There are many income tax regulations which individual taxpayers in Canada, who own and rent residential property (homes, condominiums) which are leased or rented to tenants for the purpose of earning income for the taxpayer (property owner) should be aware of.
This article does not comment on whether or not investing in real property (land, buildings) aka “Real estate investment” is advisable. Instead, it provides some basic taxation information which in turn should be discussed more fully with your taxation professional or advisor.
Canada Revenue Agency (CRA) has specific regulations pertaining to property rentals that must be followed. Some of the most important of these are summarized below:
Rental Income / Expenses are reported on a separate Schedule (T776 – Statement of Real Estate Rentals).
Buildings can be depreciated using Capital Cost Allowance (CCA) rules specific to the type of asset. Typically CCA for buildings acquired after 1987 the CCA rate is 5%. CCA rate for buildings acquired before 1988, the CCA rate is 4%. There is “half year rule” in the year of acquisition (transfer of use).
Each rental building must be place in a separate CCA class if the cost of the building is greater than $50,000.
CCA is deductible, but CCA cannot create a rental loss for the taxation period. This restriction applies to the total net rental income, and does not apply on a property-by property basis where the taxpayer has more than one rental property. Unused CCA can “carried forward” and used in future periods to offset property income.
Land cannot be depreciated – it is important to know the difference between the value of the land, and value of the building, as only the building can be depreciated.
Rental expenses include;
- Borrowing expense (interest) is deductible for tax purposes, but not principal. If there is a mortgage underlying the property, it is important to obtain a schedule from the lender indicating the interest vs. principal components of the payments made for the taxation period.
- Operating expenses such as; maintenance, utilities, and other reasonable business expenses. There are specific regulations pertaining to expenses which are allowable and not allowable. For instance, Home office expenses are not allowable deductions, nor any personal expenses.
- Personal occupation of a rental unit – claiming a percent of personal and business use – there are specific CRA guidelines.
- Renovation expenses – some can be deducted as operating expenses, but other expenditures which increase the “economic life” of the building are capital in nature and would follow CCA rules for tax deduction. It is important to understand the difference.
Sale of rental unit:
- Capital Gain / Losses – there are specific guidelines on “Proceeds of Disposition” and “Cost Base” that support this calculation.
- Terminal loss
- Recapture of CCA
- No GST, No HST on residential property income.
- ITC – no GST / HST input tax credit
- Specific rules apply to GST/HST on purchase and sale of residential rental properties.
Rental properties located in foreign countries – full-time permanent residents of Canada are taxed on their “worldwide income”. This means the income / loss on property rentals located in other countries must be reported on their Canadian income tax returns (and mostly likely the foreign country income tax return). Any duplicate taxation would be recovered via Foreign Tax credits.
Individuals who own rental property must calculate the income or loss from the property for each calendar year. Individuals then add the income or deduct the loss from the rental property from other personal income for the year. When a property is co-owned, each co-owner owns a part of it and must individually report rental income according to the proportion owned. A co-ownership of real estate may be in the form of a “joint tenancy” or a “tenancy in common”. A joint tenancy differs from a tenancy in common because each joint tenant has the “right of survivorship” to the other’s share. A right of survivorship means that the surviving individual joint tenant immediately becomes owner of the whole property on the death of the other joint tenant. In contrast, on the death of an individual tenant in common, his or her interest will pass according to his or her will. Individuals with rental losses or gains maybe subject to the alternative minimum tax (AMT). A major advantage to individuals holding rental property is that, unlike corporations, individuals are not taxed on the capital at the federal level nor in the provinces where a capital tax exists.
Each of the common law provinces in Canada (i.e., all the provinces except for Quebec) has enacted its own partnership legislation. In general, a partnership is a relationship that exists between two or more persons carrying on business in common with a view to profit. Note that the existence of a co-ownership of property does not, in itself, create a partnership.
When a partnership owns a rental property, the income is computed as if the partnership were a separate person. The partnership’s income or loss is then attributed to the partners, who must include their respective share of it in their income. The CCA and other discretionary deductions are claimed in computing the income of the partnership, which means that the tax situation of each partner cannot be taken into account. The partners must agree among themselves on the amount that they will deduct in computing the income of the partnership. If partners are individuals, they must include their share of the financial expenses paid by the partnership in computing their adjusted income for purposes of the AMT as well as the financial expenses related to any borrowing undertaken in order to invest in the partnership. From an AMT standpoint, there are no advantages to rental property being held by a partnership rather than being co-owned. However, if partners are corporations, they can defer payment of income tax if the corporation has an earlier year end than the partnership. Also, if partners are corporations, the computation of both federal Part I.3 tax and the provincial capital tax is done differently. When computing the taxable capital of the corporations, it is necessary to include their share of the items on the partnership’s balance sheet that usually enter into the computation of taxable capital.
