In medieval Europe, with small farms spread out over a large area, where robbers would attack travellers and invaders plunder the villages, landlords came to rescue and offered protection in exchange for a share of the crops. These days the role of the landlord is much different, but being a landlord still has its share of tribulations in trying to find the right tenant, unexpected repairs, and of course, how to properly report everything for tax purposes.
The property purchase
When you buy the rental property, the purchase price must be allocated between the building and the land. Why? Because under the income tax rules you can take depreciation, called capital cost allowance in tax speak, on the value of the building. Similarly, you need to allocate other purchase costs such as legal fees and land transfer tax between the land and building.
What about the costs you incur in getting the property ready to rent? Canada Revenue Agency has specific guidelines on this and has a publication T4036 Rental Income Guide about renting real estate. If no rental income is being earned while repairs are being made to the property, then the repair costs, interest, legal and accounting fees and property taxes must be added to the cost of the building, they cannot be deducted as a current expense. Other costs such as utilities, insurance, and advertising can be deducted as current expenses.
Converting a property from personal use to rental use
Mary and Pete want to move into a new home and keep the old home as rental property. What are the tax consequences? When a personal use property is changed to an income earning property CRA considers that you have disposed of the property and reacquired it. I advise clients to obtain an appraisal from a designated Real Estate Appraiser to obtain the fair value of the property at the date of conversion. Mary and Pete have never designated any other property as their principal residence, so any gain from the change of use is fully exempt. However, under new proposed CRA rules, Mary and Pete still have to report the disposition on their tax return. The fair value at the date the property changes to a rental property becomes the new cost of the property.
Mary and Pete have a small existing mortgage on the old home and plan to obtain a mortgage on the new home. They are hoping that they can write off the interest on the new home against rental income since it will be the larger amount. I sadly advise them that no, CRA says they can deduct the interest on the old mortgage but not the new one. The good news is that they can restructure the borrowings so that they effectively end up financing the rental property and not the new property.
Rental Income and Expenses
Rental income and expenses are reported on form T776 which helps you determine your net rental income or loss. The net rental income or loss is reported on the jacket of your tax return and you pay tax on the rental income at your marginal tax rate. If you are having your return prepared by a tax accountant, see Resources & Tools for rental income and expense worksheet on Personal Tax page.
When it comes to repairs made to the property, you will need to determine whether the expense is current in nature or capital in nature. Repairs such as painting and plumbing repairs can be deducted in the year incurred (current expense). Repairs such as a new roof or windows are likely capital expenditures which means they need to be added to the cost of the building. The T4036 guide has a good explanation of current vs. capital expenses.
The other interesting deduction is travel. Can you deduct costs incurred to travel to the rental property to make repairs and collect rents? Well, it depends if you own one rental property or two or more rental properties and whether the property is in the general area you live or outside of it. See “Line 9281 – Motor vehicle expenses” in the T4036 for the criteria.
Capital Cost Allowance (depreciation)
You are allowed to deduct the cost of the building over a period of years to reflect that the property does wear out over time. This deduction is called capital cost allowance (CCA). However, the decision to take CCA should be made carefully for two reasons. One is that there are elections that can be made to defer any gain from changing a property from rental to personal, but the elections are only allowed if no CCA has been taken. The second reason is that if the property actually goes up in value when you sell, that depreciation that you took in previous years comes back into income, CRA refers to this as recapture.
For purchases such as ovens, dishwashers and other appliances, these are also depreciated, but at a faster rate than the building.
Rental Losses and renting to family members
Large rental losses and ongoing rental losses have a 95% chance of being audited by CRA. If you have large rental losses, CRA wants to know if you are expensing repairs or purchases that should have capitalized. If you have ongoing losses, the CRA says your rental operation is not a source of income and they will deny the loss.
If you have recurring rental losses but you reasonably expect to make a profit (and no, the sale of the property does not count), you can deduct those losses but be prepared to prove to CRA that you have a plan to make the operation profitable.
If you rent to a family member and charge fair market rates, then you should report the rental income and expense (subject to comments about losses above) and you can give the family member a rent receipt.
If the arrangement is more of a cost sharing arrangement, or you are renting below fair market rates such that you would always have a loss, then do not report the rental income and expenses, and do not give a rent receipt to the relative.
Renting out only part of your home
If you are renting out part of your home, CRA does not consider that there was a change in use as long as the rental is ancillary to the main purpose of the home being a principal residence, and as long as no capital cost allowance is deducted. You will need to determine the percentage of expenses that relate to the rental portion, for instance, 1 out of 4 rooms, or based on square footage.
Selling the rental property
When you sell the rental property, you will likely have a capital gain, which is the proceeds of sale minus selling costs minus cost of the property including upgrades. Capital gains are taxed at half your marginal tax rate. If you sell the property for less than the purchase price special rules may apply.
For any forms mentioned in the blog, go to CRA website (www.cra.gc.ca) and type form name in search box