The cost of owning a house is getting increasingly high, so many Canadian homeowners opt to invest in income properties to cope with the costs and potentially earn a return in the long run. According to research conducted by CIBC, 15% of homeowners are landlords, while 11% have started renting a part of their primary residence. If they were to buy a home today, almost two out of five (37%) would choose one with rental income.
You can earn income as a rental property owner and claim tax deductions. These deductions apply to property taxes, legal fees, maintenance and utility costs, insurance premiums, and more. There are two common types — amortization and depreciation. Another type of deduction you may qualify for is capital cost allowance (CCA), a deductible expense for the depreciation of something.
In this article, we will analyze what amortization is and how it applies to rental properties. We will also discuss what CCA is, how to calculate it, and whether it is a good decision to claim it.
Amortization is a tax deduction used for recovering your capital costs over time. It applies to intangible properties, such as goodwill, a trademark, a value of a business name, the costs of starting a business or obtaining a lease, and more.
If you have been wondering whether you can amortize your tangible asset, such as a rental property, the answer is no. You can only depreciate it. This is because amortization does not apply to tangible property, but the concept of depreciation does. Depreciation is similar to amortization because it also gradually reduces the value of the property. However, you can amortize some of the costs of owning a rental property.
When purchasing a property for the first time, loan and acquisition costs are added to the cost basis and cannot be amortized, but they do increase your depreciation basis. In contrast, the IRS treats refinancing your rental property’s loan as a new expense, as you have made improvements to it. The amortization of a mortgage is allowed since it isn’t a tangible asset.
Taxes are often calculated using amortization. The CRA requires that companies amortize long-term assets for the duration of their use before claiming the capital cost allowance (CCA). Often, businesses can accelerate or defer some amortization to minimize their tax liabilities. But you can also reduce your taxes by claiming CCA on intangible assets, such as rental properties.
If you own a depreciable property, such as a building, apartment, or car and use it for rent, it will naturally become obsolete or wear out over time. When calculating your net property income, you cannot deduct the cost of the property, but you can deduct the depreciable property’s price. This deduction is known as capital cost allowance (CCA). Claiming it is optional, but if you decide to do so, it will be deducted from your rental income, thus reducing your taxes.
CCA helps you keep your assets in good condition and avoid maintenance costs related to wear and tear, breakdowns, replacements, and other factors that reduce their value. It may apply to property and assets, such as furniture, computers, telephones, or any equipment used for business. Even vehicles, office buildings, and musical instruments you use to earn a living can qualify for CCA. It is worth noting that you cannot deduct the entire cost of these items as an expense at once. Instead, these costs will be deducted over a more extended period in small increments and at a specified rate set by CRA.
Before claiming CCA for a rental property, such as an apartment, you should keep several things in mind. Remember that CCA is only available on the building, not the land. Therefore, your capital costs cannot include the land’s value. Another vital point is that you cannot claim CCA unless the property has been available for use. In other words, a property that meets this definition is at least 90% available for rent without any renovations or upgrades in progress.
Once you decide to claim CCA, you will need to complete a T776 Rental Income form. However, there are more things to consider at that point.
First, you need to define your depreciable assets (assets prone to devaluation over time), in this case, your rental property. This means you can deduct the capital costs of equipment, appliances, and furniture that come with renting a building, including the property price, legal fees, and other costs associated with the purchase.
Then, you need to determine what class your depreciable property falls into and the rate that applies to that class. A building may belong to Class 1, 3, or 6, depending on the date you purchased it and when it was made. Hence, a 4% rate deduction will apply.
Any future landlord must also be familiar with the following rules associated with claiming CCA. One is rental loss, which occurs when your expenses exceed your gross rental income. Thus, neither your rental buildings nor your equipment will be eligible for CCA because it cannot increase your net rental loss.
There is also the half-year rule, which applies to the year you acquired your property. According to this rule, you cannot claim CCA on all your net income additions but only half of them in the year you bought the property.
