Good Friday morning everyone!
Thank you for the day off last week — Good Friday snuck up on me and a workshop with stringent deadlines hit last minute, so Toonie got the cut. We’re back at it again this week.
Tax season is in full force. We’ve got 21 days of madness left.
Boy am I excited to get through this slog. It feels like the most gruelling tax season I’ve ever been a part of.
I genuinely hope CRA keeps that deadline nailed down to April 30th. Nobody wants this thing to go to September 30th like last year. A final date that pushes everyone over the finish line would be great.
I’ve had great luck in pointing friends and prospective clients to my tax document checklist. More than a few friends have used the list and I’ve had to ask very few questions to finish up their returns. I may have to keep that list updated for each tax season.
That article addressed a need back in the latter half of March. Today’s newsletter is going to address a different need. Today’s conversation is one I find myself having with more and more people as investments are made and as folks’ portfolios continue to grow.
“Recapture” is a concept of income deferral that is fundamental to capital assets (capital assets = any asset that has a useful life of more than one year) and real property (real property = land and buildings). It may get a bit nerdy today, but by the end of it, I hope you can see why I think depreciation is like an RRSP-lite.
What is Recapture?
First and foremost, what the heck is recapture? Let’s build an example to follow along.
Let’s say you own a concrete business. You purchase concrete from the vendor, you lay rebar down, build out the forms, pour the concrete, and trowel it until it’s smooth as glass. In order to trowel quickly and with less effort, you go out and purchase a power trowel — one of those really cool motorized machines that you can sit on and ride around on the drying concrete to smooth everything out.
Let’s say that power trowel costs $50,000. And as I mentioned earlier, any asset that has a useful life beyond one year should be considered a capital asset.
Next, it’s tax time. You have revenues. You have expenses. And let’s say you have net income of $100,000. (You had a great year!) Generally accepted accounting principles allow you to “amortize” (or “depreciate”) your capital assets over their useful life. So if that power trowel has a 5-year useful life, you can depreciate 1/5th of the $50,000 cost each year, ensuring you have expensed that power trowel fully by the end of the 5th year (this is called “straight-line depreciation”).
Canada’s Income Tax Act handles depreciation a little differently. “Capital cost allowance” (CCA) is the system for expensing an asset over multiple years. CCA methods use a declining balance method rather than a straight-line method — instead of equally writing off 1/5th of the cost over the useful life, a percentage is used each year. So for most general equipment, you take the cost ($50,000) and multiply it by an accepted rate (say, 20%). The first year of CCA would then be $50,000 x 20% = $10,000, and CCA rules almost always require you take only 50% of the deduction in the first year of ownership. First year CCA on that power trowel is, therefore, $5,000 and it comes off your net income of $100,000.
You will pay tax on $95,000 in your first year! Boo ya, congratulations!
Now, the second year rolls around and you make another $100,000 of net income before CCA. This time around, CCA rules allow you to take the full deduction allowed. We’re using the declining balance method, remember, so this means we have a bit of math to determine the amount of CCA in the second year.
In the first year, you took $50,000 x 20% x 50% to come to CCA. This resulted in a $5,000 deduction. For the second year, that $5,000 comes off the total cost. So you’re looking now at ($50,000 - $5,000) = $45,000. This $45,000 number is known as your “UCC”, or “Undepreciated capital cost”. The UCC amount started at $50,000 in the first year and is depleted with every CCA deduction you take. The first year was $5,000. The second year is $9,000 (($50,000 - $5,000) x 20%), leaving you a UCC balance of $36,000 ($50,000 - $5,000 - $9,000) at the end of year 2.
It’s now year 3 and you decide you no longer want to do concrete work, so you sell the power trowel. Let’s say you sell it for $45,000.
We have a taxable event ladies and gentlemen!
When it comes to tax time, you are going to experience “recapture”, or said another way, “recapture of capital cost allowance”. At the beginning of year 3, your UCC is $36,000 and you sold the trowel for $45,000. $45,000 is not more than its original cost ($50,000), and it’s not less than its UCC balance ($36,000). In short, you “recapture” the CCA deductions you took in years 1 and 2 up to the $45,000 selling price.
Since you deducted that CCA from your business income, you have to recapture that CCA as though it were business income. So if you had $100,000 of net income in year 3, you would have to include $9,000 ($45,000 proceeds - $36,000 UCC) in your net income.
