There are a number of accounting and tax considerations tied to earning rental income. If your clients own rental property and collect money for the use of their property, be aware of the following requirements imposed by external parties.
Cash or Accrual Method of Accounting
The accounting method you decide to use when reporting your clients’ rental income may have a material impact on their bottom line. Unless the income is considered business income, whereby the accrual method would apply, your client can choose between the cash method or the accrual method of accounting. The cash method, of course, means that revenue and expenses are reported only when the funds are collected or disbursed. Under the accrual method, you record revenue, for example, in the period you earn the revenue, regardless of whether the lessee has actually paid.
As mentioned, there are rules that dictate which accounting method to use. If your client, in addition to renting out space, provides additional services such as cleaning, concierge or other serves, then the more likely it is that Canada Revenue Agency will consider the income to be business rather than rental income. Bear in mind that the number of units available for rent has no impact on whether there is business or rental income.
As long as expenses are reasonably required to incur your client’s rental revenue, you are able to deduct the costs when preparing your client’s tax return. You must consider though whether these expenses should be reported as current expenditures or capitalized costs. The CRA classifies current expenses as a cost that reoccurs after a short period time. Ongoing maintenance and utilities are examples of current expenses. There are other costs, though, that CRA considers capital expenditures. These costs give a lasting benefit or advantage such as extending the property’s useful life. Adding vinyl siding to a building’s exterior walls is an example of a capital expenditure.
When completing your client’s tax return, you are allowed to deduct all current expenditures including the costs for advertising the rental property as available, premiums for insurance coverage on the rental property for the current year, and legal services to prepare leases or collect overdue rent. Legal fees to buy rental property cannot be deducted against rental income. You can also deduct maintenance and repair costs only if, as CRA makes plain, those expenses do not incorporate your client’s own labour. Fees paid to manage the property are deductible, as are office expenses and property taxes. Other deductible costs include your client’s travel costs if the expenses are related to the collection of rent, supervision of repairs, or management of property. You can also deduct the amounts paid to personnel related to the care and maintenance of your client’s rental property. If your client is an employer, you can deduct its Canada Pension Plan, Quebec Pension Plan, Employment Insurance premiums, and Workers’ Compensation contributions.
There are some situations where the deductibility of an expense requires calculation and forethought. You are not allowed to deduct, for example, any personal expense related to a rental property. For example, your client may have a single property with eight rentable units. If five units are rented and three retained for your client’s personal use, only the expenses specifically traceable to the five units are deductible. This means that 62.5 percent (5/8) of the building’s expenses—taxes or insurance for example—are therefore deductible.
And do keep in mind that some business expenditures will always be non-deductible. You can’t deduct, for example, repayments on the principal portion of a loan or mortgage, nor can you deduct personal labour, tax penalties, or transfer taxes on the purchase of a new rental property. The latter, however, likely qualifies as a capital expenditure.
Non-capital losses are unused losses from business operations. Canadian tax rules stipulate you can carry back a non-capital loss for three years. Additionally, you can carry forward the loss for a certain number of years. Any non-capital loss occurring in a tax year after 2005 can be carried forward 20 years. If losses are unused after 20 years, any remaining losses expire and cannot be incorporated into your client’s tax returns.
Capital Cost Allowance
Capital cost allowance (CCA) is used to claim a current depreciation expense on capital expenditures. The amount of capital cost allowance your client can claim depends on the type of property and the date it was acquired. You can group your client’s depreciable property into groups such as buildings or condominiums. Land is typically not depreciable property, so it does not have an assigned CCA rate.
A rental building can belong to one of several classes, and each class has a different CCA rate. A building can be Class 1 (4 percent), Class 3 (5 percent), Class 6 (10 percent), Class 31 (5 percent), or Class 32 (10 percent). A condominium that is part of a building has the same CCA rate as the building. If your client owns a condominium in a Class 31 building, the condominium is a Class 31 rental property.
Reporting Foreign Rental Income
If your clients own foreign property with a cost basis in excess of $100,000, they may be required to declare this property on their tax return. Your clients must make an annual disclosure using CRA’s Form T1135 (Foreign Income Verification Statement). The penalty for nondisclosure is $25 per day up to $2,500 per taxpayer. You do not need to disclose any of your client’s personal property such as a cottage or an automobile, nor do you need to disclose property such as a warehouse, inventory or equipment that is used for running a business.
There are strict rules regarding how your clients are required to report their rental income and properties. For their income taxes, understand which of your client’s expenses are deductible. Properly assess the property’s CCA class and make note of any foreign properties your client may be holding as rental property. Following these reporting rules will simplify your client’s rental property operations.