Q: I’ve had a rental property in Toronto for a number of years. I report all the rental income and expenses with one exception—I have never included the deduction for capital cost allowance. I’ve always filed my own returns so do not have the benefit of professional advice. As I understand it (as per CCA rules), I can elect to deduct any amount or no amount, as long as I do not exceed the allowable percentage in the relevant class. As well, if I otherwise would not have a loss for the tax year, capital cost allowance cannot be used to create a loss. However, I do not understand the effect of capital cost “recapture.” It may be helpful to know some details of my rental (condo) unit. I purchased it for $200,000 in 2002. I lived in the condo before converting it to a rental in 2008 when I moved into a second property that I purchased. I estimate the rental property’s current value would be $500,000. Specifically, I have three questions:
- Could you please explain capital cost recapture?
- Since I did not previously use the CCA deduction, can I take this deduction retroactively?
- As I understand it, CCA can only be taken for the building and not the land value. How do I determine the proportionate value? Any assistance you can provide would be greatly appreciated. As well, I would appreciate any other information you deem relevant.
A: Hi Mabel. It certainly sounds like you successfully transitioned from homeowner to small landlord. It’s not always an easy leap, so congratulations.
Still, the questions you have—about finances and taxes of running a rental business—are the very reasons why people become confused and afraid of becoming a landlord. The good news is you have quite a lot of assistance available to you, including the MoneySense experts!
To help you understand your particular financial dilemma, we first need to go back and explain capital costs allowance from the perspective of the Canada Revenue Agency.
When a business-owner purchases an asset that is required for business, the assumption is that the asset’s current value will depreciate over time. To recognize this loss, the CRA allows business owners to deduct this depreciation—not as a lump sum but as a percentage of the asset’s overall value, over time.
For example, if you bought a $3,000 ATV to be used in your business, you cannot deduct the entire cost of this asset in the year of the purchase. Instead, you would claim the annual depreciation of this asset, based on the asset class designated by the CRA (just look at the schedules provided by the CRA to determine what class the asset belongs to and then make the calculation accordingly). If for instance, the CRA states that vehicles depreciate at 20% per year, then you would claim 20% of the ATV’s current value as a tax deduction. You would continue to do this every year until you the asset’s value reaches $0.
The big reason for this adjusted capital cost allowance for each of the business assets is that the CRA considers all depreciation incurred by the business assets as one annual cost borne by the business—so all depreciation on all assets is calculated, added up and the total depreciation (known in tax terms as the capital cost allowance on an asset) is then used as a tax deduction to reduce taxable earnings.
Yet, the CRA recognizes that some businesses will add and dispose of assets throughout the lifetime of the business. This addition and removal of assets require the business to adjust its total capital and the subsequent costs. This is the point where capital cost recapture comes into play.
When you sell, give away, destroy or re-assign business property (say for personal use), or if the item is stolen, the CRA considers the asset to be disposed of and all dispositions must be reported on your annual tax return. But remember, the CRA also lumps all capital costs—the depreciation of assets—into one lump sum. That means any additions and losses are added and subtracted from one, final annual capital cost sum. That means you could actually end your fiscal year with a negative capital costs sum.
For instance, what if you bought that $3,000 ATV and the very next year it was stolen? Thankfully, your business insurance policy paid the claim, to the tune of $2,800. Now, the CRA would expect you to claim each transaction as part of the annual capital cost calculation. How would that look? At 20% you would have a capital cost allowance for that stolen ATV of $560, but because you were paid $2,800 from your insurance company you would subtract the this from the capital cost for that year leaving you with negative $2,240. Sadly, you now have to report this sum as income. All of these calculations are made on Form T2125, Statement of Business Activities.
What does this mean for you, Mabel? Right now, nothing. You have not changed the use of your business asset—your rental property—and you have not been claiming capital cost allowance, so you do not need to adjust these costs.
The great news is that if you do go back and calculate the capital cost allowance on your rental you can use this to offset any capital gains earned on the property. You will realize a capital gain once you go to sell the property (or when you change the use of the property, say to transfer it back to a personal residence). The time limits and specific application rules depend for carrying a capital loss depends on the type of capital gain, as well as other factors, but typically you can apply the losses going back as far as three years.
To carryback a capital loss, fill out form T1A, Request for Loss Carryback. Don’t worry, you don’t have to file an amended tax return for the year to which you want the loss applied.
The losses reported on form T1A lower your taxable income, resulting in either a refund or a reduction of your back taxes owed. However, this adjustment does not change your net income, nor your eligibility for benefits as you cannot obtain retroactive benefits as a result of carrying a capital loss backward.
Finally, if you do decide to calculate the capital cost allowance on your rental property in order to apply for it retroactively for the last three years, you are correct in assuming that the CRA will only consider building depreciation, not land. An easy way to determine the value of the building versus the land is to review the mortgage documents on your rental property. All lenders request or obtain an appraisal and the values of this appraisal are, typically, included in the mortgage documents. Under the section on replacement costs, there should be two values: land and building. Now, this gets a bit trickier if no appraisal was done on the property, as it would require you to call and pay for an appraisal that would give you this value, at time of purchase.
Mabel, I hope all this information helps. I should point out that while there is a tremendous amount of free information on CCA and rental property management when it comes to the books, it pays to pay a professional. An accountant that is familiar with rental properties would be worth their fee in determining the best course of action for you when it comes to annual management and deductions and when it comes time to sell the property. All the best!
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