Real property is considered an important if not essential part of a good investment strategy. When you acquire and own rental property specifically, you need to consider the tax implications of this type of investment.
Rental property may be acquired by an individual, acting alone or as a co-owner, or by a partnership, a corporation or a trust. Each of these types of ownership has advantages and drawbacks for Canadian residents.
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Individuals Ownership
Individuals who own rental property must calculate the income or loss from the property for each calendar year. This calculation must take account of the provisions of the Income Tax Act that apply to this type of income:
- There is a separate capital cost allowance (CCA) class for each property costing $50,000 or more (excluding the cost of the land).
- Investors cannot claim CCA for more than the total of the net rental income from all the rental properties that investors own personally and the net rental income attributed to investors by a partnership. In other words, a rental loss cannot be created or increased with CCA.
When a property is co-owned, each co-owner owns a part of it and must individually report rental income according to the proportion owned. Thus, each co-owner may choose, depending on the circumstances, to claim all or part of the allowable CCA.
Individuals then add the income or deduct the loss from the rental property from other personal income for the year. Individuals who have a sizable rental loss due to high financial expenses may be subject to the alternative minimum tax (AMT). Even in a profit situation, they may also be subject to the AMT if they claimed substantial financial expenses and CCA, and have other amounts to add to their adjusted income because of capital gains or investments in tax shelters.
A major advantage to individuals holding rental property is that, unlike corporations, individuals are not taxed on the capital at the federal level nor in the provinces where a capital tax exists.
Partnerships Ownership
When a partnership owns a rental property, the income is computed as if the partnership were a separate person, according to the rules described above. If an individual or a professional corporation is a partner, the partnership has a December 31 year end. Otherwise, it may choose another year end.
The partnership’s income or loss is then attributed to the partners, who must include their respective share of it in their income. The CCA and other discretionary deductions are claimed in computing the income of the partnership, which means that the tax situation of each partner cannot be taken into account. The partners must agree among themselves on the amount that they will deduct in computing the income of the partnership.
If partners are individuals, they must include their share of the financial expenses paid by the partnership in computing their adjusted income for purposes of the AMT as well as the financial expenses related to any borrowing undertaken in order to invest in the partnership. Thus from an AMT standpoint, there are no advantages to rental property being held by a partnership rather than being co-owned.
If partners are corporations, they can defer payment of income tax if the corporation has an earlier year end than the partnership. For example, if the partnership’s year end is December 31 and the corporation’s is December 29, the partnership’s income for the fiscal period ending December 31, 2002, that is attributable to the corporation will be taxable in its fiscal period ending December 29, 2003.
Also, if partners are corporations, the computation of both federal Part I.3 tax and the provincial capital tax is done differently. When computing the taxable capital of the corporations, it is necessary to include their share of the items on the partnership’s balance sheet that usually enter into the computation of taxable capital.
Corporations Ownership
A corporation is a separate person that reports and pays income tax on the rental income. If rental losses are expected and the corporation has no other sources of income, ownership by the corporation is generally not beneficial. Shareholders cannot immediately take advantage of losses, since they cannot deduct these losses from their personal income.
Corporations record their rental income for each taxation year, which may end on a date other than December 31. The rules that apply to rental property, described above with respect to individuals, also apply to corporations. However, if the main activity of a corporation is the sale or rental of real property, the restriction on the amount of CCA that it may claim will not apply. Thus, when expecting to make large and profitable real estate investments, it may be preferable to create a separate corporation for real estate activities, rather than combining the real estate business with other businesses.
For a Canadian-controlled corporation (CCPC), the tax rate applicable to rental income can vary depending on whether the rental activity is considered to be a specified investment business or an active business. In the former case, the maximum rate applies, plus a refundable tax of 6 2/ 3 per cent. In the latter case, a small-business deduction of 16 per cent can be taken at the federal level on the first $200,000 taxable income, and provincial income tax may be reduced. In some provinces the tax rates drop significantly, from 52 to about 16 per cent.
A specified investment business is deemed to exist when five or fewer full-time employees are engaged in the property rental activity. Thus, if owning a rental property is a secondary investment activity, there is no advantage in a corporation owning it in order to defer taxes, since the applicable tax rate will generally be greater than the rate that an individual would pay. Note that if a property is rented to an associated corporation that deducts the rent from its active business income, the rental income will be considered as active business income regardless of the five-employee criterion.
An advantage of rental property being held by a corporation is that the capital gains deduction (CGD) may be available on the sale of the corporation’s shares if it was carrying on an active business. The shares would not be eligible for the CGD if the corporation was carrying on a specified investment business.
Trusts Ownership
Having a rental property held by a trust is a relatively new type of ownership, which was originally advocated as a way to reduce Part I.3 tax and the provincial capital tax (except in Ontario). Today, ownership by a trust is often suggested for non-tax reasons such as asset protection.
For tax purposes, trusts are considered to be individuals. Trusts therefore file an income tax return, and the tax rate for inter vivostrusts created to hold rental property is the maximum rate for individuals.
Trusts compute their rental income in the same way as individuals do. However, in computing their income, trusts are allowed to deduct income payable to the beneficiaries of the trust. In this case, it is the beneficiaries who must pay the tax on this income. Thus, if all the income is payable to the beneficiaries, the tax payable on the rental income may be reduced by taking advantage of the tax rates or tax status of the beneficiaries.
Trusts are not subject to Part I.3 tax or the provincial capital tax. And, unlike in partnerships, if a business corporation is a beneficiary of the trust, it does not have to account for its share of the taxable capital items of the trust, except for purposes of the Ontario capital tax.
The main disadvantage of trusts is the rule on deemed disposition of their assets every 21 years. Also, trusts are subject to the AMT if they incur rental losses.
When deciding whether to acquire and own rental property, it is important to consider which type of ownership is appropriate under the circumstances. After all, you don’t want to be left paying more taxes than you have to.
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