5 Ways to Make (or lose) Money With Investment Properties – Part 4 – Taxation

by Mr. Cheap

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Go the first post in the 5 ways to make money with investment properties series.

I haven’t had personal experience with this part of making money with real estate, but everything I read and hear seems to make the case that its typically a significant part of an investor’s return.

Once I read that basically the more “unusual” whatever you’re doing is, the better the taxation. At a certain level this makes sense, the government is best served by getting the biggest chunk of the largest amount of economic activity. Based on this idea, the advice was that the more “typical” an activity (like working a 9-5 job), the heavier the taxation. Real estate investing is hardly new, but not everyone does it, and therefore its given a bit of a tax break. Additionally, its viewed that there’s a positive outcome for society (increased amount of shelter) and its worthwhile on that basis as well for the government to encourage the activity.

Go the first post in the 5 ways to make money with investment properties series.

Anything you spend on your property is typically a deduction (i.e. you don’t pay tax on the money you earn to pay for that). So if you pay $1000 to get your property re-painted, you won’t have to pay taxes on $1000 of rental income (since you spent it on the property instead of putting it in your pocket). SOME people exaggerate their expenses to keep more of their money from being taxed, but I think this is a very bad idea (if you want to pick a fight with someone, don’t go after Revenue Canada!).

The real advantage (which I’m looking forward to) is the ideas that you can “depreciate” your property. Say you had a rental property that had earned you $250 / month ($3000 over the year). Typically if you were in a 40% tax bracket you’d owe $1200 in taxes on this money. What depreciation lets you do is assume that the value of your property declines over time. You get tax savings based on this decline. When you sell your property, you pay capitial gains taxes on the sale price – the purchase price + the depreciation. Thus depreciation lets you defer taxes until you sell the property (which its obviously better to pay the taxes in the future instead of right now). ADDITIONALLY, depreciation lets you not pay taxes on income, and instead pay it later as capital gains (at half-rate) (Please see the comments, I misunderstood this).

Obviously I don’t have the best grasp on this yet (I’m planning to take the H&R block course this fall so that I’ll gain a better understanding), but the basic ideas that real estate investors all seem to agree on is that you pay a lot less taxes on money you make from real estate then money you make from other investments.

Ways that you might abuse this concept to lose money is when you pay for a deduction (e.g. if a real estate deal is a bad deal, doing it for the tax deduction is probably a bad idea). Also, if you get too caught up in this idea and start doing illegal things (again, a very bad idea), you might be trading slight gains for jail time (no fun).

Go to the next post in the series buying at a discount.

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{ 2 comments… read them below or add one }

1

Actually CC, CCA recapture (depreciation) is taxed as income the year that you sell. I thought the same but was corrected (check the cra website).

Also, in certain cases (depending on your tax bracket), it may not be beneficial to claim CCA on rentals over the years because if you sell with a large amount of recapture, you may push yourself into a higher tax bracket the year you sell. For example, if you’re claiming recapture in the current year to save taxes in the 33% tax bracket and then you end up paying it back when you’re in the 43% tax bracket due to increased wages AND recapture income (in Ontario it only takes ~$4000 to go from 33% to 43%), you would have been better off NOT claiming CCA.

The only thing I would add is that you can’t use CCA to claim a loss (or increase a loss) on a property. This might be especially important in years where you have major repairs, etc.

I’m no tax expert either (!) but we don’t claim CCA on our two rental properties though some math could probably be done to figure out what makes the most sense for you. We haven’t actually done that…

2

Here’s how someone broke it down on the Canadian Business forums (I love it when others do the math ;)):

Assuming Ontario, a 7% opportunity cost (with the refund) and a 46% tax rate at the time of disposing of the property, if your current marginal rate is:

46% -> claim CCA
43% -> claim CCA if you’ll keep the property for at least 1 year
35% -> claim CCA if you’ll keep it for 5 years
31% -> claim CCA if you’ll keep it for 6 years
21% -> claim CCA if you’ll keep it for 12 years

7% Opportunity cost = return of the deduction you get. For example, if it’s put in a stock expected to appreciate 7% per year.

If your marginal tax rate is 46% this year, claim the CCA. It’s free money because the worst that can happen is that you’ll have to be taxed at 46% next year. You’re flush at worst.

If your marginal tax rate is 43% and you were able to invest the deduction at 7% for 1 year, you’ll be ok even if you sell next year an pay 46% tax on the CCA recapture.

If your at 31% and expect to make a 7% return by investing the deduction, take the CCA deduction only if you think you’ll hold on to the property for 6 years if there is a chance you’ll pay taxes at 46% when you sell.

Lots of variables can positively change the conclusion:

- You may be taxed at lower than 46% in the above examples. Example, if you deduct at 31% and sell 3 years later with a small gain, you may still remain at 31% or 35%.

- If you put the $4000 in an RRSP and put the RRSP refund (of $1200) in an RRSP and make 7% of $5200 return, it’s better faster.

So it’s all rules of thumbs, and with every rule, there is an exception. The assumption is also that there is an opportunity to make money with the deduction. If you blow it on a $1200 trip, you have potentially borrowed the money for the trip and you’ll pay the trip off in 10 years at $1800

The thread can be found here:
http://forums.canadianbusiness.com/thread.jspa?forumID=16&threadID=3593&messageID=121101#121101

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