The tax rules surrounding rent-to-own (RTO) real estate investments provide an insight into the complexity of the Canadian Income Tax Act and illustrate why having the right advice, and using the proper structure, is critical. Think of this as a primer on those rules, and how they may affect your taxes as you plan your real estate investment business with your real estate accountant and team of professionals.
Accounting for an RTO held in a corporation
The “deposit” or upfront lump sum payment that your tenant provided you with is either refundable or non-refundable depending on your agreement with them.
Generally speaking, if the deposit is non-refundable, then the payment will be recorded into income the year it was received. This option income is normally considered “active”. This means that the deposit is considered business income, and, for example, is taxed in Ontario at a combined federal and provincial rate of 15.5%, assuming the income qualifies for the small business rate. So what, you say? Any “passive” income is taxed at a higher rate in corporations – at a combined rate (in Ontario) of approximately 46%. There’s your difference!
A deposit that is refundable will not be recorded into income when payment is initially received. Rather, it will become a liability on your balance sheet, until either the tenant walks away from the property and you pay it back to them, or they exercise their option to purchase the home and it is then recorded as income you’ve earned.
The normal monthly rent payments from your tenants is “passive” income. An argument can be made that the “excess” income typical to many rent-to-own deals is active income given its correlation to the final refund/payment/exercise price.
Rent-To-Own properties are an asset. But, did you know they are considered and treated like an inventory item and not a capital asset? That’s right! You cannot deduct capital cost allowance (CCA), or what is sometimes referred to as depreciation, on the property for the majority of RTO deals.
What happens when I sell?
The sale of a Rent-To-Own property is considered “active” or business income.
Your proceeds on the sale (predetermined sale price in your agreement with the tenant), less the deposit you already took into income (and paid tax on), less the cost of the property and costs to sell is your net income. Again, taxed at the lower rate of 15.5% in Ontario if the small business rate applies (and decreasing another 2% over the next four years). Compare this with your marginal personal tax rate that may be approximately 50% in Ontario.
I don’t have a corporation…my RTO is personally held
Ok, so you hold your Rent-To-Own personally? Here are the differences in accounting and tax treatments from an investment held in a corporation.
Typically, if the “deposit” is non-refundable, it must be included in your income the year it is received.
This means, you could have an unplanned tax bill at the end of the year! If your annual income level is already close to reaching the next tax bracket, then you add on option income of say $10,000, you may be bumped up into the next tax level and owe a lot more tax than you thought you would!
These are recorded on your personal tax return on the T776 Statement of Real Estate Rentals.
Similar to any other type of business income or employment income you earn, rent received, less costs are added to your net income. You then pay tax at whatever rate you fall into.
What happens when I sell?
You record the sale on your personal tax return as income as compared to a capital gain, in most cases. This sale is considered income not a capital gain.
Seller beware: You cannot offset this income with net capital losses from past years.
George E. Dube, CPA, CA
Real estate accountant, real estate investor, speaker, author