As investors look ahead into the New Year it is not too early to start thinking about tax season and the areas that are appropriate for expensing. Staying organized, understanding which category investments fall under and when money spent is for income or future capitalization are key elements to a smooth tax experience.
According to Shawn Stern, Tax Partner in KPMG’s Real Estate Group, real estate can fall under three separate categories and depending on which category an investor falls in will dictate the types of expenses they are permitted to make.
The categories are:
Existing rental property
Development stage of rental property
Development of resale property
Existing rental property
Existing rental property, notes Stern, refers to a house, building or commercial property that has already been built. Deductions and expenses that occur in this category come with several moving parts: operating costs, leasing costs, repairs and maintenance, and specific costs such as landscaping and disability.
Within existing rental property, operating costs are generally deductable as long as they are incurred to earn the rental income. These would be items such as:
property management fees
legal fees associated with tenant issues
Leasing costs such as broker commissions or legal fees to help draft leases are generally expenseable. So are cash allowances and inducement payments to rent property such as tenant-specific leaseholds (landlords who build partitions, for example, in an empty office space).
While these costs are generally deductable over the term of the lease, Stern says sometimes they can be deducted upfront when the costs are incurred. “A very general test that can be used to filter it would be to ask ‘are these costs being incurred just to get one tenant or is there an argument that these costs were incurred to do something other than to gain a tenant’.”
If one can make the argument that these costs are deductable upfront, then the deduction can be made today, and because the owner is getting the leasing over the next number of years, they will drive down their tax bill upfront and ultimately the money saved can be used to do other things.
Repairs and maintenance
Repairs and maintenance within this category creates some complications. Building owners have to ask themselves are they extending the useful life of the building or is it just maintenance?
Stern offers the example of an office tower as an explanation. “If you take a big office tower, for example, the building will be up for 100 years but over those 100 years you may have to replace the roof, probably have to replace the doors, the elevators and things like that. When we look at this and we say you are repairing a roof on a building, are you extending the useful life of the building or is that just maintenance?”
Because those types of repairs do not extend the useful life of the building, they can be deducted immediately. The big benefit, according to Stern, is that they provide an immediate tax savings for the owner. If the owner has to capitalize it to the cost of the building they are going to save tax over a long period of time and the immediate benefit is lost.
Dennis Anderson, a Tax Partner with Ernst & Young’s Real Estate Group, says repairs and maintenance can be a tricky part of tax filing. “Repairs and maintenance is one of the bigger potential pitfalls that potentially the Canada Revenue Agency (CRA) may audit. Because it’s always a question of fact whether a repair or maintenance expense is capital in nature or currently deductable.”
Anderson notes that generally, the currently deductable pieces are what would be referred to as “putting it back into its original state,” such as painting walls and replacing carpet.
To read the rest of this article and learn more about taxing questions for investors, pick up a copy of our January issue, now on newsstands.
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