Business and Tax Implications of Owning Rental Property
A great many fortunes have been made in real estate. Conversely, as was evidenced in 2008 with the deflation of the housing bubble, many fortunes have also been spectacularly lost. Fortunes aside, owning real estate is one of the best ways to build equity. If you own your home, you are already one step ahead. With rental property, you can further augment your net worth if after investing the necessary down payment the rental income covers and/or exceeds the mortgage payment and related expenses, (Leaving you free to move on to buying your next property). This is not a decision to take lightly as with any investment there are several business and tax factors to consider before taking the plunge:
Down Payment/Mortgage Insurance:
Any purchase of a property requires an initial capital investment . The actual down payment is determined by the specific property restrictions, mortgage requirements, how much you can afford, your current level of debt and other restrictions. In Canada typically the buyer will have to put 20% down to avoid paying mortgage insurance. For down payments that are less than 20% your bank will usually require you to get mortgage insurance, for which premiums range from 0.5% to 2.90%. If you are self employed, you are subject to a higher premium and are required to put down a minimum of 10%. Also, premiums in Quebec and Ontario are subject to sales tax. Additional details relating to mortgage insurance can be found at the CMHC (Canadian Mortgage and Housing Corporation)Website.
Mortgage Payments:
The value of your property, the amount of the down payments, the time period over which payments are to be made and the prevailing interest rates will influence the amount of your mortgage payment. The time period of a typical mortgage is usually between 20 and 30 years. The longer the time period the lower the mortgage payment and the higher the total interest payable. You will also have to decide whether you want a fixed or variable mortgage interest rate. If you expect interest rates to go up soon , it might make more sense to take a fixed rate mortgage. However, if you expect the interest rate environment to stay static or go down, then a variable rate is often preferred as fixed rates often have a premium built into them for uncertainty.
Rental Potential:
When purchasing a rental property you will need to assess its rentability. This not only includes assessing how much you can actually charge for the unit in question, but history of vacancies and macro-economic factors including:
Are potential tenants able to afford the rent,?
What is the employment rate in the area?
Are there a unusually high number and/or rate of vacancies?
Is there new construction in the neighbourhood? ( which may be good as indicates economic stability however the downside is that more competitive rental units may become available).
What is the outlook for interest rates? Higher interest rates means that less people are able to purchase their own home and are therefore more likely to rent.
What type of amenities are available to potential renters - are there good schools in the neighbourhood? Parks, grocery stores, public transit, availability of parking can all be important factors when reviewing the type of tenant that is most likely to rent.
Expenses:
Ideally you want the net rental income, after deducting expenses and taxes, to at least cover the full amount of the mortgage payment. This allows the property to pay for itself, which can then become a revenue generating property once the mortage has been fully repaid. In order to that the rental revenues covers expenses, you should have a thorough understanding of the ongoing costs that are commonly incurred by the property including utilities, ongoing repairs and maintenance, condo fees if applicable, property taxes and anything else specific to the property. To get a thorough understanding of the expenses before purchasing the property, you should ask for the financial statements, if available, that lists the income and expenses. If these are not available, you should try and get a copy of statement of rental revenues that is included with the seller’s tax return (Form T776 if the property is owned personally or the T2 if the property is in a corporation) . This can help to prevent surprises by identifying unknown costs.
Income Taxes and accounting:
The gross rental revenues less applicable expenses represent the net rental income and are taxable. Keep in mind that most expenses incurred that relate to the property are deductible and include the following:
Utilities (paid by the landlord for the rental units)
Repairs and Maintenance,but not improvements. Any costs that significantly improve the property eg.adding new flooring or a new bathroom or kitchen will usually be added to the cost base of the property and can be depreciated (see below)
Mortgage Interest (but not principal which reduces the amount of debt payable and is not an expense) – This can be found on your mortgage statement or amortization table
Condo fees if applicable
Administration or Property Management Fees paid to a third party to manage the property
Professional fees to prepare tax returns or obtain advice include legal and accounting fees.
Insurance paid on the property
Property Taxes, school taxes, water taxes etc. levied by the municipality or city in which the property is located
Cable/Internet paid by the landlord
Depreciation/CCA (see below)
Welcome taxes are not deductible against rental income but instead can be added to the capital cost of the property and depreciated.
As with anything ensure that you have a good accounting system and maintain all documentation including receipts, bills, rental contracts and any legal documents in case of audit and for your own records. You can either maintain a spreadsheet or automate your accounting with an accounting software such as QuickBooks Online.
Sales Taxes:
In Canada sales taxes apply only to commercial property, while residential properties with long term rentals are exempt. Consequently you will need to charge your commercial tenants sales taxes. Airbnbs and other short term rentals are considered to be similar to hotel rentals and as such sales taxes should be charged. You are also allowed to claim back sales taxes paid on expenses relating to commercial properties but not residential properties.
Capital Gains/Depreciation (Capital Cost Allowance) on rental properties:
Revenue Canada allows buildings, but not land, to be depreciated usually at 4% on a declining balance method. These are included in Class 1 on the tax return (either the T776 statement of rentals on the personal tax return or on the T2 if held in a corporation). This means that for example if your property was purchased for $200,000, you would be allowed to deduct approximately $8,000 on a declining basis i.e. on the remaining balance after deducting the CCA that has already been claimed. Most tax software will calculate this for you automatically. It is important to ensure that you add any capital costs eg. welcome taxes, improvements to the land or building and other items that are not expensed to ensure that the proper cost is reflected. There is however a special restriction – if you sell your property for more than the cost you are subject to CCA recapture. This means that the full amount of the CCA deduction claimed will become taxable upon sale of the property, which is often the case as properties tend to appreciate in value. The balance of the gain will be classified as a capital gain and as such only 50% is taxable at your marginal tax rate. For example: if you purchased your building at $200,000, claimed $15,000 in depreciation and sold it for $250,000, then the additions to your taxable income will be the full $15,000 for the CCA + $25,000 which is half of the remaining $50,000 gain. This is important to know for property owners as it can result in significant tax consequences if you have depreciated a building over a few years.
Regulatory:
Every province has its own regulatory body to ensure the rights of tenants, landlords, impose rules with respect to rent increases and deal with the numerous other aspects of administering property. It is good to familiarize yourself with these regulations to improve decision making. You should also ensure that you are knowledgeable about the differences between commercial and residential property as the rules governing each of them are different. The other factor to consider is whether incorporation is suitable. One of the primary benefits of incorporation in this case would be to help shield you from liability. If you are running an airbnb or vacation rental, there are also specific rules that require renters to pay a specific hotel tax and register for GST/HST and QST.
Other:
Finally, even if your rental income covers your expenses, taxes and mortgage payment, you should always maintain a fund to cover unexpected and ongoing repairs. Additionally, if the value of the property falls this could be problematic as mortgages are based on the assessed value. Many homeowners in the US founds themselves without a home when the housing market collapsed, causing their debt/mortgage payable to exceed their equity.
With a little bit of luck and good business sense, investing in rental properties can increase your net worth significantly. Additionally while other investments tend to be less tangible, people will always need a place to live. As the great businessman and landowner Tony Soprano says to Christopher in The Sopranos “Buy land, ‘cause God ain’t making any more of it.”
Ronika Khanna is an accounting and finance professional who helps small businesses achieve their financial goals. She is the author of several books for small businesses and also provides financial consulting services.
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