The article “What You Need To Know If You’re Making The Leap From Land Owner To Landlord” was originally published on Financial Post on July 16, 2019.
Here are some tips on financing, taxation and what you can expect from future price growth
Home ownership rates in Canada have stayed relatively constant over the past 20 years, hitting a low of 64 per cent in 1999 and a high of 68 per cent in 2013.
But recently released figures from StatsCan’s 2018 Canadian Housing Statistics Program, which found that 38 per cent of Toronto condominiums are not owner occupied, suggest that at least for certain cities and property types, an increasing number of Canadians are making the leap from land owner to landlord.
If you are considering adding a rental property to your portfolio, there are a number of financial planning factors to keep in mind.
One common misunderstanding with rental property debt relates to tax deductibility. Just because a mortgage or line of credit is secured by a rental property, that alone does not make the interest tax deductible. It is the use of the borrowed funds that dictates tax deductibility.
As a result, refinancing a rental property and using the money for personal purposes means the interest on the additional debt is not tax deductible.
Likewise, if a debt is incurred on your principal residence to use toward a rental property — say, a downpayment — the fact that the debt is not secured by the rental property does not negate tax deductibility. If the borrowed money is used for the rental property, the interest is tax deductible against the rental property income even if the debt is not on that particular property.
Commonly missed deductions for rental property investors include accounting fees, which are not generally tax deductible on most personal tax returns.
Travel expenses can also be deducted. According to the Canada Revenue Agency (CRA), “You can deduct travel expenses you incur to collect rents, supervise repairs, and manage your properties. Travelling expenses include the cost of getting to your rental property, but do not include board and lodging.”
Mistaken expenses that are commonly claimed that are not tax deductible tend to relate to repairs and renovations. The CRA distinguishes between current and capital expenses. A current expense is a tax deductible expense that is generally a modest cost that reoccurs frequently, restores a property to its original condition, or is a replacement that is part of the ordinary maintenance of a property.
Capital expenses tend to have a more lasting nature and improve a property beyond its original condition. Generally, if the expense is considerable relative to the value of the property or might otherwise be considered a “renovation,” the expense may not be tax deductible. Replacing a separate asset within a property — like an appliance — is considered a capital expense.
Capital expenses are instead added to the adjusted cost base of a rental property and reduce the eventual capital gain on sale. They are also added to the undepreciated capital cost and can potentially be claimed over time as capital cost allowance (depreciation) to the extent a taxpayer has net rental income for the year. Capital cost allowance cannot be claimed to create or increase a net rental loss.
Real estate investors often wonder if they should set up a corporation to own their rental properties. Generally, the answer is no, except in certain circumstances.
One situation is if an incorporated business owner wants to use corporate savings to buy a rental property, as either an investment, or to use in the course of their business. Using a corporation for the property can reduce the personal tax otherwise payable to withdraw corporate cash, include that withdrawal in personal income, and then use after-tax personal funds to buy the real estate.
Another instance when a corporation may be appropriate is if an investor is buying a commercial property, where the liability risk may be higher than a typical residential property.
A final tax consideration for real estate investors relates to flipping a property. The CRA is paying much closer attention to investors who buy and sell a property soon thereafter. If an investor’s intention does not appear to be to earn rental income, but rather, to earn a profit from buying and selling, an investor risks paying twice as much tax on that profit.
Rental property proceeds are generally taxable as capital gains, 50 per cent of which are tax free. But a property that is flipped can be subject to taxation as business income, which is fully taxable.
Canadian real estate has appreciated handsomely in recent years, particularly in cities like Vancouver and Toronto. Young people especially may have a skewed perspective on real estate prices, which have historically grown at more modest rates.
Over the past 30 years, “real” Canadian real estate prices have grown by about 2.5 per cent per year. This means real estate has grown nationally at 2.5 per in excess of inflation. But even the past 30 years in Canada may have been somewhat exceptional.
Going back to 1890, real U.S. real estate prices have only grown by about 0.4 per cent per year, barely outpacing inflation.
Now, more than ever, Canadian real estate investors should focus on income over appreciation. Understanding how financing and taxation impact real estate investing can help a landlord better manage a real estate investment, but investors need to be particularly cautious about overestimating future price growth.
Jason Heath is a fee-only Certified Financial Planner (CFP) and income tax professional for Objective Financial Partners Inc. in Toronto.