How Rental Depreciation Works

By Emily Southey | 16 minute read

Real estate depreciation offers many benefits to rental property owners. For example, it can allow you to reduce your taxable income by writing off certain expenses that come with buying and improving your property. 

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What Is Rental Property Depreciation?

To properly understand rental property depreciation, we must define the following terms:

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• Depreciation: Depreciation is the decrease in value of an asset, whether through age, use, or deterioration. It can also be a deductible or expense claimed to make up for this decrease in value. When it comes to real estate, investors might acquire a depreciable property. While an investor cannot deduct the cost of the property when calculating their net rental income for the year, they can deduct the cost of the property over several years. In Canada, this type of deduction is referred to as capital cost allowance (CCA).  
• Depreciable property: A depreciable property is a piece of property that wears out over time. Anything from cars to real estate to farm equipment can be considered depreciable property.  
• Depreciable rental property: A depreciable rental property is any rental property on which a property owner claims capital cost allowance. The capital cost can be written off as CCA over several years.  

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How Does Rental Property Depreciation Work?

Rental property owners in Canada can claim capital cost allowance on the depreciable property, which is essentially a way of deducting the property’s improvement expenses from their taxes. However, the Canada Revenue Agency (CRA) has strict rules on what expenses can be claimed and the maximum amount of CCA that can be claimed. Ultimately, the amount of capital cost allowance that can be claimed on any one property depends on the type of property you own and the date it was acquired. 

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Most depreciable property is grouped into classes, and from there a specific rate of CCA applies. Most often, investors use the declining balance method to calculate their CCA. To use this method, you must apply the CCA rate to the capital cost of the depreciable rental property. Over the lifespan of the property, the rate is applied against the remaining balance. The remaining balance then declines every year that you claim CCA.

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Calculating Capital Cost Allowance

To further explain how rental property depreciation and CCA work, please read the following example: 

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An investor purchased a rental property for $100,000 in 2020, and the CCA rate is 10%. Therefore, the maximum amount of CCA they can claim is $10,000. If they claimed $10,000 last year, then they would apply the same rate of 10% the next year. However, this 10% rate would be applied to $90,000, as the $10,000 claimed in the year prior would be deducted from the original purchase price of $100,000. Ultimately, investors must deduct the amount already claimed from the original purchase price each year before applying the specified rate to the remaining amount. Claiming CCA on a rental property over three years might look like this:  

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• First year: $100,000 (purchase price) x 10% (CCA rate) = $10,000. Therefore, $10,000 is the maximum amount of CCA that can be claimed in year one. 
• Second year: $100,000 (purchase price) – $10,000 (first year CCA) = $90,000, and $90,000 x 10% = $9,000. Therefore, $9,000 is the maximum amount of CCA claimed in year two.  
• Third year: $100,000 (purchase price) – $10,000 (first year CCA) – $9,000 (second year CCA) = $81,000, and $81,000 x 10% = $8,100. 

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This method of calculation would continue for every year that you claim CCA. Keep in mind that property owners are not required to claim the full amount in any given year. Rather, they can claim part of it or forgo a claim altogether. Ultimately, claiming CCA means that the amount available for you to claim in subsequent years will be reduced.

Limits on Capital Cost Allowance

There are a few limitations on capital cost allowance that rental property owners must be aware of. First, for the year the rental property is acquired, you may only be able to claim CCA on half of the net additions to a class. This is known as the half-year or 50% rule. Further, in the year you sell the rental property, you may be required to add an amount to your income as a recaptured capital cost allowance or deduct an amount from your income as a terminal loss. Additionally, if you own multiple rental properties, you must calculate your overall net income or loss for the year from all rental properties before claiming CCA. Another important rule is that a rental property owner cannot use CCA to create or increase a rental loss.