A corporation is a taxpayer under the Canadian Income Tax Act and pays tax on its taxable income for the year, including rental income. Corporations record their rental income for each taxation year, which may end on a date other than December 31. If the main activity of a corporation is the sale or rental of real property, the restriction on the amount of CCA that it may claim will not apply. Thus, when expecting to make large and profitable real estate investments, it may be preferable to create a separate corporation for real estate activities, rather than combining the real estate business with other businesses.
If rental losses are expected and the corporation has no other sources of income, ownership by the corporation is generally not beneficial. Shareholders cannot immediately take advantage of losses, since they cannot deduct these losses from their personal income.
For a Canadian-controlled corporation, the tax rate applicable to rental income can vary depending on whether the rental activity is considered to be a specified investment business or an active business.
A specified investment business, is one whose principal purpose is to derive income from property such as rent, dividends, interest, and royalties. In a specified investment business, the maximum corporate tax rate applies, plus a refundable tax of 6 2/ 3 per cent. A specified investment business is deemed to exist when five or fewer full-time employees are engaged in the property rental activity. Thus, if owning a rental property is a secondary investment activity, there is no advantage in a corporation owning it in order to defer taxes, since the applicable tax rate will generally be greater than the rate that an individual would pay. Note that if a property is rented to an associated corporation that deducts the rent from its active business income, the rental income will be considered as active business income regardless of the five-employee criterion.
Active business is any business other than a specified investment business or personal services business. If the case of an active business, a small-business deduction of 16 per cent can be taken at the federal level on the first $200,000 taxable income, and provincial income tax may be reduced. In some provinces the tax rates drop significantly, from 52 to about 20 per cent.
A major disadvantage of a corporation owning a property is Part I.3 federal tax and the provincial capital tax. The debt as well as the capital invested to acquire the property is part of the taxable capital, while the property does not entitle its owner to the investment allowance. As a result, large amounts of Part I.3 tax and capital tax are payable. An advantage of rental property being held by a corporation is that the capital gains deduction (CGD) may be available on the sale of the corporation’s shares if it was carrying on an active business. The shares would not be eligible for the CGD if the corporation was carrying on a specified investment business.
For tax purposes, trusts are considered to be individuals and therefore file an income tax return. The tax rate for inter vivostrusts created to hold rental property is the maximum rate for individuals. Trusts compute their rental income in the same way as individuals do. However, in computing their income, trusts are allowed to deduct income payable to the beneficiaries of the trust. In this case, it is the beneficiaries who must pay the tax on this income. If all the income is payable to the beneficiaries, the tax payable on the rental income may be reduced by taking advantage of the tax rates or tax status of the beneficiaries.
Trusts are not subject to Part I.3 tax or the provincial capital tax. And, unlike in partnerships, if a business corporation is a beneficiary of the trust, it does not have to account for its share of the taxable capital items of the trust, except for purposes of the Ontario capital tax.
The main disadvantage of trusts is the rule on deemed disposition of their assets every 21 years. Also, trusts are subject to the AMT if they incur rental losses.
About the author
Derek Edelkoort, CPA, CGA, of Edelkoort Smethurst CPAs LLP, is Fully Registered in Public Practice with the Certified General Accountants of Ontario to provide Corporate and Personal Taxation, and Financial Statement Compilation services to the public, is an authorized Canada Revenue Agency (CRA) e-filer, and is also an Internal Revenue Service (IRS) Registered U.S. Paid income Tax Preparer. Derek Edelkoort is also an IRS Certified Acceptance Agent.
More specifically, I have experience with tax implications pertaining to rental units. As this article points out, there are numerous tax considerations. I would be pleased to discuss how I can assist taxpayers. Please don’t hesitate to contact me.
Derek Edelkoort, CPA, CGA,
Edelkoort Smethurst Schein Chartered Professional Accountants LLP
4903 Thomas Alton Boulevard, Suite 207
Burlington, Ontario, Canada L7M 0W8