All too often novice real estate investors and undesignated “accountants” fail to properly account for the various components of a rental property and face unexpected tax consequences as a result. These components primarily consist of the land underneath and adjacent to the building, the building itself, and sometimes ancillary parts of the property that may include additional structures, equipment, or furniture. Generally, the issue is that whoever performs the accounting for the acquisition assumes that the entire amount of the purchase price is allocated to the building for tax purposes, and this entire value is depreciated through Capital Cost Allowance (CCA) on the investors tax returns. So, what is the issue with that you may ask? Well, assume that a property was purchased for $1,000,000, and a reasonable valuation of the land under and adjacent to the building was $300,000 (leaving the building value at $700,000). When the accountant incorrectly includes the land in the building asset class, and claims the maximum CCA amount each year, they are essentially depreciating the land, and land does not depreciate!
So, what would happen if this mistake was identified by CRA? All past CCA claims of the land value would be denied and brought back into income, so if this mistake went unchecked for a 5-year duration, then $55,300 of prior CCA claims would be added to income with further additional interest charges and penalties. So, to avoid this unexpected tax bill, make sure that you or your accountant has correctly broken out the land vs. building value of your rental property upon acquisition. If you are looking for some guidance on how to determine the allocation of this value you can refer to the below resources:
Appraisal report from a licenses appraiser
Competitive Market Analysis (CMA) report from a licensed real estate broker
Purchase and Sale Agreement for the property
Property tax bill
Replacement value of property from insurance quote
In either scenario, you should be able to determine the relative value of the land vs building however, should you have any further questions, reach out to Taylor Roberts, CPA and he would be glad to address them personally.