Should you claim capital cost allowance on a rental property?

Rental property investors need to report their annual income and expenses on their tax return. You must also track your adjusted cost base (ACB), which may increase over time with renovations to determine the eventual capital gain when you sell. 

There are related tax concepts called undepreciated capital cost (UCC) and capital cost allowance (CCA) that are important to understand. 

What is UCC?

The Canada Revenue Agency (CRA) defines the capital cost of an asset very simply as “what you pay for it. Capital cost also includes items such as delivery charges, the GST and PST, or the HST.”

In the case of a rental property, it may also include acquisition costs like legal fees or land transfer tax. 

Undepreciated capital cost (UCC) “is the balance of the capital cost left for further depreciation at any given time. The amount of CCA you claim each year will lower the UCC of the property.” 

What is CCA?

CCA is depreciation you claim on an asset. In the case of a rental property, you can claim CCA on a building but not on land. This depreciation is a percentage of the undepreciated capital cost that can be claimed as a tax deduction against rental income. It is typically up to 2% in the year a property is acquired (due to the half-year rule) and 4% on a declining balance basis in subsequent years. 

As you claim CCA, it reduces the undepreciated capital cost over time. You need to track your UCC each year. 

In the case of a condo, most of the purchase price may be eligible for CCA because the land value is typically small. In the case of a property on a large parcel of land, you may only be able claim CCA on a portion of the purchase price. You need to allocate the purchase price between the land and the building when you acquire a rental property.

A professional appraisal may be the most reliable method to determine a proper allocation, but an appraisal is not mandatory for tax purposes. A taxpayer can make a reasonable estimate. 

Why claim CCA?

Claiming CCA reduces your net rental income, and therefore your tax payable. It can save you tax of between roughly 20% and 50% depending on your personal income and province of residence. 

For a corporation, tax savings from CCA are generally about 50%. 

How much CCA should you claim?

You can only claim CCA to the point where your net rental income is zero. You cannot use a capital cost allowance deduction to create or increase a net rental loss. 

As a result, there is a maximum amount of CCA that can be claimed, which can only be determined when preparing your tax return. The CCA limit could change from year to year as rental income and expenses rise and fall.

Spouses who own a rental property jointly can claim different amounts of CCA. 

If you own a rental property in a corporation, you should generally consider claiming CCA. If your income is relatively high, it is usually advantageous to claim CCA, as well. If your income is relatively low, you should think twice—and here’s why. 

Calculating recapture

When you sell a rental property in the future, you have to determine all of the capital cost allowance claimed historically on the property. This past CCA is claimed as a “recapture” and considered taxable income in the year of sale. 

If you have claimed a lot of CCA and owned a rental property for many years, this recapture can lead to a big tax hit. As a result, many people shy away from claiming CCA at all. 

However, if your income tax rate is 50% today and it will be 50% in the future when you sell, CCA is usually advantageous to claim. If you could claim $100 of CCA today and save $50, but had to add that $100 of income to your tax return in 10 years and pay $50 of tax, should you not claim CCA today? Paying $50 in 10 years is better than paying $50 today. 

A corporation does not have the same marginal tax rates as an individual taxpayer, so higher income does not typically mean more tax. As a result, a corporation should usually claim CCA to benefit from tax deferral.

If your income is low today, and you are only paying 20% or 30% tax, claiming CCA could be detrimental. You might save $20 or $30 today and pay $50 back in a higher income year when you sell due to the capital gain and large income inclusion. So, low- and modest-income earners—especially those who anticipate a rental property sale in the short or medium term—should think carefully before claiming CCA.

Read more from Ask a Planner:

• How is cryptocurrency taxed in Canada?
• We’re 10 years apart—can we retire together?
• How to unwind a spousal loan
• Preparing taxes for someone who died

The post Should you claim capital cost allowance on a rental property? appeared first on MoneySense.