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Claiming Tax Deductions for Rental Property Expenses: Current or Capital?
The Income Tax Act (the “Act”) generally divides expenses into “current” and “capital”. When expenses are “current” they can be deducted from income in the year incurred. When expenses are “capital” they are not deductible in computing income in the year incurred (though they are deductible under the capital cost allowance or “CCA” regime). Generally, current expenses provide a short-term benefit while capital expenses provide a long-term benefit.
The recent case of DiCaita v. The Queen, 2021 TCC 5 looked at a number of issues relating to expense deductions for rental properties. The case is a reminder that property does not need to be generating income at every stage of operation in order to be considered a source of income and that not all renovation work will be a capital expense.
The case is also a reminder that expense claims should be substantiated with receipts/invoices and must be reasonable, and that no deductions will be permitted for personal expenses.
The case dealt with a taxpayer who had undertaken repair work at one of his vacant rental properties. The Canada Revenue Agency (“CRA”) denied the deductions related to the repair work on two grounds. The first was that because the unit was vacant when the expenses were incurred there was no source of income, and therefore the expenses were not deductible under paragraph 18(1)(a). The second was that the expenses were capital in nature, and therefore not deductible under paragraph 18(1)(b).
Notably, the court found the taxpayer (who was the only witness) to be articulate, intelligent, honest, well-organized, and credible.
The following provisions of the Act were most relevant:
- Section 9: sets out the basic principle for calculating income and losses from business or property
- Section 18: sets out the general limitations to expense deductions
- Paragraph 18(1)(a): provides that an expense is deductible only to the extent that it was incurred for the purpose of gaining or producing income from business or property
- Paragraph 18(1)(b): disallows expenses on account of capital outlays
- Paragraph 18(1)(h): disallows expenses that are for personal or living expenses
- Section 67: provides that an otherwise deductible expense must be reasonable in all the circumstances
The taxpayer owned a Vancouver townhouse unit in a condominium complex (“strata” in BC) built in the 1970s. It always had a high occupancy rate, meaning there was little opportunity for repairs other than minor work. The unit was for the most part original to the 1970s. The complex manager undertook major exterior work, lasting almost 2 years. The work caused the tenant to leave and the taxpayer was unable to find new tenant. The taxpayer decided to use this vacancy to undertake interior repair. While somewhat substantial (given the age of the building), it did not require any structural work or building permits.
When looking at whether an expense was incurred for the purpose of gaining or producing income from business or property the court relied largely on the Stewart v. The Queen, 2002 SCC 46 analysis that “the taxpayer must establish that the predominant intention is to make a profit in accordance with objective standards of businesslike behaviour.”
The court found the taxpayer’s intention at all times was to earn a profit from the rental property, and that the taxpayer went about his rental activities in accordance with objective standards of businesslike behaviour. The court rejected the CRA’s position that a vacant rental was not a source of income, holding that “[a] property does not need to be generating income at every stage of operation in order to be considered a source of income.”
The court also provided an overview of the principles dealing with whether an expense was current or capital in nature. Some of the highlights include:
- The overarching test is the “purpose and nature” of the work. This is guided by case law, the Act, and common sense.
- The test is difficult to apply, and will lead to different results in different situations. “Ultimately, whether an expense is incurred on account of income or capital is a determination that can only be made after the facts have been considered in full. No one factor is determinative and considering them collectively is necessary.”
- The terms “capital expenditure” and “operating expense” are not clearly defined in legislation. Determining whether the expense is current or capital in nature is to be made in accordance with Generally Accepted Accounting Principles (GAAP).
- The traditional meaning of “capital expenditure” is an expense incurred to procure “the advantage of an enduring benefit” which would include “preserving an asset”. However, it would not apply to expenses which did not create an identifiable asset. The expense will tend to be a capital expenditure if the repairs result in something new being created.
- It is a question of fact whether renovations are current or capital in nature.
- When it comes to repair work, any work will improve the property to some degree. The inquiry should be focussed on whether the work resulted in a different capital asset than before the repairs.
In looking at the “nature and purpose” of the work, the court concluded the expenses were current in nature. This was based on the following:
- The work did not create a different capital asset than before.
- The work was “restorative, not rehabilitative”, in which the worn out items were replaced. In other words, the work was meant to bring the unit back to its previous state, not to upgrade it to appeal to different renters or change the character of the unit.
- There was no material change to the structure, layout, or functionality of the unit.
- The expenses were modest when compared with the value of the unit.
- Whether the work was undertaken over a long period of time or all at once (as was done here) does not change the character of the work.
Whether an expense is current or capital is an important determination that every business owner needs to make. Because no two situations are the same it can also be a difficult choice. When undertaking any kind of renovation work it’s crucial to look at all of the facts and determine how much has changed once the work is complete. For more information on our Tax Team or to speak with an experienced tax lawyer regarding your tax and business law needs, please contact us.
This article was written by Tax and Commercial Litigation Lawyer Graham Morton.