Buy-and-hold real estate investing has its own unique set of tax and accounting rules. As discussed in articles on flipping properties, and rent-to-owns, using the proper structure is critical. Think of this as a short 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 the rest of your team of professionals.
Accounting for buy-and-hold investments held in a corporation
With a buy-and-hold, you can now set up your properties as capital assets. Those assets are earning you rental income, and that is normally considered “passive” income. In the year you acquire your property, here are some things to keep in mind:
- The Canada Revenue Agency (CRA) has been taking the stance more recently that many repairs (no matter how small) that occur during the first year of ownership are all capital items and not to be expensed, even if they would otherwise qualify for deductions in other years.
- Your bookkeeper or accountant at the time of preparing your corporate year end filing will need to record your property on the books. That’s easy; the building is worth the sale price. Not so fast! There are two parts to every property right? Land and building – even a condo has strata. A portion of the sale price must be assigned to the land. Land is not depreciable, but the building is. For the more adventurous, although usually not practical, you may allocate some costs to furnishings, fences, parking lots, etc. to have more depreciable assets at higher rates.
- To add to the sale price, other costs you incurred to purchase that property must be capitalized and not expensed:
o Land transfer tax
o Legal fees
o Inspection fees
o Other costs you can discuss with your accountant
So all those costs you thought you could “write off” to reduce your income (and in turn pay less tax) are in fact items to be capitalized and written off over time.
Alright, now that you’ve capitalized a lot of your expenses – is there any upside to that? Of course there is.
You can claim Capital Cost Allowance (CCA) on the value assigned to the building. Hold on – isn’t real estate supposed to appreciate, not depreciate!? That is the beauty of CCA. CCA is a tax treatment. On your income statement, it will appear as an expense – but you didn’t physically pay that expense to anyone, no cash went out the door (ignoring the initial purchase and financing of the property). Claiming CCA is essentially a way of deferring your tax bill. You will have to pay tax eventually.
You can normally claim CCA on a year-to-year basis to reduce your taxes owing. Remember passive income is taxed at a higher rate in a corporation, approximately 46%. However, if you ever sell that property you will pay tax on the CCA you claimed previously, assuming that you have sold the property for a gain.
- Original purchase price for property is $300,000
- 75% is assigned to building, 25% to land
- $300,000*75% = $225,000 value of building you can claim CCA on
- Over the course of 15 years you claim $100,500 in CCA
o Potential tax deferral of 46%*$100,500 = $46,230
- You sell at $500,000
- $500,000 less cost base of $300,000 = $200,000 capital gain ($100,000 taxable)
Because the property appreciated, you will be taxed on all previously claimed CCA.
A note about the initial tax rate of 46%. Ontario has, identical to other provinces and territories, a refundable amount of taxes equal to 26.67%. Thus, if applicable, your net corporate tax rate in Ontario is approximately 20% (or 10% on capital gains) once qualified dividends are paid.
No corporation? For buy-and-holds that are personally held
Recording your rental income personally on your tax return requires filling out form T776 “Statement of Real Estate Rentals”. There is a section on that form to set up and claim CCA as well. The same capitalization rules and value allocation between land and building apply here too.
We had a client this past personal tax season who was shocked when they were not receiving a massive refund on their tax return. They had purchased their first rental properties and thought they could expense the $40,000+ in renovations they completed during the year, coupled with the fact they had low rental income as it was not a full year of operations. Sorry folks – that is not the way it works! Further, there are additional restrictions on claiming CCA such that losses cannot be created or increased.
George E. Dube, CPA, CA
Real estate accountant, real estate investor, speaker, author
Hey George. This is such important information. I have been in the real estate industry for over 22 years and am ashamed to admit I know so little about these accounting practices. I simply recommend that every investor speaks with an expert like yourself before and after they jump into the real estate market.
In the example above, you assigned $75,000 to land and $225,000 to the building. When you sell the property for $500,000, would you not allocate the proceeds of sale in the same proportions and therefore 25% of $500,000 or $125,000 would be allocated to land and $375,000 to building, therefore the taxable capital gain, assuming no depreciation is taken, would be $150,000. Would this be the correct tax treatment, or do you pay capital gains on land value increase as well?
You’re partially correct. In theory, yes you would typically allocate the proceeds as you have described. However, as you do pay capital gains on the land in addition to the building, the total capital gain remains at $200,000 between the land and building.
I’ve purchased a new rental condo and paid HST
Under my corporation. I received part of the HST rebate
Later. Should I report the rebate as income or
should I capitalize to reduce the asset value?
When you purchase a property, the GST/HST is typically added to the cost of the property. In other words, it is capitalized to reflect the ultimate cost of the property. As such the partial refund would be netted against the acquisition cost to reduce the asset cost, and not brought into income.
Hi George, to complement the RTO and buy and hold investing articles, could you do an article on tax treatments of limited partnerships formed to hold RE for a group of investors?
Great suggestion. I’ll put one together for this.
– George Dube
My wife has purchase a rental property and would like her tax returns to be prepared to reflect this. Could you kindly give me a call.
Thank you Harold. I’ve asked our team to get in touch to help answer your questions.
How much do you allocate to land for a condo?? Everything outside of your condo and parking lot is common area, right?
25% when you have actual property sounds okay; but, for a condo would you allocate in the area of 10% to land?
This really depends and is definitely something to talk about with your advisor.