Author Topic: Ways to reduce tax on rental income?  (Read 3818 times)

tofu_muffin

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Ways to reduce tax on rental income?
« on: September 09, 2012, 08:57:01 AM »
My husband and I are both in the Canadian military and will retire in a few years with healthy DB pensions (44% of our best 5 years salary) which will easily cover our living expenses. We currently live in the city to be close to work and we own some land 45 minutes drive out in the country. This land out in the sticks is where we will build our small passive-solar retirement home.

We plan to keep our city house and use it as an income property after we retire. This house will be paid off before we rent it out so we will lose the option of deducting mortgage interest as a rental expense. As we will be close enough to manage and maintain the rental property ourselves, I can't think of any rental expense deductions other than property taxes (approx $2500/year) and occasional maintenance items.

Our pensions and other post-retirement income from part-time hobbies/work we plan to do will keep us in the ~37% marginal tax range. I am a good Canadian socialist but I am reluctant to hand over nearly 40 percent of the rental income (rent=$24000/year).

One option that has been suggested is to slow down the payments on the city house mortgage and use those savings to build the retirement house with cash. I'm hesitant to do that though as I think we can save enough to build the second house with cash anyway, especially since we plan to do the majority of work ourselves. Both of us have lived in "reno-project houses" that we bought cheap and worked on as we could afford to/learned how to, flipping for profit later. 

Canadian tax law says that if I refinance the city house after it is paid off in order to access the equity to invest elsewhere, the mortgage interest would no longer be tax deductible since I would essentially be using that mortgage to invest for personal gain. Someone please correct me if I am wrong here, I am by no means a tax expert.

I realize this is a nice problem to have - 2 paid off houses, how to keep more of my money for myself?
Is anyone else in this situation? Any suggestions on how to keep more of the rental income working for me instead of handing over a huge chunk of it as income tax?

Mattamatics

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Re: Ways to reduce tax on rental income?
« Reply #1 on: September 10, 2012, 11:18:21 AM »
In your situation (due to the fact that you anticipate having no debt, or need for it by the time your current residence becomes a rental) a lot of the typical advice - ie cash damming, or undertaking the smith manoeuvre isn't beneficial, or reducing your current mortgage payments (paying interest solely for tax planning/minimization purposes is never beneficial).

However you're forgetting CCA (amortization expense) on the property which you can take (4% of net book value (NBV)) to reduce your taxable income. In your situation (and in most siuations) I'd recommend you take the deduction, which will reduce the taxable rental income. (Note you'll have to allocate some of the value of the property to land which can not be amortized.)

Also when you do convert your home to a rental property you'll want to get a reasonable assessment of the property's fair market value as your capital gains exemption for the old property is only until it's change in use (deemed disposition). Any capital gains from that date forward are taxable. (You should likely talk to an Accountant or CRA, to find out exactly what documentation you will need)

Also if you want to look further into tax minimization (from a Canadian perspective) on your rentals I'd suggest checking out/posting to http://canadianmoneyforum.com/forumdisplay.php/5-Real-Estate as well.


In regards to your statement:
"Canadian tax law says that if I refinance the city house after it is paid off in order to access the equity to invest elsewhere, the mortgage interest would no longer be tax deductible since I would essentially be using that mortgage to invest for personal gain. Someone please correct me if I am wrong here, I am by no means a tax expert."

Canadian tax law would look to see what the proceeds of that loan were used for to determine its tax deductibility. For example many Canadian undertake what is called “The Smith Manoeuvre” which is where you pay down your principal mortgage (not tax deductible) and then borrow via a HELOC to invest in stocks. The interest on the HELOC is considered tax deductible (against investment income) as it’s invested to earn investment income via the stocks. If you were to borrow against your rental house to build your new personal residence, then you are correct the interest would not be tax deductible.

Frugal Trader @ MDJ has dozens of posts dedicated to the Smith Manoeuvre at http://www.milliondollarjourney.com/the-smith-manoeuvre-resource.htm
That I’d highly recommend reading (and then talking to an accountant before undertaking it)


Hope this helps, I didn't want to get into specifics as it seemed like you were looking for a more overall strategy/idea of options that are out there - if you want more specifics, post your details and I can try to provide an opinion.
« Last Edit: September 10, 2012, 11:20:46 AM by Mattamatics »