Now that we’ve learned a bit about how you as an individual benefit from exemptions and how the laws surrounding your own capital gains can be minimized in our previous article, let’s now turn towards investors, or really anyone who plans to make some kind of income through properties. It goes like this:
Although a property will almost always go up in value (over the long term), both the IRS & the CRA will allow you to claim depreciation of your properties (with the assumption that there has been wear & tear on the building…). For the purposes of the rest of this article we’re going to focus on the CRA because of the substantial variation in treatment that can occur on a state-by-state basis (though if you guys really want it, I’ll definitely do a US extended version - just message me!). That wear & tear is classified as a passive loss and can be used to offset any passive income made by the LLC that you use to manage all the rentals and new purchases of properties.
Why an LLC, well, LLC’s are inherently protective, and well, shield you from liability. If there was, for example, an inability to pay on your end, your personal assets would be safe. Additionally, it holds all kinds of tax advantages. Of course, as we all know, personal income is taxed at the highest possible rate, and so owning the properties under your name makes it much harder to compound gains. Effectively, if you own the properties under an LLC it is much easier to keep more of say, rental income every year to be reinvested in more properties and rental income, and generally compound on your gains.
Going back to depreciation, when your company makes money off of rental returns or capital gains from selling off previous ones, that depreciation expense can be used to reduce those gains artificially. The value of your property has not actually gone down, but on paper, you are able to prevent taxation on any rental income that property produces. Keep in mind though, that this is not permanent, unless of course, you simply never sell the property (which becomes an important consideration when you receive offers on it). Effectively, all depreciation expenses reduce the nominal price at which that property’s capital cost is. For example, let’s say I bought a property for $100,000, and then over time depreciated it by $50,000 to offset other gains. If I then sold that property for $150,000, then there would be recapture as your initial price is deemed to be $50,000, and you would now pay taxes on the amount that you had previously saved. Of course, this is still valuable as it allows you to delay taxes (effectively making money through the time value of capital), but also to optimize your cash flow and have more access to capital before you sell the property.
So, how much can you depreciate, and what happens if you have more depreciation than you need. Well, for that last one, any losses above the income you receive are carried over as operating losses for the business and can be used in much the same way as passive losses to offset future gains. The amount you can depreciate per different type of property is as follows:
Buildings acquired after 1988: 4%
Buildings acquired before 1988: 5% (higher to reflect aging buildings being more likely to lose value)
If they’re made out of stucco, wood, galvanized iron… basically very short-lasting materials, you can depreciate up to 10%
The last thing is that if a Class 1 building (bought after 1988), is used for processing goods for lease or sale, you can depreciate it at a higher rate of 6%. This is incredibly important for businesses, who might acquire properties simply in the course of operation, but can still gain all the depreciation benefits that a company built specifically for rentals would get, by offsetting real business income with depreciation.
Overall, I hope this has given you guys a better idea of how depreciation expenses work, and how you can use them to your benefit as a future business owner, or at least sparked a little bit of imagination for just how important tax management can be.
By: Mateo Gjinali
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