LINE 126 - RENTAL INCOME
NEW FOR 1988 and 1989 and 1990
THE OLD RENTAL SCHEDULE 7 IS GONE. You may use an acceptable substitute but the government has provided a new SCHEDULE T776 to report Rental Income. This is a two page form which requires more details of partners in rental operations including Social Insurance Numbers, percentages, etc. There are still not enough lines for expenses as the government form omits the prompts for management fees, common expenses, interest on your furnace loan, etc.
The Capital Cost Allowance portion has been greatly expanded pointing out the problem which Revenue Canada has had with taxpayers making incorrect deductions in this area. The government guide is very good but I believe it errs in favor of the government.
For instance, this book gives details of some court cases indicating that fairly major exterior renovations are expense items. The Gold Bar Developments case reported on the next page would indicate that replacing windows and furnaces (even if improved) would be an expense item. However, on page 12 of the 1989 Rental Income Tax guide, they state that thermopane windows and a new energy furnace are capital items and may not be expensed. Clearly, it is a matter of opinion and would be governed by the condition of the old windows and the old furnace before replacement. However, at this point I would remind the Tax office that it would be more expensive to replace the old furnace with an `identical' new one and it would likely cost more to replace old wood-sash windows with identical windows. In many, if not most cases, it is cheaper to replace old with new than to replace with original simply because of the cost of labor and the unavailability of the identical item.
If you own or control property that you rent out to others, even to your own incorporated company, you must report the rental income and prepare form T776, Statement of Real Estate Rentals (see example). You must keep detailed records of all money collected and paid out. Most of the expense items on the rental schedule are obvious, but you should be able to back them up with receipts. Revenue Canada now wants to know how many units are available for rent for each property listed. This applies to residential rentals, so if your rental property is commercial or industrial, enter zero.
PART DEDUCTIBLE AND FULL DEDUCTIBLE
If an expense applies to the whole structure, and you use part of that structure personally, put the expenditure in the `part' deductible column. If the expenditure applies to the rental area only (as with commissions or advertising for rent expenses), put the expense in the `full' deductible column. You might, for instance, have a mortgage on the whole building and the money was used to buy the building. The interest expense on this mortgage would go in the `part' deductible column. If you had a second mortgage on the whole property, but the money was used exclusively to build the rental suite, you would charge "ALL" the interest to the `full' deductible column. One commonly overlooked deduction is the interest charge on a credit card when the card has been used to buy a fridge, stove, carpet, etc., for the rental house.
MORTGAGE INTEREST (other interest)
If there is more than one mortgage on the house relating to the purchase of the investment property, be sure to claim the interest on all of them. The interest on any other money borrowed to purchase the property is also deductible no matter what was used as security. One difficulty encountered here is that very few people seem to know how much mortgage interest they have paid in a year, even though it is usually the largest single expense in the operation of a property. These people know the amount of the mortgage payment that they make every month, but that is not the interest figure. We at the CEN-TA GROUP have seen on several occasions people who were meticulous about making their mortgage payments on time every month, but whose total amount owing was increasing. The reason for this is that the payments were wrongly calculated in the first place, and were not enough to cover the interest. If you do not understand the compound interest calculations, you must have an amortization schedule which gives breakdowns of the interest and principal portions of the mortgage payments. At any rate, make sure you read INTEREST DEDUCTIONS at Line 221.
MAINTENANCE AND REPAIRS
The big problem here is, "what is a repair, and what is a capital expense?"
A good explanation was given in 1962 by Mr. Justice Abbott in the Haddon Hall Realty case. He said, "Among the tests which may be used in order to determine whether an expenditure is an income expense or a capital outlay, it has been held that an expenditure made once and for all with a view to bringing into existence an asset or an advantage for the enduring benefit is a trade of a capital nature. "
This reasoning was used by Judge Brule of the Tax Court of Canada. In December 1984, Gold Bar Developments Ltd. lost their claim for expensing the cost of a new exterior on part of a commercial building the company owned. Judge Brule ruled that the expense was a major outlay used to put the property into proper condition, and not one of an annual or recurring nature. However, in 1987, Gold Bar won their case in the Federal Court.
However, in 1987, Victorio Pugliese lost his claim to expense roof repairs and a new furnace. Judge Couture of the Tax Court of Canada ruled that the furnace was of a capital nature and that the expensing of $2,700 on the roof seemed to be a replacement rather than a repair.
