Tax Tips and Traps

As tax season is upon us  I thought I offer some tax tips and tricks!

If you have rental losses, they should try to deduct as many expenses as possible from other income sources such as a business income.

Capital cost allowance (CCA) on rental properties cannot be used to create or increase losses. The pre-CCA rental income is calculated on a pooled basis and includes any recaptured amounts. As a result taxpayers with rental losses should first deduct from rental income expenses that can only be attributed to such income and then deduct the CCA attributable to the rental property. Expenses which can be attributed to other income sources should be deducted. If they are deducted against the rental income, the taxpayer will be required to reduce the amount of CCA claimed, which would reduce the overall amount of expenses deductible against total income.

As an example, accounting fees may be deductible from investment income rather than from the taxpayer's rental income.

The spouse with the lower marginal tax rate own the property on which taxable capital gains may arise.

By having the spouse with the lower marginal tax rate own the property, taxpayers can reduce the amount of tax payable on any capital gains to avoid the Income Tax Act's attribution rules. However, that spouse would also have to report the ongoing rental income or loss. CRA may look to the spouse's relative contribution to the purchase price of the property in assessing the reasonableness of the above strategy.

Leasehold inducements can be deducted from capital costs, rather than being included in the current year's income, by filing a special election.

Filing the special "subsection 13(7.4)" election allows taxpayers who purchases property to reduce the capital cost of leasehold improvements made to the property to the extent of the leasehold inducements. Without such an election, any leasehold inducements must be included in income and taxed in the current year. By electing to reduce the capital cost of leasehold improvements, the inducements are spread over the term of the lease, by reducing the CCA that would otherwise have been deducted in subsequent years. The election, therefore, results in a significant deferral.

No specific form has been developed by CRA for this election, so a simple letter stating the taxpayer's intention to make the election will suffice. It is extremely important to file your income tax on time, as CRA has denied this election where tax return were filed late.

Capital Cost Allowance (CCA) is the mechanism by which the INCOME TAX ACT permits the costs of purchasing an asset to be "written off", that is, deducted from a taxpayer's income. It is based on an often arbitrary set of rates set by the INCOME TAX ACT, and is subject to changes by government for economic and political purposes. CCA rates and rules are important because they impact the after tax earnings of the property owner.

There are currently many separate CCA classes, each with lengthy descriptions of what assets are to be included. Each class has it own rate at which the cost of assets in the class may be deducted from a taxpayer's income. The prescribed rate for each CCA is the maximum rate at which the cost of assets in that class may be deducted from the income in a year. The seven classes which included most real estate related assets are described on:

https://www.canada.ca/en/revenue-agency/services/tax/businesses/topics/sole-proprietorships-partnerships/report-business-income-expenses/claiming-capital-cost-allowance/classes-depreciable-property.html

To be eligible to for CCA, an asset must be acquired to gain or produce income. Assets owned and used for personal purposes, or owned and used for other purposes that do no gain or produce income, are not eligible for CCA deductions.

Generally, all assets falling within the description of a CCA class are pooled together for the purpose of determining the permissible CCA deduction. in so doing, a CCA "pool" representing the cost of all assets in the CCA class is created. Whenever any CCA is deducted from income, that same amount is deducted from the CCA pool, which reduces the amount of CCA deductible in the future.

Whenever an asset is purchased, its capital cost is added to the CCA pool, which increases the amount of CCA deductible in the future. After making the appropriate deductions from the CCA pool, the resulting amount is referred to as the undepreciated capital cost (UCC) of the pool. UCC is directly analogous to the accounting concept of "net book value."

There are several rules which affect these standard CCA calculations.

> With few exceptions, in the year that the asset was purchased, only one half of the normal CCA deduction is allowed.

> CCA cannot be claimed on a building until the earlier fo the date it is available for use and the second year after the building is acquired. Generally, the term "available for use" means the earlier of the time that construction is completed or the time that substantially all the building is used for its intended use.

> CCA cannot be created or increase a loss on a group of rental properties. This means that in a given year the taxpayer may have to restrict the CCA deduction for certain classes.

When an asset is sold, its adjusted cost based or the proceeds of its sale, whichever is lower, is deducted from the UCC pool. If, after the sale of all assets in a UCC pool balance is positive, the remaining balance is included in the taxpayer's income as "recaptured CCA" On the other hand, if the UCC pool balance is negative, that amount is deducted from the taxpayer's income as a "terminal loss"

Unlike many other deductions, CCA can be carried forward indefinitely until the taxpayer either sells the relevant asset or chooses to deduct the CCA from income.

