December 15th 2021
So we are getting very close to the end of the year. Soon it will be tax time. And in preparation, you’ll want to begin compiling your financial records. For those whose only income comes in the way of a weekly paycheque, it may be quite simple to file your tax returns. Just fill in your tax return information from your T4. But if you are a follower of ‘The Money Machine’, and a real estate investor, tax preparation is a little more complicated than that.
One of the very important things for you to do is to keep complete and accurate records. And, I might add, not just financial records. If for example you paint an apartment between tenants, you’ll want to keep all expense receipts. But it’s not a bad idea to also journal what you did when you did it. And the brand and colour of paint you used. It’s handy next time the unit comes vacant to know how long ago it was last painted, and in the event, one or two rooms need painting, by referring to the precise paint used, you may get away with a touch-up rather than having to fully repaint the entire apartment.
But back to financial records for a minute. Whenever you spend money on a rental unit in the way of repairs, maintenance or upgrades, you are entitled to a tax break. And that can be extremely helpful when it comes to keeping your properties upgraded and well maintained because basically, it gives you access to more money to spend. Before-tax dollars if you will. But because not all expenses are handled in the same manner, it can make a huge difference which way expenses are allocated as to how much tax savings is involved.
Essentially there are two approaches to handling repair, maintenance, and upgrade costs. They can be treated as an expense or they can be capitalized. When an item is expensed, you can apply the entire amount spent in reduction of your net earnings on your tax return. When you capitalize the cost you can only reduce your income by the allowable percentage attributable to depreciation.
Let me explain by way of example. Suppose you purchase a rental property for $500,000. The government allows you to claim a certain amount as depreciation. Generally, a rule of thumb is 75% of the acquisition cost is attributed to building and 25% is land. And you can’t depreciate land. So in our example, of the $500,000, $375,000 would be available to depreciate. The rate for personally held property is 4% annually. So, in other words, you could claim depreciation in the amount of $15,000 for the year and show that as an expense on your income tax.
Now, let's suppose over the year, you spend a further $50,000 on repair and maintenance. If those costs can be expensed, you can ‘write-off’ the full $50,000 against rental income on your tax return. If on the other hand, those costs are capital in nature, they are added to the total amount you can depreciate, in this case, $375,000 + $50,000 = $425,000, and that amount can be depreciated by 4%. So as a capital cost allowance, that $50,000 gives you a $2,000 expense against income. Expense vs capital cost, $50,000 benefit compared to $2,000 benefit. Quite a difference. Of course, when capitalized, you can continue to depreciate from that expanded base year after year, whereas expense is a one-time item. And not everyone wants to claim depreciation because it brings up the challenge of recapture if and when you sell. But that is a topic for another time.
But what distinguishes an expense from a capital cost? Again, as a rule of thumb, if you are repairing or replacing something already in existence it can be expenses. If on the other hand you are enhancing or creating new, it will probably need to be capitalized. Furnace blows up, the replacement can be expensed. Fence blows down, again replacement is an expense. On the other hand, install A/C where it wasn’t there before, or erect a fence new and those items should be capitalized.
It can be complicated and how you deal with ‘grey’ areas will depend on how aggressive a stance you want to take. As we’ve seen, your approach can make a significant difference come tax time. Give it some thought and when in doubt, consult a tax advisor.