No general rule, but there are several factors to consider when timing a deduction claim
Items for a rental property such as a fireplace and carpet replacement are most likely a capital expense. Photo by Getty Images/iStockphoto By Julie Cazzin and Andrew Dobson
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Access articles from across Canada with one account Share your thoughts and join the conversation in the comments Enjoy additional articles per month Get email updates from your favourite authors Q: My wife Rita and I own a condo in Ottawa. This is not our primary residence and we recently rented it out. Prior to that, we did some repairs, including adding a new furnace, new lights, a gas fireplace and new carpeting throughout. I understand we cannot claim these expenses as operating expenses and should claim them as a capital cost. How do I determine if it is better to take capital cost from the rental building this year against this year’s income rather than a deferred capital cost and reduce our capital gains if we sell it in the future? Is there a general rule for when to claim it? — Lionel
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FP Answers: Hi Lionel. Unfortunately, there is not a general rule, but there are several considerations when determining whether to claim the deduction now or defer it.
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The concept of capital cost allowance (CCA) in taxation refers to the ability to write down the value of an asset, also known as depreciation, in order to lower current taxes with a tax deduction. It is available for rental properties and business assets. Since you mentioned the difference between capital expenses and operating expenses, it might be worth reviewing how capital and current expenses are classified.
You correctly stated that items such as a fireplace and carpet replacement are most likely a capital expense. The distinction between capital and current expenses refers to the timing of a deduction. A capital expense is added to the tax cost of the asset and is depreciated over time, saving tax over time. A current expense can be deducted in the current year and save tax in the current year.
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Article content Obviously, a current expense is better than a capital expense, but you cannot pick and choose. The Canada Revenue Agency (CRA) offers a few examples of capital expenses and current expenses and breaks the differences down into a few basic questions to understand where an expense stands.
Does the expense provide a lasting benefit? An expense that provides a lasting benefit is likely a capital expense. Does the expense maintain or improve the property? An improvement is likely to be a capital expense. Is the expense for a part of the property or for a separate asset? A separate asset is likely to be a capital expense. What is the value of the expense? A larger expense is more likely to be a capital expense.
Overall, we can simplify by stating that current expenses generally recur over shorter periods of time whereas capital expenses provide a lasting benefit. A simple example would be repairing a broken ceiling fan versus replacing an entire fridge.
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Article content A rental property itself also has a cost that can be depreciated over time. Additions to the capital cost increase the base upon which a CCA can be deducted. There are different classes for CCA purposes, but most residential real estate is depreciated at up to four per cent per year. I say up to four per cent because you do not have to claim the full amount. You may not be able to claim it all since a taxpayer cannot use CCA to generate a net rental loss. You can only bring your net rental income down to zero.
The Canadian tax system uses an increasing scale of tax brackets that tax individuals at higher percentages at higher levels of income. Though claiming a CCA could result in a lower taxable income in any given year on an absolute basis, it may not always make sense to make the claim as you can defer it to a later year where it may make more sense.
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Article content Essentially, to understand the value of a CCA claim in the current year, you need to understand your income trajectory. If you expect to earn higher income in the future, a CCA claim may not be suitable because you may get a bigger tax savings if you delay the claim to later years when your income is higher.
Perhaps more important is the tax you may pay when you sell the rental property. If you claim CCAs over the years, you may pay additional tax beyond the capital gains tax on price appreciation when you sell the property. The past CCA claimed is recaptured in the year of sale and added to your income. If you deduct the CCA in years where your income is low, it could backfire if you have a high-income year when adding the deduction back into income upon the property sale.
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Article content In other words, if you save tax at 20 per cent on the deductions, but pay 50-per-cent tax on the recapture when you sell, is it worth it? The shorter your ownership time horizon, the more important it is to reconsider claiming the CCA in a lower income year, Lionel.
Should I include a pension as part of my fixed-income holdings? When is capital gains tax due on a cottage purchased in joint tenancy? Can we retire on $170,000 in savings and maintain our current lifestyle? Depending on your personal circumstances, there may not be materially different implications of claiming versus not claiming the CCA. Regardless, you should track your rental property expenses, carefully consider if it is a current expense you can deduct in the current year, and keep a record for when you sell the property.
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As with many other financial decisions Lionel, there are pros and cons that should be considered each year when you file your taxes.
Andrew Dobson is a fee-only, advice-only certified financial planner (CFP) and chartered investment manager (CIM) at Objective Financial Partners Inc.