When purchasing an investment property there are a few tax implications to consider. Operating income and your taxable income will not always be the same. Then there are capital gains when you sell the property.
Let’s start with operating income vs taxable income. There are two major deductions or expenses that will affect your taxable income.
- Mortgage payments are not fully deductible, only the interest is.
- Some improvements are depreciated over time instead of being expensed immediately. For example, a new roof is called a capital improvement or capital expense and will be expensed or depreciated over time. Appliances fit into that category as well. Repainting the interior or exterior are current expenses and can be used immediately. Repairing a wooden deck or stairs are also current expenses.
Here’s a simple example to figure this all out:
Congratulations, you’ve just purchased a bungalow with 2 units! Fantastic, you’ve made on average an additional $13,200 in income! But wait a minute, that’s not your taxable income. Your taxable income is $19,600 and will be taxed at your effective tax rate. You can see that the mortgage expense is affecting the difference.
| Operating Income | Year 1 | Taxable Income |
| 36,000 | Rental income | 36,000 |
| -14,400 | Mortgage payment / interest | -8,000 |
| -6,000 | Property taxes | -6,000 |
| -1,200 | Insurance | -1,200 |
| -1,200 | Regular Maintenance | -1,200 |
| 13,200 | Net Income | 19,600 |
Unfortunately, you bought an older property and it needs a new roof in year 2. This is considered a capital expense and must be depreciated over time. Your taxable income is $19,000.
| Operating Income | Year 2 | Taxable Income |
| 36,000 | Rental income | 36,000 |
| -14,400 | Mortgage payment / interest | -8,000 |
| -6,000 | Property taxes | -6,000 |
| -1,200 | Insurance | -1,200 |
| -1,200 | Regular Maintenance | -1,200 |
| -15,000 | New roof, 4% depreciation rate | -600 |
| -1,800 | Net Income | 19,000 |
Whoa! I can hear you now, “But I lost money on my rental; how can I have taxable income?” A new roof is going to extend the life of the house so the cost needs to be spread over future years. Each year going forward you will have that depreciation to claim though.
It’s year three and things have changed. Maybe you’re getting married or having a baby, but it’s time to sell that bungalow. You purchased the property for a great price three years ago and real estate prices have continued to increase over the years. Real estate and legal fees are deductible expenses against the sale of the property but you’ll still have some tax to pay. The resulting actual capital gain is reduced by 50% to get your taxable amount. This will be taxed at your effective tax rate.
| Sale price | 500,000 |
| Real estate & legal fees | -30,000 |
| Proceeds from the sale | 470,000 |
| Purchase price | -400,000 |
| Capital gain | 70,000 |
| Taxable capital gain | 35,000 |
If your effective tax rate is 24%, the average in Canada, you will pay $8,400 in income tax.
So, in 3 years you made money!
| Year 1 operating income | 13,200 |
| Year 1 income tax | -4,704 |
| Year 2 operating income | -1,800 |
| Year 2 income tax | -456 |
| Year 3 capital gain | 70,000 |
| Year 3 income tax | -8,400 |
| Net income | 67,840 |
Please keep in mind this is a very simplified example.
I hope this helps you to understand the wonderful world of investment properties. Please contact Pam Little, CPA, to see how these apply in your case.
Pam Little is a Chartered Professional Accountant with over 20 years of experience. She helps small and mid-sized businesses manage their revenue and expenses and maximize tax benefits. To book a free consultation contact Pam Little, CPA at pam@pamlittlecpa.com or call 416-268-1605.