When your clients spend money renovating or repairing their properties, it’s important for them to understand the tax treatment of such expenses.
Real estate expenses can be categorized into two broad buckets: current expenses and capital expenses. Generally, current expenses can be fully deducted in the year incurred to provide immediate tax relief by reducing net rental income. On the other hand, capital expenses can be added to the adjusted cost basis (ACB) of the property, which provides a deferred tax benefit by reducing the future tax liability on disposition. In certain circumstances, a tax deduction may be claimed over several years under the capital cost allowance mechanism.
For personal use property with no rental income, current expenses can’t be deducted, so your clients would receive a tax benefit only from capital expenses incurred on such properties. If your clients were earning rental income, current expenses may be more beneficial from a tax perspective, as they would reduce their fully taxable rental income in the same year.
So, how can your client distinguish between the two types of expenses?
Per the Canada Revenue Agency (CRA) guide T4036 Rental Income, capital expenses are costs incurred to extend the useful life of the property or improve the property beyond its original condition. An increase in market value resulting from the expense isn’t a major factor in determining the nature of the expense. The CRA lists various criteria in the guide to help determine whether the nature of an expense is capital or current, as discussed below.
Does the expense provide a lasting benefit?
If the expense provides an enduring benefit or advantage and isn’t likely to recur after a short period of time, it’ll usually be treated as a capital expense. For example, installing vinyl siding on the exterior walls of a wooden house would be a capital expense, but painting the exterior would be a current expense.
Does the expense maintain or improve the property?
If the expense only restores the property to its original condition and doesn’t materially improve the property, it will usually be treated as a current expense. As an example, replacing wooden steps with concrete steps would be a capital expense, but repairing or restoring existing wooden steps would be a current expense. Similarly, replacing the roof and restoring it to the original condition would be a current expense, but using better-quality material with greater durability (such as replacing asphalt shingles with a metal roof) would be treated as a capital expense.
Is the expense for a part of the property or for a separate asset?
If the expense relates to repairing or replacing an integral part of the property and not replacing a separately marketable asset, it will usually be treated as a current expense. For example, replacing the electrical wiring of a property would be treated as a current expense as long as there is no betterment, i.e., the rewiring doesn’t improve the property beyond its original condition.
What is the value of the expense?
If the expense is considerable compared to the property’s value, it would usually be treated as a capital expense. However, as per the CRA, this criterion can’t be used as a determining factor. In a situation where a large amount was spent on repairs and maintenance at once due to delays in regular maintenance work, the expense may still be treated as a current expense regardless of its total cost. In other words, delaying ordinary maintenance that results in larger repair costs doesn’t change the nature of the expense from current to capital.
Is the expense for repairs made to used property you acquired to put it in a suitable condition for use?
If the property requires certain repairs or replacements to make it suitable for business use at the time of acquisition, the cost of such expenses would be treated as a capital expense even though in other circumstances the same expenses would be treated as a current expense. In addition, when the property is already in use, the same repairs or replacement expenses may be treated as current expenses based on the criteria discussed above.
Is the expense for repairs made to an asset in order to sell it?
Any cost of repairs made in anticipation of a sale, or as a condition of sale, would be treated as a capital expense. However, if the repairs would have been made in any event, then the sale or anticipated sale of the property wouldn’t have any bearing on the classification of the expense.
As there are many different tests and criteria involved in distinguishing real estate expenses, it’s important for your clients to work with their tax advisors to maximize the tax benefits from real estate expenses.