Lower Your Rental Property Taxes using Capital Cost Allowance

Yeah, so if you had debt, you would settle that out of the proceeds right away because that happens, it's attached to the property that's already done. And then you'd be left with a certain amount of money and then you have a tax bill to pay. And so you might even have a shortfall where you didn't have enough money left over to pay the actual tax bill. Important to understand how capital cost allowance operates, especially in the rental property scenario. Okay, so just doing a quick little recording here to look at an example of using the capital cost allowance on a piece of real estate. Um, for the purpose of this, we're going to look at, you know, multi unit complex and we're just going to pick an adjusted cost basis. In other words, the cost or the original purchase price or the current set value of the acquisition of that building versus its current value. And then talking about what would happen if a real estate investor has been utilizing the capital cost allowance as a way to essentially deduct against income off of that building. Where now we're looking at a position where we've owned the building for a long time, let's say it's, you know, know 10 to 15 years or what have you, and we have to sell that building or the time has come, we got a great offer, it's time to sell, we have a great market, whatever it is. Or maybe the owner of the corporation dies, in which case the value of the shares at that time of the corporation is what we will be kind of dealing with. So the fair market value of the.

Building, the part I'm just not going to dive into, is related to the corporation owning the asset and then the deemed disposition on death. Because there's two kind of asset classes that are involved here, the shares and the building. Just going to focus it specifically on the building component. So the building was acquired whatever time period, let's just say 10 years ago for 1.5 million. I'm also excluding the fact you've made renovations and made additions onto it, let's just assume it's just to keep it really simple, you've purchased it for 1.5, 10 years later, it's $3 million. CCA is an optional deduction that you can elect to take. If you take that election in that year, you are eligible to reduce your taxable income. So on this building that was 1.5 million initially acquired at cost, the class of that building could be 4 or 6, and the CCA for that is 10%. So what that means is in the first year the CCA that you're eligible to take is $150,000. And the next part is the UCC is whatever you paid for. Subtract the CCA you've taken and the tax benefit you've gotten from that, which is now 1.35 million. Now, if we look at this chart here, that's what this chart shows. I just put in 1.5 million. And then you go all the way down to year 10, because as the UCC starts going down, you're still taking the same 10% rate. So now you're taking the previous UCC. And that UCC is going to keep going down because it's grinding down that adjusted cost basis. So over time, in 10 years, you've been able to take advantage of 976,982 in terms of reduction of income over that period of time. So if you earned 500,000 in that first year, just hypothetical example, taxable income was 500 CCA subtract that, your net taxable income is 350, so you pay 12%, if you're in Ontario, 12.2%. So your taxes is 42,000. Now, what happens when you decide to sell that asset? This is where proper advice and tax planning is extremely, extremely important. Because CCA is eligible for you to take, you have the option of taking it or not. Generally, the preferred way of taking CCA is on assets that you know with good certainty the value will not go above the cost that you paid for. So in the instance of real estate, the general perception is the real estate value goes up. In this case, the real estate value, let's say, is $3 million. So when you sell the building for $3 million, though you paid 1.54, you have a gain of 1.5 million. The corporate environment, you'll have to pay taxes. 50% of that is taxable, so taxable capital gain. And then because it's passive income, 50% of that is also taxable at that tax rate. So the total taxes you're going to pay on that specific sale is $375,000.

So you sold it for 3 million minus the tax payable. There would be, in theory, if the building was paid for and there wasn't a mortgage or anything to pay off, you would have 3 million minus the 375 tax bill available to work with. But now there's some additional things that come out of that.

So that 976,000 that you took in terms of CCA, that's going to get added back and this term is called recapture. So your taxable income for that year actually ends up being $1,300,000. That whole amount that you may have deducted over the 10 year period of time because the value is more than the ACB that you bought it at. So you have capital gains that you also pay and you also have the recapture on the CCA that you deducted over time. But now the CRA is going to recuperate. All of that that you recovered because it actually was not a depreciable asset, is actually an appreciable asset from that standpoint. And the government will want to get tax revenues from that.

To take this a different way, if this was like a truck for a business and you own the truck and you drive it and you put miles on that truck, it's going to depreciate over the time that you own it. And that would be the type of asset that would most likely be utilized with a CCA model because we know it's a declining value of owning that vehicle for the purpose of the business. Let's say owning.

If I was in a manufacturing business and the machinery I use because of wear and tear over time, that I would take CCA on because there's an actual depreciable value on it because there's wear and tear that's happening. Building there is wear and tear, but because of the market, it's such, you know, so desirable people will pay more for it because they want it. So that's not what I would take.

