there are no concrete rules on whether a transaction is on capital account or an adventure in the nature of trade there are several indicators that the CRA and courts would take into consideration. Among these considerations are:
- Whether the property was bought and sold in a manner similar to a dealer in that property
- Whether the taxpayer has developed a pattern of buying and selling properties with short holding periods
- Whether or not the taxpayer’s intentions were consistent with a business transaction or adventure in the nature of trade.
The determination of whether or not the sale of a property is a capital gain or business income is complex and has been played out in the courts on numerous occasions.
Source: Fabio Campanella, Special to Financial Post
Fabio Campanella is a partner at Campanella McDonald LLP – Chartered Accountants. Fabio@campanellamcdonald.com