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3 Tax Tips for Real Estate Investors
Category: Tax and Estate Planning
Real estate, particularly in Toronto and Vancouver has been very good to investors as of late. Like any boom in any asset class, when you see an extended bull market you tend to see investors pile in. Real estate is no exception. Investing in real estate can be complex and time consuming but the long-term returns can be very rewarding. This article will focus on three basic tax tips for real estate investors who are getting into the market with a buy-and-hold rental property as a direct investment. I will write articles on flips, renos, new-builds and REITs later.
Think before you income-split:
One of the most powerful tax saving strategies is income splitting. When a family has members who fall into different tax brackets it’s natural to want to take advantage of the ability to split income and route it to family members in lower tax brackets. I often see these strategies applied incorrectly. The income tax act has very well developed rules that shut down your ability to split income with family members and obtain an unfair advantage, these are the “attribution” rules of the income tax act and they can be very confusing.
For example, say a working spouse earning $250,000 per year decides to purchase an investment property in the name of their non-working spouse in the hopes of routing all the rental income over to them. Sounds like excellent tax planning at first as the non-working spouse will pay significantly less tax. But not so fast, if done incorrectly this type of transaction may be caught under the attribution rules and all the rental income may attribute back to the higher income spouse anyway.
This can be circumvented in several ways but one way would be to setup a loan between spouses. This loan would be bona-fide and charge interest at the current “prescribed rate” as set by the government. The lower income spouse would pay the actual interest (and tax that as a tax deduction) to the higher income spouse (who takes it as taxable income) by January 30 of each following year. The spread between the prescribed rate of interest and the rate of return on the investment will be the net income transferred to the low-income spouse for tax saving purposes.
I’ve represented hundreds of clients on CRA audits and reviews and I can tell you with confidence that attempting to negotiate or defend a position without documentation is a waste of your time. If you are not saving your documentation (auto logs, property tax bills, invoices for repairs and maintenance etc.) you may as well not make the deduction on your tax return because unless the evidence for the transaction is produced the CRA will have a strong case to disallow the deduction.
This is particularly important for auto expenditures and repairs and maintenance expenditures in years that you have tax losses carried against other taxable income. The reason? You are a prime target for audit and review when you have rental property losses that provide a tax advantage.
It’s simple: save all receipts, try to avoid cash transactions, and have everything nice and organized should the CRA come knocking.
To depreciate or not to depreciate:
Depreciation or Capital Cost Allowance (CCA) is an optional and legal way to shelter the current income tax payable on your rental profits and defer it to a later date. CCA can be an effective tool if used correctly but care must be taken as it can cause you to lose money in tax if used incorrectly.
CCA works by depreciating a portion (4%) of the physical building component of your rental property (as opposed to the land component). CCA is optional and in most cases, can be up to 4% of the original cost of your rental property on a declining balance year over year. CCA can be used to reduce your net rental income to zero and can’t be used to create a loss.
CCA is a double-edged sword: it can reduce your tax bill immediately but will be “recaptured” usually in full if you sell the property at a gain down the road. Some common errors I’ve seen in the thousands of tax returns I’ve reviewed over the years are as follows:
1. Taking CCA in a year of low income: this is usually a waste because your future tax rate will be higher.
2. Taking CCA when you know you will sell the property shortly: an analysis must be done to ensure you won’t be pushing yourself into a higher tax bracket in the next tax period.
3. Avoiding CCA completely: just because you don’t want to pay “recapture” tax down the road doesn’t mean CCA is bad. You should look at this from a time value of money perspective. If you won’t be selling the property anytime soon then CCA may be a great option.
Tax and investment are intimately intermingled and having a close connection with your accountant and investment advisor can mean the difference between saving on taxes and leaking significant money to tax unnecessarily. Physicians and dentists require a special touch due to their legal structure constraints and high levels of income. With a bit of planning and an advisor that understands your industries you are well on your way to building significant wealth.
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