First what you should do before buying a rental property is determine whether to register a corporation for this purpose or make a purchase as a private person. If you are able to pay for insurance when acquiring a property, the benefit from using a corporate structure will be insignificant. Since year 2011 there are no tax benefits for real estate acquisition by a corporation in Ontario. Given that the corporate tax rate for a passive rental revenue is identical to the highest personal property tax rate of 46.6%, there is no point in involving a corporation.
An additional factor in favor of real estate acquisition by a private person is that any rental losses can be used to reduce revenues from other sources. If a property is registered in the name of a corporation, the rental losses can be utilized only at the expense of future rental revenues.
If you want to buy a property as a private person, you will have to decide which legal entity you would like to be a part of: sole proprietorship, partnership, or joint venture. Many people buy rental property with their friends, relatives, or spouses. If you decide to buy real estate together, then I recommend signing a partnership agreement, which will indicate under what conditions you will run business, and how you will distribute revenue.
Purchase Price Allocation
Once you have purchased a property, you need to allocate the purchase price into the land and the building. The land has no wear and tear to impose a tax on, thus it is more beneficial to allocate the better part of the price to the building, which can depreciate by 4% a year. The majority of people do not have any supporting data for price allocation (in which case insurance policies and real estate tax bills can sometimes come in handy). Therefore, allocation of 75-80% to the building and 20-25% to the land has become a standard practice.
As a rule, when buying a condo, it is allowed not to allocate the value of property or maximum value to the land, but 10% of the total amount.
Major and Minor Repairs
If you have bought a rental property that requires cosmetic repair, all repair expenses will increase the value of the building, but only when the building is ready for use it begins to depreciate, i.e. you can start to deduct depreciation.
In case the building starts being rented immediately after it had been purchased, and later it requires some repairs, it is necessary to determine whether the repair will improve the condition of the rental property and, accordingly, increase its value, or it will be just a minor repair. If the repair is major, then, according to Canadian Revenue Agency (CRA) Interpretation Bulletin / 28 R paragraph 4, it must be added to the value of the building. Such instances are often lead to disagreements between taxpayers and CRA.
Property Depreciation for Tax Purposes
If the property generates revenue, the wear and tear (depreciation) can reduce it, but not lead to losses, except if the property is registered in the name of a corporation for rental purposes only. Wear and tear allows you to receive cash profit by reducing the tax during the year. Depreciation involves cashless writing off, allowing you to save cash. A lot of people use cash savings for aggressive mortgage pay-offs or investments into other projects.
The disadvantage of wear and tear is that when selling a property, all depreciation charges during the rental years are converted back to revenue, provided that the property on sale exceeds its original value. This increase is called “recapture”. People who own rental property for many years face the times when the profit from the “recapture” is so large that they do not want to sell rental property to avoid an increase in the annual revenue.
Personally, I do not agree with this position, provided that the sale price is high enough to cover the expenses and tax payment associated with the agreement. However, “recapture” is a problem that needs to be addressed, especially if the property has been depreciating for many years.
Let us consider a case where you decide to turn your rental property, which has been depreciated for many years, into your main place of residence and move into it for permanent stay. In this case, you have to allegedly sell and buy the property as one person. This is called a deemed disposition.
As a result of switching the property ownership (change in use) from rental to personal use, you have to pay profit tax as a result of deemed disposition. If you have a basic understanding of the consequences of the profit tax, you will be able to make an educated decision when buying a property.
I recommend addressing tax accountants for professional consultation.