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Deductions Versus Depreciation

Deductions and depreciation both represent ways of limiting how much tax you pay on your rental property. As we have covered depreciation above, now we are going to delve into deductions. But first, let’s briefly distinguish between the two. Deductibles are expenses paid on a rental property that can be deducted from your income taxes in the same year that they are incurred. Meanwhile, deprecation is a form of non-cash deductible and the total amount is amortized over multiple years. It essentially allows investors to take tax deductions on the predicted decrease in value over time of their rental property(ies). However, what they both have in common is that they can reduce a real estate investor’s taxable income. To further highlight the difference between the two, new light bulbs to replace burnt-out ones in your rental property would be considered an expense. However, new light fixtures that are installed and add value to your property would be depreciated over time. 

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Current expense versus capital expense

Before you can start deducting expenses from your rental income, you must understand the difference between current expenses and capital expenses. A current expense is a recurring expense that maintains or restores the rental property. Using the example above, new light bulbs would be an example of a current expense. General repairs or maintenance, such as painting, would also be an example of a current expense. Oppositely, capital expenses must boost the property’s overall value or provide a lasting benefit to the property. The entirety of such expenses usually cannot be deducted in a given year but they might be able to be spread out over several years via your CCA claim. In the example above, a new light fixture would be considered a capital expense. Basically, to qualify as a capital expense (depreciation) rather than an operating expense (deductible), the item purchased must add value to the property of the home and should have an expected lifespan of more than one year. 

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Deductions That Can Be Made to Rental Properties

The CRA allows rental property owners to make all kinds of deductions based on the expenses incurred for their rental properties. Each type of deduction that is eligible is given its own line on the T778 form, which makes it a relatively simple process for rental property owners filing their own tax returns. However, understanding exactly which expenses qualify and in what situations is important as not everything is fully deductible in all cases. Keep reading to discover a detailed breakdown of the deductions that can be made on rental properties in Canada.

Insurance premiums

If you own a rental property, then odds are you have home insurance or landlord insurance. Not only can insurance provide peace of mind to rental property owners but they also come with the benefit of being tax deductible. Specifically, property owners can deduct insurance premiums for the year they are incurred. That said, you must limit your deduction to cover expenses only incurred during the current year. If your policy has coverage beyond one year, you can only reduce the expenses in the current year they offer coverage. 

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Interest fees

Interest fees are another deduction that can be made to rental properties. Though the principal of your mortgage is non-deductible, rental property owners can deduct the interest payments made on their mortgage loan. They can also deduct other mortgage-related fees, such as the cost of mortgage applications, brokerage fees, appraisals, insurance, and more. Further, real estate investors can claim interest on any money they borrowed to improve the property (for example, loans they took out for updates or renovations), as well as any interest paid to tenants on rental deposits. However, for the former to qualify, the CRA stipulates that the expenses must be “soft costs,” which they define as funds borrowed for the purpose of financing construction, upgrades, and renovations of your rental property with the aim of increasing its value or making it more suitable to rent out. Overall, there are a variety of interest fees that rental property owners can claim to reduce how much they pay in taxes. 

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Advertising fees

Rental property owners can deduct expenses incurred to advertise their property to potential tenants. This can include a wide range of advertising mediums, including print, radio, online, and television. It even includes finder’s fees. So if you paid to advertise your rental property in any way, be sure to claim it.

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Professional fees and legal fees

Professional fees and legal fees incurred through the operation of the rental property might also be tax deductible. For example, many property owners hire a lawyer to review the lease agreement before the tenant signs it or even to collect overdue rent. Similarly, a landlord might hire an accountant for booking services relating to the property or to help them prepare financial statements or audit their record. Consultancy fees are another example of professional fees that can be claimed. Please note that fees incurred in the operation or maintenance of the rental property once purchased are often deductible. However, fees incurred to purchase the rental property, such as the cost of hiring a home inspector, appraiser, or real estate attorney, cannot be deducted from the gross rental income.

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Property management fees and administration fees

When you buy a rental property, you become a landlord. However, if you don’t have the time or energy to take on the role of a landlord, you can hire a property management company to do it for you. While this costs money, the good news is that you can deduct this expense. The same goes for the costs of hiring a tenant agent to find and vet prospective tenants or collect rent from tenants.