In December, 1983, Sydney Harold Healy lost most of his claim for $130,000 to refurbish a building which he had owned for thirty-five years. The property was vacant from 1974 to '79 and he spent considerable sums (over $130,000) in 1977, '78, and '79 bringing the building up to a sufficient condition that he was able to rent it to the Government of Ontario as a Court House. Justice Christie of the Tax Court of Canada allowed $10,000 for paving and $3,687.97 for roofing in 1977, and $370 for an architect and $1,125 for an engineer in 1979. The rest of the $130,000 was capitalized as improvements.
And in 1986, Jean Methe found out the same thing. The taxpayer had expended over $140,000 in 1980 and '81 refurbishing a building bought for $38,000 in 1980. The taxpayer tried to write off $65,000 as repairs, and the rest he added to the capital cost of the building. DNR denied the claim and reduced it to $25,000. Judge Taylor of the Tax Court of Canada agreed with DNR. I am surprised that Judge Taylor or DNR allowed as much as they did for repairs. What it does show is that income tax is a gray area.
Where this really becomes important for most people is when there is a new purchase. At several real estate courses I have attended, I hear the expert up front tell the class or attendees that they should buy a junker, fix it up, and rent it. They always paint glowing reports about all the tax deductions they can expect because of the expenses. In these cases, ANY SINGLE EXPENSE you KNOW you have to make when you BUY the property, is NOT deductible at all, (not even one can of paint). All expenditures, (both money and trade), used to put property into rentable condition, are of a capital nature, and may be depreciated over the years.
Few people carry enough insurance in rental situations. The cost is deductible; buy what you need. Make SURE that your policy recognizes the rental nature of the house. Remember that if the house is left empty for more than thirty days, the policy is invalid. Make sure that you or someone else visits every twenty days or so if your tenant takes a vacation for a couple of months. Make sure that your Public Liability is enough. At a convention on Sexual Assault (Feb 28, 1986 - Bayshore Inn, Vancouver), a lawyer from Campbell River, B. C. presented a paper which indicated that a landlord could be held liable for the damages suffered by a tenant in a sexual assault if adequate security was not provided, i.e., proper dead bolt door locks, secure windows, well lighted entrance ways and parking areas, etc. Also, make sure that you have business interruption insurance. It is possible to have a $3,000 fire which is covered by your policy, but while everything is been handled, you lose $5,000 worth of rent. Some policies will exclude water damage if the house is not visited `every 24 hours' while the owner is away. Be careful here. You could have an uninsured house if your tenant goes on a two week vacation.
Make sure that you do not get caught in a co-insurance caper. This happens when you buy $40,000 of insurance on a $60,000 building. If there is a $15,000 fire, the insurance company only pays $10,000 because YOU co-insured yourself for 1/3 of the damage ($20,000/$60,000). Make sure that you review your insurance on an annual basis, and KNOW that it is covering the replacement value. Also, keep a separate rider on your policy to cover any part-time employee's actions while they are doing something for you. Remember, your tenant `could' be ruled a part-time employee if he or she was fixing up the unit for a reduced rent.
In September, 1988 I spoke at a convention of Mobile Home Park owners. Some of the other presentations put on were excellent and I picked up one point which is very important. Make sure when you are buying your policy that it covers events that happened during the term of the policy, not just when it was discovered. It would be easy for your current insurance company to deny a claim that was just put forward for an injury which took place three or four years ago (i.e., hidden injury or degenerative injury) but when you go back to the company which insured you at the time, you find out that the policy only covers you if it was brought to their attention when their policy was in place. When I approached a lawyer about this, he proceeded to tell me that the same thing was true of lawyers' insurance. If you suffer damages at the hand of an insured lawyer, and he is no longer a lawyer (I have on my desk a list of over forty lawyers in BC who ceased to be lawyers on January 1, 1989), you may have no one to collect from.
As an example: a BC lawyer is (Jan, 1989) currently serving a jail sentence for fraud). Today, we have been informed that a second mortgage which was supposedly paid off several years ago had not been discharged by that lawyer. The mortgagee is demanding $17,000+ to discharge the mortgage which he says is still in place. The lawyer has no money and is not practicing. There is no one to sue.
Make sure that you keep the receipts. (Perrier does not count here.)
OIL, GAS, HEAT, ELECTRICITY
If you are sharing the unit, i.e., half a duplex, this can get complicated, even down to figuring out the respective heat loss from the main floor, and the attic, and arriving at a properly scientific percentage. What you spend is what you get. Do consider that, if possible, splitting services into two or more meters will likely SAVE you money in the long run. Rarely does a "heat and light included" tenant respect the cost.
