How Rental Income Is Taxed in Canada: T776, Deductions and CCA

Rental income or business income?

Most landlords earn income from property. If you rent out space and provide only basic services, such as heat, light, parking and laundry facilities, the CRA generally treats it as rental income, reported on Form T776, Statement of Real Estate Rentals.

The more services you add, the more likely your rental becomes a business. Cleaning, security, meals or other services that go well beyond the basics, which is common in some short-term and furnished rentals, can push the activity into business income, which is reported differently (on Form T2125, using the CRA's business income guide). The distinction affects which forms you use and how some rules apply, so if your rental looks more like a hotel than a lease, it's worth getting advice.

Either way, the income is taxed at your marginal tax rate, added to your employment and other income for the year.

Reporting on Form T776

Form T776 is where you list your gross rents, your rental expenses and any CCA you claim. Gross rents flow to line 12599 of your return, and your net rental income or loss goes on line 12600. If you own more than one rental property, the CRA's guide explains how to report each one, so check it before combining figures.

Most landlords use the accrual method, meaning you report rent in the period it's earned and expenses in the period they're incurred, whether or not money has changed hands. If you have almost no amounts receivable and no expenses outstanding at year-end, the CRA lets you use the simpler cash method instead.

If you own a property with someone else, how you report depends on whether you're co-owners or partners. Co-owning a rental as an investment doesn't by itself create a partnership. Co-owners generally report their share of the income and expenses, based on their ownership interest, on their own T776. A true partnership, where you're carrying on a business together, has its own reporting rules.

Remember that rental income has no tax withheld. If your net tax owing climbs above the threshold, you may be required to pay quarterly tax instalments.

Current expenses you can deduct

You can deduct reasonable expenses you incur to earn rental income. On Form T776, they're grouped into categories including:

• Advertising to find tenants.
• Insurance on the rental property.
• Interest on money borrowed to buy or improve the property, and related bank charges.
• Office expenses, such as supplies used for the rental.
• Legal, accounting and other professional fees.
• Management and administration fees, such as a property manager's commission.
• Repairs and maintenance.
• Salaries and wages paid to someone to look after the property.
• Property taxes.
• Travel to collect rent, supervise repairs or manage the property, within the CRA's rules.
• Utilities you pay as the landlord.
• Motor vehicle expenses, in limited circumstances.

Some costs are never deductible. You can't deduct the principal portion of your mortgage payments (only the interest), land transfer taxes paid when buying (they're added to the cost of the property), penalties, or the value of your own labour. If you prepay an expense, such as a year of insurance that crosses two tax years, you deduct each part in the year it relates to.

Current versus capital: the distinction that matters most

The most common source of trouble on a T776 is deducting a capital expense as if it were a current one. The CRA's general test: current expenses are recurring and provide a short-term benefit, while capital expenses provide a lasting benefit or improve the property beyond its original condition.

Repairs that restore something to its original condition are generally current and deductible in full: fixing a leaky faucet, repainting, patching drywall, replacing a few broken shingles. Improvements that go beyond the original condition, such as finishing an unfinished basement, adding a deck or replacing the entire roof with a higher-grade material, are generally capital. So is buying a separate asset that lasts more than a year, like a new fridge or stove for the unit.

Capital expenses aren't lost. They're added to the cost of the property and recovered gradually through capital cost allowance, and they also increase your cost base when you eventually sell. Keep invoices and photos for major work, since the classification is often a judgment call the CRA may ask you to support.

Capital cost allowance and its risks

Capital cost allowance is the tax version of depreciation. Each year you can claim a portion of the cost of depreciable property, such as the building and appliances. Most rental buildings fall in Class 1, at a 4% rate on the declining balance. Land isn't depreciable, so when you buy a property you have to split the purchase price between land and building and claim CCA only on the building portion.