CCA on right now. In this example, let's assume that there's a family or a couple husband and wife that own this building. And they've been doing this for 10 years as you've shown. So the CCA they've utilized has allowed them to reduce the taxable amount or the bill payable on an annual basis on the cash flow on that real estate. You wrote down taxable income in year one of 500,000. We'll assume that that's the revenue that is generated by this six unit apartment building. Okay? So if they are doing that each and every year, and yes, they have a declin amount, but if they're taking that income and then they're using it to go maybe buy other assets, but they're actually stripping it out, let's say at the corporation or whatever. So the theory might be maybe they'll be able to go and do something more productive with that money by taking the extra tax deduction they could get using the CCA today. As long as they are aware that they're going to have to pay it back at the end, they're going to have to recapture anything they've deducted. So they've still gotten the advantage of having a lower tax bill. The problem is that they chose to take it early. So. So now they have to get even with the CRA because of what they've already done. Is that a fair way of looking at it?

Yeah. So what you're going to see here is if you never taken CCA, you would have paid 61,000 in taxes at that first year mark. But because you take CCA, you're paying now $42,000. So you're actually only recovering 18,300 in.

This situation where you've got the recapture line at the bottom of the 976. Okay. So yeah, you've got the income of 750 on the capital gain plus the recapture amount. So the total income at the sale is now 1.7. That's taxable.

The capital gain portion on that building is 1.5 million. The cumulative recapture is 976. So what's income is 24769 82, which 50% of that capital gain is taxable, which is a taxable capital gain. And then the full recapture of 976 is included. So that income for that year is 1.726982. And this is, by the way, also normal income. Whether it's normal income or not, once you're over the 500,000 threshold, that's also going to get taxed at the higher corporate rate, which is at the 26, 28%. Depending on your province, the capital gain is going to be taxed at 50% of the 50%. And then this normal income is also going to tax at the higher business rate, not the 12.2, at the 26%. So ultimately, if we look at the effective amount of taxes you would pay on that specific situation, you sold the building for 3 million, you're going to pay taxes of 1.6. So your net cash is 1.2. And if you had debt or whatever, you still have to settle the debt and then that's your net proceeds.

Yeah. So if you had debt, you would settle that out of the proceeds right away because that happens, it's attached to the property, so that that's already done. And then you'd be left with a certain amount of money and then you have a tax bill to pay. And so you might even have a shortfall where you didn't have Enough money left over to pay the actual tax bill. That's a good understanding of what the situation is and important to understand how capital cost allowance operates, especially in the rental property scenario and some of the possible pitfalls that are there. Now, if the same individual again passes away, let's say that we take a corporation out of it and it's just owned personally. Same situation applies, but now it's deemed to be SOL at the fair market value at the time of death. And so now the estate, the children or whoever are looking after dealing with this tax bill from something that's been done maybe 10, 20 years ago with capital cost allowance being utilized, which would probably be, I would have ventured to guess, a bit of a nightmare to comb through from 20 years of past tax returns that they probably don't have available in a box to look at.

Unless they sell the property even still.

It'S effectively considered sold at the time. But even just sorting through to determine if they use the capital cost balance over those years have to be reported and they have to know that basically.

Right? Oh, I, I would mean from a planning situation, the CRA would deem it sold. Whether the physical building was sold or not. They want that 1.7 million paid to them.

Yeah, crazy. Well, man, thank you.

A proper design of a policy will come in to deal with the tax bill for a death. But it's just important to recognize that's what exposure you have and can start.

Planning around right now, if someone wanted to pass on building like this to their kids upon death, so there's still going to be a sale, but if they could plan for that, now they know they have a problem, they have to deal with the problem. Could they not consider doing something, we have a video on an estate freeze. Could they consider doing maybe an estate freeze on it? Sorting out the problem that they've already created using the capital cost allowance and then, you know, suggesting to the kids to not use capital cost allowance on a move forward basis, but locking in the value now as the estate moves forward basically from that freeze point.

So there's two concepts that can be explored. There's a tax estate freeze, and then there's also specific tax maneuver called a rollover. Now under both of those scenarios, that recapture portion still will trigger a taxable event. What gets deferred on transferring to children either through tax maneuver or through estate freeze, is the capital gain. That 1.5 million that can get transferred to the ownership of the children to take care of, but that recapture portion is not.

Got it? Yeah, it needs to be dealt with. But knowing you have a problem, you know you've got an open wound that's bleeding. When do you want to go see the doctor and get it fixed? You probably want to go get it fixed right away. You don't just want to throw a band aid on the situation would be the way I would look at it.