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Tax write-offs from income properties don’t always materialize.

If I had a dollar for every time a client inquired about ditching their well-diversified portfolio of securities in favour of a rental property, I could have already purchased a reasonably priced foreclosed Florida condo to rent out to vacationing snowbirds.

Clients are either lured into becoming a landlord by the promise of collecting monthly rent cheques from hassle-free tenants or, at the very least, by the attractive tax losses rental properties seem to provide.

Yet the Tax Court is littered with cases about personal rental property schemes in which the anticipated tax write-offs fail to fully live up to expectations. Take the recent case of home owner and landlord George Leisser (Leisser v.The Queen, 2011 TCC 472).

Leisser is in his late 80s, lives in Westmount, Quebec and went to Tax Court over his 2004 and 2005 tax returns.The returns were reassessed by the Canada Revenue Agency, substantially reducing the net rental losses he claimed.

The Westmount property has three floors (excluding the basement) and Leisser lives on the second floor.The top floor is rented to his daughter and the main floor had three smaller rental units, two of which were rented, the other being vacant in the two years under appeal.

In computing his rental income, he attributed one-third of the property’s expenses to his personal apartment and deducted two-thirds of the building’s expenses. The CRA reassessed Leisser, treating the third floor occupied by his daughter along with the vacant unit on the first floor “as not being of a commercial nature,” thus disallowing the deduction of the portion of the expenses related to the daughter’s unit and the vacant unit.

(Naturally, the corresponding rent paid by the daughter would be excluded from Leisser’s income.)

The evidence showed the daughter paid only $570 a month for a five-room apartment. Yet on the first floor, arm’s-length tenants were paying about $500 per month for one-room apartments. Because of this, the CRA argued Leisser’s daughter was not paying a fair-market-value rent and therefore, the third floor unit was not a true source of income.

The judge agreed, finding there was indeed a significant personal element involved in leasing the third-floor apartment; namely that Leisser, “out of a very understandable wish to assist his daughter, gave the daughter a much lower rent than if he were renting out the unit to an unrelated person.”

As a result, the court concluded the unit was not being operated in a “sufficiently commercial manner” and therefore could not constitute a source of income, which is a requirement for deducting expenses. As the judge wrote, “Although the daughter has her own dwelling unit, the situation is more akin to the daughter contributing to household expenses than that of a commercial lease.”

The judge ruled that the CRA was correct in excluding rent paid by the daughter from Leisser’s income and in excluding from the property expenses the pro-rata share of the expenses related to the daughter’s third-floor unit.

With respect to the vacant unit, Mr. Leisser described how he had had difficulties with a tenant who left in 2001, after which he decided to take a break from renting the unit. He testified that he was “scared to rent the unit to just anyone and was only prepared to rent the unit by word of mouth”—that is, only to a tenant recommended to him by someone he knew.

While Mr. Leisser appears to have made little effort to rent the unit (i.e. he did not advertise its availability), he was prepared to do so if he could find a suitable tenant through word of mouth. In addition, there was no evidence that the vacant unit had been reallocated for the personal use of Leisser or his daughter.

The judge therefore concluded that the vacant unit was still part of the first-floor rental property and was therefore part of a “source of income” with the favourable result that Leisser was indeed entitled to deduct the related expenses.

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Jamie Golombek, CA, CPA, CFP, CLU, TEP is the Managing Director, Tax & Estate Planning with CIBC Private Wealth Management in Toronto.

Originally published in Advisor's Edge Report

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