A few rules shape how CCA works for landlords:

• CCA is optional. You can claim any amount up to the maximum, including nothing, in a given year.
• You can't use CCA to create or increase a rental loss. It can only reduce your net rental income to zero.
• In the year you acquire property, you can usually claim CCA on only half of your net additions to a class (the half-year rule), though some properties are treated differently under accelerated investment incentive rules.
• Each rental property with a capital cost of $50,000 or more must be placed in its own separate class.

The catch is recapture. When you sell a rental, if the proceeds for the building are higher than the undepreciated capital cost left in its class, the CCA you previously claimed is recaptured and added to your income in the year of sale, taxed as regular income rather than as a capital gain. Because each property over $50,000 is its own class, the sale of that building is often what triggers it. If the opposite happens and the class still has a balance after the last property in it is sold, you may be able to deduct a terminal loss.

In other words, CCA often defers tax rather than eliminating it. It can still be worth claiming, especially if you expect to be in a lower bracket when you sell, but go in knowing the bill may come due. Any increase in the property's value beyond its original cost is treated separately as a capital gain.

Renting out part of your home

If you rent a basement suite or a room in the home you live in, you report the rent on a T776 just like any other landlord, and you can deduct the share of expenses that relates to the rented area. Divide shared costs, such as property taxes, mortgage interest, insurance and utilities, based on a reasonable measure like square metres or number of rooms. Expenses that apply only to the rented area, such as painting the suite, can be deducted in full.

You can only claim these expenses if you have a reasonable expectation of making a profit. Renting a room to a family member at a token rent, for example, generally doesn't let you claim a rental loss. The CRA says that if you rent to someone for less than you'd charge an unrelated tenant, you can't claim a rental loss.

The bigger issue is your principal residence exemption, which normally shields the gain on your home from tax. The CRA usually considers that you've changed the use of part of your home when you start renting it out, which means a deemed sale of that portion at fair market value. It generally won't treat it as a change in use if all three of these conditions are met:

• The rental use is relatively small compared with your use of the property as a home.
• You don't make structural changes to the property to suit the rental.
• You don't claim CCA on the rented part.

That third condition is why many homeowners with a modest suite choose not to claim CCA. Claiming it can expose part of your home's future gain to tax, and the CRA's rules also don't allow CCA on a property you designate as your principal residence. If you've made structural changes, such as adding a separate entrance and kitchen, or the suite is a large share of the home, talk to a tax professional about the change-in-use rules and the elections available under the Income Tax Act before you file.

Short-term rentals

Short-term rentals, defined by the CRA as residential properties rented or offered for rent for less than 90 consecutive days, come with an extra rule. If your short-term rental is non-compliant, meaning the province or municipality doesn't allow it at that location or you don't have the required registration, licence or permit, the expenses and CCA tied to the non-compliant days are not deductible.

The disallowed portion is calculated in proportion to the number of non-compliant days, using charts on Form T776. Before listing a unit on a short-term platform, check your local rules and get any permits in place. Otherwise you may end up paying tax on gross revenue with few or no deductions.

Also consider whether your short-term rental has become a business because of the services you provide. Furnished, frequently turned-over units with cleaning and other services are more likely to be treated as business income.

Record-keeping and common mistakes

Keep a separate bank account for the rental if you can, and save receipts, invoices, leases and a record of rent received. The CRA tells individuals to keep tax records for at least six years, and for a rental property you'll also want records of the purchase price, closing costs and capital improvements for as long as you own it, since they determine your cost base and your CCA.

Common mistakes that lead to reassessments include:

• Deducting capital improvements as repairs.
• Deducting mortgage principal instead of only the interest.
• Claiming CCA that creates or increases a rental loss.
• Claiming 100% of shared household costs when only part of the home is rented.
• Claiming losses on property rented to family below market rent.
• Forgetting that interest on a home equity line of credit is only deductible to the extent the borrowed money was used for the rental.

If your situation involves a change in use, a large renovation or the sale of a property you've claimed CCA on, the cost of an hour with an accountant is usually far less than the cost of getting it wrong.

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