Are You Ready For Real Estate Moguldom? The Business and Tax Implications of Owning Rental Property

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From the Rothschild family to John Jacob Astor to Donald Trump, 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 while, after investing the necessary down payment,  having the investment pay for itself (Leaving you free to move on to buying your next property).  This is not a decision to take lightly and 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 from0.5% 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 Quebecand 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 is unlikely that they will go down), it might make more sense to take a fixed rate mortgage.  However, if you expect the interest rate environment to stay static, then a variable rate is often preferred as fixed rate 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 (can people afford to rent, jobs, vacancies in the area, new construction etc.) Ideally you want the net rental, after expenses and taxes to cover the mortgage payment. 

Expenses:

You should have a thorough understanding of the expenses that are commonly incurred by the property including utilities, annual repairs and maintenance, condo fees if applicable, property taxes and anything else specific to the property.  If available ask for a financial statement that lists the income and expenses.  If these are not available, you should ask for a copy of rental statement that is included with the seller’s tax return.   This will help to prevent surprises.

Income Taxes:

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
  • Repairs and Maintenance,but not improvements.  Any improvements eg. adding new flooring or changing the roof need to be added to the cost base of the property and can be decpreciated (see below)
  • Mortgage Interest (not principal) – 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 include legal and accounting fees.
  • Insurance
  • Property Taxes
  • Cable/Internet etc.
  • Depreciation/CCA (see below) 

As with anything ensure that you have a good accounting system and maintain all documentation including receipts, bills, rental contracts and any legal documents.

Sales Taxes:

In Canada sales taxes apply only to commercial property, while residential properties are exempt.  Consequently you will need to charge your commercial tenants sales taxes.  You are also allowed to claim back sales taxes paid on expenses. 

Capital Gains/Depreciation (Capital Cost Allowance):

Revenue Canada allows buildings, but not land, to be depreciated usually at 4% on a declining balance method.  This means that for example if your property was purchased for $200,000, you would be allowed to deduct approximately $8,000.  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 you will be added back, in full, to your taxable income.  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.

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 far 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 (perhaps slightly paraphrased) the thing about land is that they're not making any more of it

Ronika Khanna is a Montreal accountant who helps small businesses achieve their financial goals.  To receive regular updates of articles pertaining to small business, accounting, tax and other topics of interest to business owners you can sign up here.  You can also follow her on Facebook or Twitter