Canadian investors have a long history of acquiring real estate for rental purposes for both income and capital appreciation potential. In this second article of a two-part series, we discuss some of the common tax considerations for Canadian resident individuals who own, or are considering the purchase of, rental and investment properties. Please note that this summary may not apply to non-residents, corporate investors, or real property located outside of Canada.
We will highlight the following topics: how rental income is taxed, deductibility of costs incurred for maintaining, renovating, and building rental properties, tax implications on disposition, and a brief overview of other taxes and fees to consider.
Tax rates and common deductions for rental income
When you earn rental income, you must disclose that income on your tax return. If you are a co-owner in the property, you will report only your portion of the income. This income is taxed at your marginal rate in a manner similar to interest income. In Alberta, these rates can range from 25% to as high as 48% in 2019.
Only your “net” rental income is taxable. In most cases, you can reduce your taxes by deducting the expenses you incurred for the purpose of earning rental income. Common deductible expenses include property taxes, insurance premiums, condo fees, utilities and advertising. You can usually deduct mortgage interest, as well, but the principal portion of mortgage payments is not deductible. You should take all of these expenses into account when determining the profitability of your investment.
You may also consider claiming capital cost allowance (or “CCA”) against your building and other capital assets used for earning rental income, like appliances and tenant improvements. CCA is a tax deduction similar to depreciation, which allows you to deduct the cost of your capital investment over the course of a number of years. However, as we will discuss below, the CCA deductions that you claim will often be reversed and included in income at the time of sale. In many cases, CCA deductions are a valuable tax deferral, rather than a true tax savings. Before claiming CCA on a rental property, you should consult with your tax advisor. Also, consider reviewing Part 1 of this series to understand how it impacts your ability to claim the principal residence exemption on rental properties.
If your rental expenses exceed your rental revenue in a given year, you will have a rental loss. Rental losses are generally deductible against your other sources of income if the expenses were incurred with a reasonable expectation of profit. A rental loss may occur, for example, in a year where a tenant moves out and the property is vacant for a period of time until a new tenant can be secured. There are some limits on claiming rental losses, however. CCA deductions cannot be used to create or increase a rental loss. Additionally, where rental losses are incurred consistently or due to rent being charged below fair market value to a family member, those rental losses may not be deductible against your other sources of income.
Maintenance versus capital improvements
Not all expenses are deductible against your rental income, even if they clearly relate to your property. The Canada Revenue Agency (“CRA”) draws a distinction between “current” expenses, which are deductible, and “capital” expenses, which are non-deductible.
A capital expense usually refers to an expense that has a lasting benefit or overall improvement to your property beyond its original state. For example, you would not ordinarily be able to deduct the cost of replacing your roof, since the benefit is enjoyed over a period of time. Adding a sunroom or deck to your home is also typically a capital expense, since it is an improvement to the overall property. Although these types of expenses are not deductible, they do still have some tax benefit. Most capital expenses are added to your tax cost of the property. This will often allow you to claim the expense over the course of several years as a CCA deduction, effectively allowing you to claim depreciation against the improvement.
In contrast, a current expense usually refers to an expense designed to maintain, repair, or otherwise restore the property to its original condition, or an expense that is consumed without a lasting benefit. While replacing your fence might be a capital cost, the cost of sanding and repainting an old fence is likely a current expense, since it is simply repairing or maintaining your existing property. Property taxes are also a current expense, since they have no lasting benefit to the property. Current expenses should be deductible in the year you incur the expense, rather than spread over time like a capital expense.
It is not always clear whether an expense is current or capital in nature. Some simple maintenance or repair jobs can cross the border into being a capital improvement or renovation. Re-wiring a home, for example, could be a current expense in some cases and a capital expense in others. You should consult with a qualified tax advisor when you carry out repairs, maintenance, or renovation on an investment property to ensure you claim the proper tax treatment.
Construction, major renovations and soft costs
Some taxpayers are surprised to discover that even simple current expenses like mortgage interest may not be deductible when your rental property is in the process of construction or renovation. For example, if you acquire a fixer-upper home with the plan to renovate it and lease it to tenants, the tax treatment will be different during the period you renovate the property. During that time, your ability to deduct so-called “soft costs” like mortgage interest, professional fees and property taxes may be restricted or denied entirely, being treated as a capital cost instead. The period of construction or renovation is considered complete once the project is finished, or once you have leased substantially all of the building space that was under construction or renovation, even if some of the project remains incomplete.
The rules surrounding soft costs can be difficult to interpret. The general rule is that soft costs that relate to the ownership of land are typically required to be treated as a capital cost. Soft costs relating solely to the construction or renovation of a building may be deductible, but usually only to the extent of your rental income during the renovation period. That is, even where soft costs are deductible, they cannot be used to create a loss for tax purposes during the period of construction or renovation. Ensure you tell your tax advisor about any renovations or construction so that expenses are reported correctly.
Sale of rental property
In most cases, the principal residence exemption is not available for rental properties, so you should expect to pay tax on any capital gain realized on the sale (for some exceptions see Part 1 of this series). The amount of your capital gain is usually the sale price of the property, less the amount you originally paid to acquire it, the costs you incurred to sell the property and the cost of your historical capital improvements. Half of that gain is included in your income and is taxable at your marginal rate.
As mentioned above, many taxpayers claim CCA deductions to offset their rental income. If you have done so, you may have additional tax to pay upon sale. CCA is intended to give you credit for the reduction in your property’s value over time due to wear and tear, but property values for real estate often increase, instead. As a result, CCA deductions are often just a tax deferral: you reduce your taxable income when you claim CCA, but you add it back to income as “recapture” if your sale price is higher than the tax-depreciated value of the property. This recapture is taxable as regular income at your marginal tax rate. You may wish to have your tax advisor prepare a tax estimate in advance of selling your rental property to ensure you understand the amount of after-tax cash you will receive on a sale and to avoid an unexpected tax surprise.
Other taxes and fees
In addition to the income tax considerations discussed, there are also several provincial fees and taxes that may be applicable. In Alberta, fees for land transfer and estate probate are minor. Where a taxpayer owns property in another province like British Columbia, however, these other taxes and fees may become quite significant. Additional fees may apply to real property in certain municipalities, such as Kelowna, Vancouver, and Toronto. You do not avoid these taxes and fees merely by being a resident of Alberta. In the event you own or are considering purchasing real estate in another province, you should consult with your tax advisor to understand the additional provincial and municipal taxes and fees that may be incurred.
For more information on rental properties as as investment, please refer to our article, Investing in rental properties.