This is rarely a deduction for rentals. If you spend it, claim it. Just remember, a share of a single line personal phone rarely qualifies. The judge assumes that `everybody' should have to pay for their own phone.
This could be business, or it could be personal. You know the answer.
You would normally only have this at `your' expense if it was multiple and you lived on the premises. This is a good place to deduct the costs of tapes, etc., if you are supplying a video system.
ADVERTISING - RENTAL COMMISSIONS
Self explanatory! Make sure that you keep the bills. A photocopy charge for pamphlets put up in laundry rooms would qualify here.
The vista boggles the imagination. If you do not claim it, it will never be deducted. This could include collection charges, business license for bed and breakfast, food for bed and breakfast, an accounting fee, or perhaps a legal fee for drawing up a lease. Likewise, the common expenses for a condominium corporation would find a home here.
CCA - CAPITAL COST ALLOWANCE - DEPRECIATION (see Line 135 - business section)
Class 3 is any building you have bought since Jan 1, 1982. The rate is 2 1/2% for first year and 5% afterwards, on a declining balance. Class 3 also applies to a steel and concrete building bought before Nov 12, 1981. As of June 17, 1987 new buildings will be depreciated at 4%.
Class 6 is any building of frame construction that you owned before Nov 12, 1981. The depreciation rate is 10%.
Class 31 is a MURB (Multiple Unit Residential Building) of steel and concrete, bought before November 12 1981, or any MURB bought after that date. The rate is 2 1/2% the first year and 5% afterwards.
Class 32 is a MURB of frame construction bought before Nov 12, 1981.
Class 8 is the catch-all for the fridge, rugs, furniture, and fixtures. The depreciation rate is 10% in the first year and 20% in subsequent years.
All depreciation rates are on the declining balance i.e., if there is a $1,000 addition for class 8, the depreciation in the first year would be 10% of $1,000 or $100, leaving $900 to depreciate for the next year. Next year, the depreciation would be $180 (20% of $900) leaving $720 to depreciate the next year.
If the item is class 3 or 6, no depreciation may be used to create a loss using classes 3, 6 or 8. If the item is class 31 or 32, depreciation may be used to create paper loss using classes 31, 32 or 8 (see david ingram's Investment Guide for a great explanation of MURBs and how to let the government and tenant pay for your pension).
Use when you have a rental suite, half a duplex, or use part of the rental building for your own use. You might also use this when you have lived in the building for a couple of months of the year, and rented it out for the rest of the year. Simply divide your area into the total area, and take this amount off of the total of `partly' deductible expenses.
NET INCOME FROM RENTALS
Put this amount on line 126 of the tax return.
PROFIT OR LOSS
After all that, if the property loses money, is the loss deductible? The answer is yes, if you can expect a profit in the future. If you are only renting out to `hold on', you do not have a legitimate loss, as the following Toronto taxpayer found out.
In 1986, Ivan Glavanovic lost his claim for five years of rental losses. He had built a house for sale in 1975 and was unable to sell it. He therefore rented it out at a loss for six years. DNR turned down his losses for 1979 and 1980. Judge Tremblay of the Tax Court of Canada agreed with DNR. He ruled that the rental was not to earn income but to hold on to the property. The losses were therefore capital in nature and should be added to the adjusted cost base of the house. It was also clear that there was no reasonable expectation of profit from the rental.
Also in 1986, Kelvin Lee found the same thing. He had rented his house on an option to purchase. Judge Couture of the Tax Court of Canada ruled that the renting while holding had no expectation of profit and was not deductible.
in 1989, Virginia Maloney was turned down by Judge Mogan of the Tax Court of Canada. She had rented her house to her mother. The rent charged was not realistic with regard to the cost of and the maintenance to keep up the property. Ms Maloney had charged her mother $100 rent in 1984 with $4,600 of expenses and $1,800 rent in 1985 with $11,000 of expenses. See Special Problems below.
and in 1990, Michel-Guy Huot was also turned down for a deduction when he rented a house to his parents for less than market value. Judge Garon of the Tax Court of Canada ruled that the taxpayer "Had failed to establish that the rental expenses were incurred in order to earn income." Because of the low rent and the uncertainty of their stay, there was no "expectation of profit." (See Expectation of Profit Section at back of book for more information on this subject."