If the taxpayer sells an asset in a certain class before the end of the year, the proceeds of the sale - up to the amount of the original cost of the asset sold - must be deducted from the total UCC fo the class. If an asset is the sole property in a class and it is sold for proceeds less than its UCC, the balance of the UCC can de deducted as an expense of the taxpayer. Such a deduction is commonly referred to as a "terminal loss" On the other hand, if the proceeds of the sale of such an asset exceed its UCC, the excess will be considered to be the taxpayer. Such an addition to income is commonly referred to as a "recapture"

Generally CCA is applied on the UCC of assets as of the end of the taxation year. UCC is defined in the INCOME TAX ACT as the capital cost of an asset plus adjustments for recapture and certain other amounts. The term "capital cost" is not defined but is generally the amount actually spent by a taxpayer to acquire an asset. Although it is tempting to use the value of an asset to determine its capital cost, capital cost is based on the cost of the asset and not on its value. Capital cost includes all "laid-down" cost such as freight, installation, duties and Goods and Services Tax, and is calculated net of any amount received in the way of inducements, grants or tax credits including the Goods and Services Tax, credit or rebates.

In certain circumstances, the INCOME TAX ACT provides specific rules to determine the capital cost of property. For example, a taxpayer acquires property for some purpose and later commences to use it to ear income. fro CCA purposes, the taxpayer acquires the property on the date of its change in use for its fair market value where such value is less than the property cost. Where the property's fair market value exceeds its cost, the taxpayer acquires the property for its actual cost before the change in use.

Where a taxpayer uses an asset regularly for both personal and business purposes, CCA will be calculated on the proportion of use for business compared to its overall use. If the proportion of use changes, the basis of cCA will change accordingly.

CCA may only be claimed on property owners by a taxpayer or property in which a taxpayer has leasehold interest.

Also see:

SEPARATE CLASS FOR PROPERTY

HALF-YEAR FULE

AVAILABLE FOR USE RULE

RENTAL LOSS RESTRICTION

Claiming CCA creates a deduction for tax purposes but in doing so, it reduces the UCC pool. This usually results in "recapture," in the year of the sale, of the amount previously deducted. While the deferral of tax is generally worthwhile, there may be some cases when you may not want to defer taxes. For example, deferring taxes in a year when your client is in a low tax bracket year will result in a higher overall tax liability if the recapture arises when you are in a higher tax bracket.

When should you claim the maximum CCA?

Generally, you should claim the maximum CCA available, even if it increases the taxpayer's total loss from all sources, since loss can be carried forward for 20 years, beginning in 2008. However, if there is a possibility of insufficient taxable income in the carry forward year, it may be wise not to claim the maximum CCA. If there is insufficient income to use up the losses carried forward, they will "expire" and they will no longer be available to you to reduce taxable income. On the other hand, unclaimed CCA can remain available indefinitely.

Whenever possible, consider making asset acquisitions on or just before DEC 31

Although only one-half of CCA is allowed in the first year of the purchase of most assets, the asset can be purchased at any time in the year (subject to available for use rule). As a result, if an asset is purchased just before the taxpayer's year end, the taxpayer may claim one-half year's worth of CCA even though the taxpayer may claim one-half year worth of CCA even though the taxpayer only owned the asset for one day.

Claim maximum CCA on lower-rate classes first.

If you must reduce CCA claim from the maximum rate allowable, consider reducing the CCA claimed on the high-rate classes and maximize the CCA claimed on the lower-rate classes. This will allow more flexibility and higher CCA claims in the future year.

Maximize CCA claim on assets that are expected to be held the longest.

If you need to restrict CCA (because of the rental loss restriction, for example), claiming CCA on assets they intend to hold onto the longest will defer recaptured CCA. There will be some recapture on that amount when the property is sold, but the recapture will be deferred for as long as the property is held.

You can avoid recaptured CCA, and capital gains resulting from involuntary sale, by replacing property within the specified time limits.

An involuntary sale of property, such as expropriation, or property destroyed and covered by insurance, gives rise to a sale that may result in recaptured CCA and capital gains. The recapture and capital gain may be avoided by repurchasing within specified time limits, similar property to be used in the same or similar business. For land and buildings, the property must be replaced before the end fo the first taxation year following the year of the sale of the original property.

* Intended to help you recognize tax opportunities and pitfalls in the special field of real estate sales and investing. Most Canadian taxpayers find the tax system daunting. Without an understanding of tax law, they are unable to identify the issues or the opportunities. If their tax return involves more than the straightforward reporting of an annual salary, many taxpayers seek out services of an expert. This post is to simply provide some tax planning opportunities or pitfalls. It is up to you to seek out professional tax advisors to flush out and resolve the relevant tax issues. This should only be consider a starting point for further discussions between you and your tax advisors. Consult your own income tax advisors concerning the income tax consequences of particular real estate transactions.