Tax Planning Strategies For Real Estate Investments
Besides great risk-adjusted returns, owning real estate gives you more control over your investment. This greater control allows you to plan tax strategies that best suit your personal situation. By making better tax planning decisions, you can ultimately put more post-tax real estate investment returns in your pockets.
Income Tax: The Basics
Assuming you own your investment property under your personal name and not a corporation, the money you make from real estate investments is broken into two types.
Income
100% of the rental income you receive is added to your total personal income, and is taxed at your personal tax rate. Income consists of the rent you make, less expenses such as:
- Utilities
- Property tax
- Property insurance
- Maintenance
- Repairs that do not extend useful life *
- Interest portion of your mortgage
*Note that replacements that extend the useful life of your property or upgrades to your property are considered capital expenditures (Capex) and cannot be expensed.
Capital Gain
Capital gain is calculated as your property’s selling price less your property’s purchase price plus any capital expenditures. A portion of capital gains are added to your total personal income, and are taxed at your personal tax rates.
Effective June 25, 2024, the way the CRA calculates capital gains tax will be changing. Watch this video to learn more about how this might impact you as a Canadian real estate investor.
Tax Minimizing Strategies
You can reduce the amount of tax you pay by reducing your real estate investment income or moving to lower tax brackets. During your real estate investment journey, pay attention to your changes in your personal situation, so you can plan out strategies to minimize tax implications.
Including Travel Expenses
As we mentioned, your real estate investment income is calculated as your rent less your property’s expenses. If you’re managing your property yourself, you’ll have to drive to the property to address various issues, such as collecting rent, performing maintenance, repairs or upgrades to the property.
If you own at least two investment properties that are not at your primary residence, you are able to include travel expenses related to managing your properties. So, remember to keep an annual travel log to record:
- km per trip related to your investment properties
- total km you traveled for the year
- total expenses you paid for the vehicle
Shared Ownership With Spouse
By sharing ownership with a spouse, you can split the income and capital gains with your spouse. Shared ownership means that the initial investment between the spouses must be contributed equally. Individually, the income from an investment property may bump up your tax bracket so shared ownership may reduce your tax rates. In addition, if one spouse has significantly lower income than another spouse, the total tax implications may also be reduced.
Note that an equal sharing of income means that each partner must contribute an equal amount upfront as an investment. If one partner does not have sufficient funds for the investment, he/she may take out a loan from the spouse, with the interest to be repaid annually at Canada Revenue Agency (CRA) prescribed interest rates.
There can be other ways to split the income in investment properties based on your personal family situation. If you need help, we’d be happy to direct you to accounting professionals who can help you out.
Timing The Sale Of Your Investment Property
Since appreciation may grow annually but isn’t realized until you sell the property, your capital gain upon a sale can be very significant.
Consider selling your property when you expect a lower annual income, such as during maternity leave, layoffs, on retirement. This way, the tax amount charged at higher tax brackets are reduced.
Tax Deferral Strategies
Claiming Capital Cost Allowance
When you own an investment property, the government allows you to depreciate the building portion of your property at predetermined annual rates. This amount, called the Capital Cost Allowance (CCA), is deducted as an annual expense from your investment property’s annual income.
When you take profit and sell your investment property, your CCA is “recaptured”. This means the cumulative CCA that was previous claimed as an expense is added back to your income, and taxed at your personal tax brackets in the year of sale. Deducting CCA allows you defer income taxes, so you can access and reinvest more of your money. Ultimately, you can get more money in your pockets through tax deferral. Here is an example:
- You purchase a property at $800,000.
- The CRA allows you to claim CCA on the building portion of your property, which is 50% of your property’s price. According to the government, your maximum building CCA rate is 2% for the first year, and 4% for subsequent years.
- Let’s assume your tax rate is 44% for simple calculations. At the end of year 5, you sell your property. Because of high capital gains, let’s assume your tax rate is bumped to 54% in year 5.
In Scenario 1, you claim the maximum CCA for each year. This allows you to defer taxes on the annual CCA portion of your income until the end of year 5 when you sell. As you can see, the income tax rate on the recaptured CCA is higher (54% vs. 44%). On the other hand, you make money from reinvesting the deferred income tax. By looking at the cash flows from Scenario 1 over the 5 year period, the net present value (at 3% discount rate) of all cash flows is tax cost of $17,525.
Scenario 2 does not claim any CCA. This means more income tax is deducted each year, and you don’t make any money from deferred income tax. In this case, the net present value (at 3% discount rate) of all cash flows is tax cost of $30,204.
As you can see, deferring taxes by claiming CCA maximizes your net returns after taxes.
“There are other scenarios in which you would not want to claim depreciation on your residential rental property. If a property may be used as your principal residence, which can ultimately be disposed of tax free, claiming CCA typically removes this possibility of receiving the proceeds tax free. Or, in a particular year, you may have a lower income. In this case, it doesn’t make sense to claim CCA. Instead, you can save it for higher income years.” – Daniel MiManno, CPA, CA
Refinancing
If you sell an investment property to access its gains in appreciation, you incur capital gains tax and your post-tax gains drop significantly. Instead of using a lower post-tax amount to invest, you can grow your wealth quickly if you use pre-tax cash flows.
When you refinance your property, the bank may be able to lend you additional funds based on the appraised value of the property. So if your property’s value increased significantly, you can take cash out of the appreciation of the property without reducing it with income tax. This way, you can grow your investment portfolio a lot quickly.
If you want to get more information about how refinancing works, head over to this guide!
How We Can Help
We’ve outlined our best tax-planning strategies that can help you maximize your post-tax real estate investment returns. Of course, your specific strategies can vary depending on your personal financial situation.
If you’re looking to buy your first property, we’d be happy to direct you to the best accounting professional for your situation. If you’re looking for tax efficiencies in order to grow your real estate investments quicker, we’re always happy to chat.