In September 1986, Louis Vaillancourt lost his claim for CCA on a class 31 building which was part of a 44 unit limited liability partnership operation of a motel/hotel deal at a ski resort. The tax office rejected the claim on the grounds that it was not `residential' property but a motel room. I agree with them. What is interesting and of danger to many MURB purchasers is that in giving his decision, Judge Pinard of the Federal Court Trial Division gave a ruling that no individual apartment (condo) in a multiple unit building could qualify anyway. This means that 200,000 MURBs sold in Canada are suddenly not tax deductions. It is my understanding that DNR is going to ignore this ruling in terms of blanket enforcement, and will only use it when there are obvious attempts to take advantage of the policy. In particular, they will attack all units at ski or summer resorts.
And in 1988, Ercole Tertulliani and Clement Cardin had their claim for soft costs turned down by Judge Couture of the Tax Court of Canada. They had purchased condominium units in a building which was not yet constructed. Clause 16 of the offer to purchase stated "Possession of and proprietary title to the property shall be transferred to the purchaser only upon execution of the sales contract". As the sales contract was only executed after all the monies had been paid, it was impossible for the purchasers to have spent the soft costs in the course of building their units. As every `soft cost' deal I have ever seen is structured in a similar manner, it is logical to assume that any other soft cost deals would fail if they were challenged by the department.
Common situations that also cause problems are:
(a) rentals to members of your own family (see Virginia Maloney above)
(b) rentals at unreasonably low rates to friends, business associates, or employees
(c) rentals of property where you use all or part of the premises some of the time for personal use.
In the first case, (rentals to members of the family such as your mother, father, brother, sister, son or daughter, or any of the respective in-laws), it is important to know that usually a loss cannot be created. If a father rents a building to a son and loses money in the deal, the tax office may not allow the loss because of the artificially low rent (i.e., renting a $500 per month house to a son for $100 per month). On the other hand, if the father was renting to the son at the same rate as to others and a loss was being incurred, the father should claim the loss as a tax deduction.
With regard to rentals to business associates or friends, we have a slightly different problem. If an employer provides a house for an employee at an unreasonably low rent, the difference between "fair" market value and actual rent charged should be added to the employee's T4 slip as a taxable benefit.
Renting between associates is an even trickier question. There have been cases where people have owned houses which they have rented to each other at below market rentals. In this way, both get a tax loss on their rental property. Ministerial discretion on the part of the tax office would seem to defeat this, but I have never personally seen this particular ruse upset. I do not recommend it as a practice, but it does seem to work at the present moment. One disadvantage in some provinces is that the provincial homeowner's grant is lost on both residences, and this then becomes a form of taxation.
While talking about rental properties, I think it appropriate that I include some thoughts on the purchase of real estate for either personal or investment use.
First let's look at what it really costs to rent.
WHAT IT COSTS TO RENT
A pitfall which I have learned about from my clients concerns the amount of money it costs to rent accommodation. Have you ever thought about how much it really costs to rent? I am frequently criticized for telling widows and pensioners to cash in their bonds, term deposits or GIC's and buy an apartment.
People say, "David, you don't understand - the pensioner needs the income from the GIC to live."
Let's look at a 55 year old widow with $100,000 "in the bank" and a $10,000 a year pension.
The widow will be paying $1,000/year income tax on her pension income and essentially she has no control over her pension.
If she receives 10% on her GIC (more likely over a five or ten year average than 12%), she will have $10,000 on top of the $10,000 pension.
Of this $10,000, about $3,000 will go in tax, leaving the lady $7,000 for rent, or expenses, or vacations.
With this amount of money, she is probably living in a $600/month apartment which works out to $7,200 a year.
At the 30% marginal tax bracket, it takes $102,856 of capital invested at 10% to produce $10,285.60 gross interest, on which she pays 30% (about $3,085.60 tax) to have $7,200 left for rent.
At 20% interest it takes $52,500 to produce the money for the rent - but at 8% interest, (remember - the whole country wants to go back to 10% mortgages which means 8% term deposits), it takes $130,000 to produce that rent.
The accompanying chart shows what might happen to this lady over the next ten years.
By the year 2000 - if she has a non-indexed pension - the whole amount plus interest would go to rent.
She Must Buy Today or hope to be dead in seven years because her capital will be gone and her total spending power will be reduced to today's welfare rate of $468/month.
"Today's" welfare rate in BC is $468 for a single male in British Columbia.
Example - at only 10% inflation, $10,000 today will be worth $3,500 in spending power in ten years.
At 15% inflation, $10,000 today will be worth $1,900 in spending power in ten years.
