Difference between current and capital expenses has big tax consequences for rental property owners


Jamie Golombek: Here’s a review of the rules for deducting expenses and a recent tax case on the subject

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With the price of residential real estate skyrocketing across some Canadian markets, especially in the greater Toronto area (GTA), it’s no wonder real estate investors have been joining the buying frenzy in recent months. Many are hoping to cash in on significant appreciation, even if it means absorbing hundreds of dollars of short-term monthly losses, as the rents landlords can charge can’t keep up with monthly carrying costs. According to new research on the GTA’s condo investment landscape by CIBC’s deputy chief economist Benjamin Tal, about 35 per cent of investors are in a negative cashflow, losing money on a monthly basis.

A 2018 survey found that 74 per cent of landlords believe that even with a negative cash flow, the benefits of tax deductions alone make owning an income property a good investment. If you’re a landlord, it’s therefore critical to understand which expenses are properly deductible for tax purposes. Let’s review the rules for deducting expenses on your rental property, as well as look at a recent tax case where the Canada Revenue Agency challenged a property owner’s rental property expenses.

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Capital vs. current expenses

There are a variety of expenses that you can deduct against your rental income, so long as they are reasonable. Expenses are typically divided into two categories: capital expenses and current expenses.

Capital expenses provide a long-lasting benefit over a number of years. Your cost of acquiring the rental property and costs to improve it beyond its original condition or to extend its life would be capital in nature. If you buy an older building and pay for renovations to bring it up to a condition suitable to rent, the renovation costs would likely be capital in nature. Most costs incurred to sell the property, such as real estate commissions or the cost of improvements to make the property more marketable, will be considered capital expenses. Capital expenses are deducted over a multi-year period.

Current expenses provide a short-term benefit. One example is a payment for repairs to fix or restore a property so that it will be in the same condition as it was when you purchased it. These expenses are often recurring in nature and are generally deductible in the year they arise.

The case

The recent case involved an Ontario taxpayer who was reassessed by the CRA, disallowing a variety of expenses he claimed on his 2012 and 2013 tax returns relating to two rental properties he owned, one in Vancouver and the other, in Phoenix, Ariz.

The Vancouver property is a townhouse unit in a condominium complex of 56 units constructed in the 1970s, which the taxpayer has owned since 1989 and has consistently maintained as a rental property. It’s located in a desirable part of Vancouver and has always enjoyed a high occupancy rate. Because the tenant turnover was so low, there was little opportunity to do more than slap on a fresh coat of paint and perform minor repairs between tenancies. Over the years, the unit got run down due to wear and tear and was “showing its age.”

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In April 2010, the condo management board undertook a major remediation of the complex lasting about 22 months to deal with issues of rot, mould, asbestos, water leakage and structural issues. The project involved only the exterior common elements of the complex and had nothing to do with the interior of any of the units. During the work, the entire housing complex became an active construction site which was very disruptive for all occupants of the complex, so much so that the taxpayer’s tenant at the time, unhappy with the disruption, vacated the taxpayer’s unit in November 2010.

While the taxpayer attempted to rent his unit out, prospective tenants lost interest when they saw the ongoing disruption caused by the exterior construction. As a result, the taxpayer decided to take advantage of the vacancy to update the unit and make repairs to the bathroom, kitchen, doors, carpeting, and more, to the tune of $22,483. The unit was successfully rented out again in December 2012 — for 50 per cent higher rent.

The taxpayer deducted the costs of the renovations on his 2012 return under the heading of “repairs and maintenance,” but the CRA denied the expenses, claiming they were not deductible because the unit was not available to be rented out in 2012 and thus the taxpayer didn’t have a source of income. Even if it were to be found that the taxpayer had a source of income, the CRA argued that the expenses should have been capitalized and were therefore not currently deductible as a current rental expense.

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The judge disagreed, first concluding that the Vancouver property was, indeed, a source of income “before, during and after the renovations…. A property does not need to be generating income at every stage of operation in order to be considered a source of income.”

As to the expenses themselves, the judge felt that they were properly classified as current expenses and thus deductible because the repairs did not result in the creation of a different capital asset than what was there before; they were restorative, not rehabilitative; there were no material changes to the physical structure, the layout or the functionality of the unit; and the expenditures were modest compared to the value of the property.

The taxpayer’s second property was in Phoenix and in 2013, there were a number of issues that required the taxpayer’s attention, such as problems with the tenant, repairs to the roof, the pool and spa, and landscaping matters. As a result, the taxpayer took advantage of a family trip to Las Vegas to rent a car and drive down to Phoenix in order to address problems with the property in person, together with his property manager. He claimed $5,612 of food, lodging and travel expenses on his 2013 return as expenses associated with the Phoenix rental property.

The judge reviewed the expenses which included nearly $1,000 in meals for one person over five days, and found them to be somewhat excessive. After a detailed review of the taxpayer’s travel expenses, the judge was prepared to allow approximately $3,400 of the expenses claimed as rental expenses, but denied the taxpayer’s claim of $43.75 for sunscreen, which “is in the nature of personal expenses.”

[email protected]

Jamie Golombek, CPA, CA, CFP, CLU, TEP is the Managing Director, Tax & Estate Planning with CIBC Private Wealth Management in Toronto.

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