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
Option income
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.
Rental payments
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.
Tax
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.
Option income
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!
Rental payments
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
gdube@bdo.ca
Hi George
I live in Québec and fill my returns in online… I didn’t think that they give you the option of declaring the sale of my house as income??? They will ask for the date of sale and they will automatically consider it to be a capital gain no?
Cheers
Jason
I am not familiar with the online filing procedures etc that are used for Quebec. That being said, I cannot imagine a situation where the sale of a property is forced to be a capital gain and thus expect you may be completing the wrong forms in completing your returns where income is applicable. I can assure you, financially the government of Quebec will be quite pleased to accept income vs capital gains and the topic has many court cases throughout the country on the same.
Warm regards…
George Dube
Perhaps a silly question. My “Rent-to-Owns” are typically 2yr terms, thus I was told not to capitalize these. Secondly, I am of course claiming interest expense on my income statement. How is the principle portion of a mortgage payment accounted for? I haven’t been doing anything with it. Will I will be double taxed on this amount because the full rent payment vs only interest expense = nearly 50% income on each payment. What happens when I sell? Maybe I am fine… I am only taxed on the capital gain of the house, and not amounts that have been paid down by a renter.
In briefly answering your questions, please keep in mind I am not familiar with your specific situation thus these are general comments. I recommend speaking with a knowledgeable advisor in some additional detail. As well, answers depend in part on whether investments are made through a company or personally as examples.
The term of your RTO is within the typical 2-3 year periods we most frequently see. Certain costs should be included as part of your property inventory as compared to expensed or included as a capital asset available for depreciation.
The principal portion treatment could be a much longer discussion. A short answer is that the principal is as you mentioned excluded from any deduction. If you were to deduct the principal, you would be effectively double dipping as you would also ultimately deduct the cost of the property. For example, if you borrowed $75k for a $100k property, and deducted both the principal and property, you would get a $175k deduction for a $100k property. The CRA is not quite that generous!
As a last comment, keep in mind that in most cases you will have straight income as compared to a capital gain on the exercise of the purchase option.
Warm regards…
Hi,
I have a RTO that we sold under our incorporated company. Can we use that income as payment to the shareholders for the downpayment when we initially bought the house?
Thanks
Alex
Provided that the company still owes you funds, considering this and all other corporate activity, yes it’s possible to use the after tax proceeds to repay yourselves tax-free from the company. Just to clarify, the corporation will still be paying taxes on the sale of the property before considering any repayment to the shareholders (I.e. The shareholder repayment does not reduce the taxable income.)
Warm regards…
Hi George,
Quick question. What if the Rent-To-Own agreement falls through after a year (the tenant defaults). If the property is subsequently sold at a much higher price in the market, is the gain on that sale (for personal tax purposes) considered a capital gain or income? I’m confused about whether the initial intent (entering into a rent-to-own for income purposes) skews the circumstances of the market (prices happened to go up a lot before we sold the asset). Thanks!
Quick answer: it depends!
Not so quick answer. While various factors are potentially applicable, without knowing more, the intention at the time of acquisition was to sell the property. This continued until presumably at least the point of default. After default, it is possible there was a change in intention/use of the property such that it become a traditional rental property, for example. If this could be successfully argued, the gain could be taxed in part as income, and then capital. The value of the property at the time of the change will be critical, but more so acceptable evidence supporting any change in intention. Needless to say it will be a challenge to justify a change in intention/use of the property but one that we certainly deal with on occasion.
George
Hi George,
I have RTO under Corporation name. Both upfront lump sum payment and rent credit (“excess”) are refundable in the agreement. Can both of them be booked as a liability in balance sheet? Monthly rent is passive income but the sale of RTO property is active income. How to report these two type of income separately in one corporation? How to report income tax for this corporation?
Thank you
Amy
Good afternoon Amy
For your first question, if both forms of deposit/excess are truly refundable without condition (this is exceptionally rare in contracts we’ve reviewed), absent other factors I would agree that the amount should generally be recorded as unearned income/deposit/liability.
For your second question, the corporate tax return allows for the tracking of different types of income by using the applicable schedules – in particular schedule 7.
Warm regards…
In a RTO situation where it is NOT a business, but rather a one time deal where the owner of a rental house is selling under a RTO, when is the capital gain reported on his personal tax return? And the full amount of monthly payments are actually going to be applied towards the purchase price of the house when it is ultimately sold, so I assume there is no rental income to report?
Without getting into all of the details, the vast majority of RTOs will be on account of income as compared to a capital gain. And there will be rental income through the contracted period. Most RTOs will have taxable income right from the initial deposit, and through to the final disposition of the property. While there are certainly exceptions to these rules, we’ve rarely seen them in the case of real estate investors, whether acquiring one property or multiple.
Warm regards…
George
The above article is very helpful but is titled Accounting for an RTO held in a corporation.
What about RTO\’s held outside the corporation but instead as privately owned? Could you do a similar length article (if needed on private ownership RTO\’s?)
The specific questions for me would be:
– are the option deposits treated any differently? ie as 100 % income in the year received (I don\’t really get why the option deposits are income as opposed to a deposit that is later used or accounted for when the option is exercised)
– are the gains on sale also all income or could they be capital gains as well?
Thanks, very appreciated to have a blog with professional input on such an arcane subject as RTO\’s. I have the book by George in my library 🙂
Regardless of the form of ownership, the RTO treatment for option deposits and the final gain on sale are identical in that they are treated as income in most cases (exceptions, as normal, do apply). The tax rates are completely different though.
Typically, deposits would be effectively excluded from income. However, most RTOs are structured such that the deposit is non-refundable unless the option to purchase is exercised. Now the exclusion from income/deposit refund is contingent on a future event which the CRA is unwilling to wait and find out! If it turns out the option is exercised, your gain on sale will be reduced.
– George Dube
Re-reading the site I see my question was answered. Sorry I missed it!
Thanks for this helpful information.
Once an RTO property is sold to the tenant-buyer and the after-tax profits are in the corporation, is the normal way they get into the hands of the shareholder via dividends and how does the tax rate for those dividends compare to the tax rate for employment income?
Also, can the corporation re-invest the profits that remain (after paying the 15.5% or so active tax) in another property?
Thank you for the questions. For your first question, I hesitate to say normal but certainly not infrequent. There are different ways of setting up remuneration strategies.
For the tax rate, they can be higher and they can be lower. It depends on a variety of factors. This is why it requires remuneration planning, particularly with the new tax rules. And, yes, the after tax proceeds can be invested in a variety of ways.
The caution is making sure that the profits were taxed at the small business rate as compared to the general rate for active business income, both of which typically would still be better than personal.
Warm regards…
George Dube