This is recapture. It’s a recapturing of expense you claimed in a prior year as income in the current year.
Here’s recapture in a visual form.
First, step 1: You buy the capital asset. The cost (adjusted cost base or ACB) becomes your UCC.
Then, step 2: You depreciate (claim CCA) on the asset in the first and second year.
And then step 3: You sell the asset. In the visual below, you will note the selling price is more than the original cost of the asset. The difference between the selling price and the original cost, in this case, is a capital gain.
In my tiny brain, I imagine little buckets of cost that slowly drain over the life of an asset. And when that asset gets sold, a whole bunch of water is dumped back into the bucket. If the water is overflowing, you have a capital gain and any water up to the very top of the bucket is recapture.
The reason this is important: Depreciation is just another form of deferred income and you can plan your affairs nicely with just the right amounts of depreciation.
Why Depreciation is Like an RRSP
To tie everything together, let’s say you sold that power trowel from the concrete business and decided to invest the proceeds into a rental property. When you buy a rental property, there are two components to the purchase (usually): land and building. There is the land underneath the building and then the actual bricks and mortar building itself.
You can’t claim depreciation/CCA on the land, of course.
But you can claim CCA on the building portion.
This mechanism is like a little RRSP built into every single rental property.
Let’s imagine your little rental business makes $3,000 of net income at the end of the year after 12 months of rent is collected, after property tax is paid, and after repairs for the unit are completed. You have two choices on how to handle this $3,000:
1. You pay tax on the $3,000 — if you have a marginal tax rate of 35%, you’ll end up with a tax bill of $1,050 for the net rental income.
2. You claim CCA on the building portion — your net rental income becomes nil, meaning you don’t pay that $1,050 of income tax, but the UCC of your building diminishes by $3,000 (you can’t create a loss using CCA on a rental property).
Option 2 is like a mini-RRSP — by claiming CCA on the building portion, you can defer the tax on the income until you recapture your CCA when you sell the property.
When it’s time to sell that rental property:
1. If you chose option 1 (no CCA claim), there’s no recapture and, assuming you sold the building for more than you bought it for, you are taxed only on the resulting capital gain.
2. If you chose option 2 (you claimed CCA), you realize some recapture of CCA on the property and you pay tax on the capital gain. So, in short, you’ll have that $1,050 of tax to pay plus the tax on the capital gain in the year you sell the property.
What the heck Josh! Right? Why would you want to leave all that tax for when you sell the property? Instead of claiming the income throughout the years of ownership, you’re going to claim all that income in one tax year? How can that be smart?
(Dear reader, you are wise!)
There are two reasons why this is wise:
1. You have to use net income to make the mortgage payment. Only the interest portion of a mortgage payment is deductible for tax purposes, leaving the principal portion to come out of net income. This means you could have net rental income of $3,000 and absolutely $0.00 cash in your bank account. By deferring the income with CCA, you can match the cash flows (the actual sale of the property and when you have all the cash) with the tax.
2. You can shelter all that extra income from recapture of CCA in your RRSP. If you have a bunch of net rental income in one year at the very end of your period of ownership, you could throw a bunch of that cash into your RRSP and defer the tax on it even longer.
Reason #2 is why I generally advise rental property owners to maintain at least some RRSP contribution room throughout their period of rental property ownership. It’s not wise to pay tax on all that income in one year when you can defer at least some of it via your RRSP.
Can you see how CCA and recapture kind of act like a mini RRSP? By claiming CCA (or like contributing to your RRSP), you defer income to a future year when you sell the asset (or like deferring income to a future year when you withdraw from your RRSP).
It’s wise to be mindful of these deferred income pools. RRSPs, pension plans, depreciation, and optional inventory adjustments for farmers are four different types of deferred income pools that could result in a gargantuan tax bill if handled incorrectly. As always, having a professional walk alongside you in this plan wouldn’t be the stupidest thing in the world.
Having some control over your income each year thanks to these tax deferral mechanisms is welcome.
The more you can control of your portfolio, the better off you can be.
This was a long and nerdy one this week. Thanks for sticking with me. Hopefully you feel at least a tad nerdier by the end of it.
I hope you and your family have a wonderful and healthy week ahead.
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