See Chart 1 "Cash in Bank $100,000".
THIS CONCEPT PREPARED BY DAVID INGRAM, November 9, 1981
I have difficulty with mathematical concepts and have to fight them out. If there is any reason I have managed to be able to explain them to people over the years, it is because of this difficulty.
In the last two years, the rent on a 3 bedroom townhouse in Brampton has gone from $600 to $1,000 a month (in spite of rent controls). And people are paying up to $2,000 `key' money (illegally) to get to be a tenant. In 1981, you could not give those townhouses away and the rent was $325 - $425 a month. In 1981, interest on Canada Savings Bonds was 19.5% and $25,000 of bonds would pay the rent in after tax dollars. Today, nine years later, it takes $180,000 of Canada Savings bonds to pay the rent in after tax dollars on the same townhouse. The townhouse has gone from $42,000 to $110,000. The same thing has taken place in Vancouver and is about to take place in Ottawa, Calgary and Edmonton. You can still find a really nice place to live for $75,000 in Winnipeg, Saskatoon or Regina. Please do NOT get carried away with the idea that you can live on a particular amount forever because rents are cheap NOW.
When the interest rates were extremely high, a very popular theory was to sell the house and live on the interest. The theory is not as popular at the moment because of the dramatic drop in interest rates. The following example explains very clearly the erosion effect inflation and taxes have on your capital.
"Sell House" Live on Interest! Why This Theory Can Not Work
High interest causes a person to "think" they can sell the equity in their house and live on the interest plus their salary. I am using a $275,000 house with a $60,000 mortgage as an example. Sell house for $275,000 - $15,000 (commission) - $60,000 (mortgage) equals $200,000 principal left over. Assume $25,000 salary. This was written in 1981 and I throw it in for your thought... Remember?
The Marginal tax rate on interest with $25,000 Salary = 50%.
Amount Int Tax On Interest Rent Or Excess Spending
Year Rate Income To Spend Expenses Power
1981 $200,000 20% $40,000 $20,000 $20,000 $12,000 $8,000
$20,000 in 1981 dollars.
1982 $200,000 20% 40,000 20,000 20,000 13,200 6,800 $15,122
After first year rent has gone up $100/month - $1,200/year and at 15% inflation $20,000 = $15,122 spending power
1983 $200,000 15% 30,000 15,000 15,000 14,000 500 9,862
Interest rate drops to 15% (remember when that was high?) and you only have $15,000 to spend. Rent went up to $14,500 and you are just about even - after tax dollar to new rent. But $15,000 in 1983 $9,862 in 1981 dollars.
1984 $200,000 17% 34,000 17,000 17,000 15,000 1,050 9,719
Interest back up to 17% (great days again) but rent goes up to $15,950 $9,719.
1985 $200,000 15% 30,000 15,000 15,000 17,545 (2,545) 7,457
Interest back down to 15%, rent up to $17,545 and we are short $2,545 to just pay the rent - oh yes - $15,000 = $7,457 of 1981 dollars and $200,000 equity only rings $99,435 of 1981 dollars.
1986 $200,000 13% 26,000 13,000 13,000 19,299 (6,299) 5,620
Gov't getting inflation down so you only get 13% - rent still goes up 10% to $19,300 and you need $525/month to pay rent shortage.
1987 $200,000 10% 20,000 10,000 10,000 21,230 (11,230) 4,523
Government really getting inflation to the ground - only $11,230 short for rent.
1988 $200,000 11% 22,000 11,000 11,000 23,350 (12,353) 4,443
1989 $200,000 12% 24,000 12,000 12,000 25,685 (13,685) 4,327
1990 $200,000 10% 20,000 10,000 10,000 28,253 (18,253) 3,219
Oh yes, the $275,000 house would be worth ( $713,270. Oh, I know you think I am wrong - real estate will not go up - inflation will STOP - and besides you or your parents lived through the depression.
You know what can happen (and did in 1929 AND IN 1987). But, while the Stock Market crashed all over the world, real estate values remained fairly constant for the average house. REMEMBER, at 11%, electricians, plumbers, and others will be charging three times as much for their services in ten years. At 7%., they will be charging twice as much.
Today, in 1991, it is 10 years after I first published the above. Amazingly, in Vancouver, I can already show you $275,000 houses worth $700,000 in the West Side. The big difference is that I can likely get 12% today, so I would have $4,000 more gross to help pay my rent or make up the $400,000 shortage in my net worth.
Next: Capital Gains
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