Tax Time – Depreciation Explained Part 2

As we get further into tax season, our topics are getting more in-depth.  Last week we did an intro into depreciation expense for tax purposes. This week we are going to discuss considerations when dealing with depreciation on your property.

Depreciation in Year 1

In the year that you acquire a property, the depreciation rule is a little different.  No matter if you bought the property in January or December of that year, CRA allows a 50% or half-year rule for depreciation purposes. So if your CCA for the year is $10,000 for a full year, in the first year you’re only allowed to claim half that amount or $5,000.

Tax Effects from Depreciation when selling a Property

Selling the property may result in a “recapture” of your CCA. You would add this recaptured amount to your taxable income when preparing your tax return. Recapture may happen if upon selling the property, the proceeds from the sale exceed the remaining undepreciated capital cost. Your undepreciated capital cost is the capital cost of all your depreciable property in the class subtracted from the allowance you claimed in prior years. Alternatively, you might be allowed to take a “terminal loss” deduction from your income. Terminal loss is when you don’t have any depreciable property in the class at the end of the year, but you have an outstanding CCA amount that you have not claimed. When viewing depreciation in this light, it acts more as a tax deferral until sale.  For example, say you bought a property many years ago for $200,000, and over the years you depreciated it so that you had a book value (or undepreciated capital cost) of $100,000, and sold that property for net price of $250,000. $50,000 ($250,000-200,000) will be taxed as a capital gain (or 50% of the gain will be taxed), and $100,000 ($200,000-$100,000) will be the depreciation recapture (100% of this amount will be taxed). This is sometimes a confusing calculation and is best done in conjunction with an accounting professional.

When Rental Expenses Exceed Income

If your rental expenses exceed your gross rental income, you have incurred a loss. You may be able to deduct your rental loss from other sources of income, but you cannot use CCA to increase or produce a rental loss.  For an example, say you had a year with lots of repairs and maintenance or lots of vacancy and you only ended up with a net income of $2,000, but you have a CCA amount for the year of $5,000 that you can use as a depreciation expense, you wouldn’t be able to use the full $5,000 to create a $3,000 loss ($2,000-$5,000) to deduct from other sources.  You would only be able to use $2,000 in this case to decrease your net income to zero.

Overall, there are pros and cons to taking CCA. On the upside, the allowance lowers your taxable income, which ultimately reduces your tax liability. On the downside, when you sell the property all prior CCA claims are recaptured and treated as taxable income, which increases your tax liability.  This can be a benefit if used correctly as a tax planning tool but can also be used incorrectly with tax consequences. This type of tax planning should be discussed with a professional.

Have you had a discussion with your accountant regarding depreciation cost/benefit for your tax situation?