Additionally, special rules apply if you want to rent one part of your primary residence, change your principal residence to a rental property, and vice versa. If you face any of the above situations, it is best to seek professional advice from a tax expert to avoid problems with the CRA.
As mentioned, you need to determine the type of your depreciable property, and the year you purchased it before calculating CCA.
Let’s see how this works in a real-life example:
Imagine you bought an apartment for rental purposes during the current tax year, and this is your only rental property. According to CCA classes, apartments in the building are classified as Class 1 with a 4% rate. The total apartment cost was $885,000 ($880,000 building value, plus $5,000 legal fees).
You reported your rental activity on December 31, with $25,000 of rental income and $23,900 of rental expenses. Thus, before deducting CCA, your net rental income was $1,100 ($25,000 – $23,900). Next, you need to calculate the capital cost of the apartment using the following formula:
Apartment value ($80,000) / total purchase price ($85,000) x total expenses ($5,000) = portion of the expenses that can be added to the cost of the apartment ($4,705.88)
For the sake of simplicity, let us assume that the value does not include any amount allocated to land. So in year 1, applying the half-year rule, the maximum CCA would be ½ of 4% of $885,000 or $17,700.
You purchased this apartment during the current year, meaning you will be subject to the half-year rule (the ITA provision that enables you to claim only half of CCA for an asset in the year when it was purchased).
Since your income was $1,100 before deducting CCA, you cannot claim CCA for more than that amount because it will create a rental loss.
When calculating CCA for the following year, you will start with the reduced Undepreciated Capita Cost of $883,900 ($885,000 – $1,100 – the amounts previously deducted from income). This is called the declining balance method since the claimable balance decreases yearly.
You may wonder why some real estate investors would not claim CCA if it reduces their taxes. This has to do with a concept called recapture, which becomes relevant once you decide to sell your property.
For instance, property sold at a higher price than the purchase price would result in a profit. Any previously claimed CCA is added back to your income as a lump sum and increases your taxes. However, it all depends on how much the property sells for and how much it depreciates (the original cost without CCA).
Any profit above the original costs is subject to capital gains (50% of it is taxable), and the recapture is fully taxable. If you didn’t claim CCA, you would only have to pay tax on your capital gain. So, without proper planning, you may end up owing significant taxes if you ever decide to sell your property.
Let’s see this in a real-life example:
You purchased your rental property 15 years ago. Your CCA deductions totalled $250,000 over the years. Based on your 40% tax rate, this resulted in an annual tax savings of $100,000. You have now sold your property for $800,000, a gain of $304,000 over what you paid for it. In addition to paying tax on a capital gain of $304,000 ($152,000 of taxable income), the $250,000 in CCA is also recaptured or included into your income. The higher the profit you made by selling your property, the higher the tax bracket — you will have to pay tax at a rate of 53% on the $250,000 of recaptured CCA or $132,500. Overall, you are paying $32,500 more in taxes over the last 15 years due to recapture ($132,500 – $100,000).
Factors such as your current tax rate, return expectations, and long-term investment goals can influence your decision to sell the property. Still, many investors would opt to use today’s savings from selling their property and invest in the stock market or purchase another rental property. The bottom line is that if you plan to hold the property for a long time and are currently in a high tax bracket, you should claim CCA on your rental property.
Although CCA is an appealing way to reduce your taxes, you must be careful and plan carefully before claiming this discretionary expense. Many factors play a role in determining whether to claim CCA or not. It all comes down to the type of depreciable property you own, the applicable tax rate, capital costs, current financial circumstances, and long-term financial objectives. Therefore, to avoid frustration and make an informed decision, it is advisable to seek the advice of an accountant if you plan to purchase a rental property or want to maximize the value of your income.
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This blog is not meant to provide specific advice or opinions regarding the topic(s) discussed above. Should you have a question about your specific situation, please discuss it with your GBA advisor.
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