The following is a guest post by Cherry Chan, Chartered Professional Accountant. Cherry specializes in real estate taxation and has many great posts on the subject on her blog. For more info visit Cherry’s website at: http://cccpa.ca/
In my previous blog post “Rent to Own Taxation (Part 1)“, I shared with you the (3) three streams of income from a typical rent-to-own arrangement and the criteria to determine whether the rent-to-own investment strategy is considered as business or capital in nature. I also shared with you that if the rent-to-own investment strategy is considered as business, the investor is required to report all three streams of income as income.
In this blog post, I will continue to explain to you the tax implication if the rent-to-own arrangement is instead considered to be capital in nature.
Stream 1. Non-refundable down payment
In a typical rent-to-own arrangement, the tenant buyer puts a non-refundable deposit down (a minimum of 5% of the purchase price at Ownership Solutions) in exchange for the option to purchase the house at an agreed price at the end of the term, usually 2 to 3 years (most commonly 3 years at Ownership Solutions).
If the agreement does not specify that such down payment is used for the purchase of the option right, the investor is required to report it as income as the amount is non-refundable.
However, if the agreement specifies that the non-refundable deposit is to be used towards the purchase of the property at the end of the term, the Income Tax Act (ITA) allows the investor to report it as capital gain in the year he receives the money.
In most rent-to-own option agreements I have worked with, they clearly specify that the down payment is to be used to pay for the purchase. Therefore it’s most likely the investor can report it as a capital gain in the year he receives this down payment.
Stream 2: Rent and rent credit
During the term of the rent-to-own arrangement, the tenant buyer is required to pay rent. A portion of this rent is then credited toward the ultimate purchase price as agreed on in the option agreement.
For the regular portion of the rent payment, the investor is required to report it as rental income.
As for the amount of rent credit, if the agreement specifies that it is used to maintain the option right and credited towards the future purchase, similar to the non-refundable deposit, the amount can be reported as a capital gain. Otherwise, the rent credit should be reported as income in the same year.
The investor should be careful with respect of drafting up the agreement specifically to the rent credit. One rent-to-own expert had expressed his concern that if the rent credit was not part of the lease agreement, the landlord investor may not be able to go after this amount in case of tenant default.
Stream 3: Purchase option at the end
If the tenant buyer decides not to exercise his option, all the reporting has been completed the year the money is received. Nothing further is required.
If the tenant buyer proceeds with the purchase, the investor is required to do the following:
- For the years the investor has reported the non-refundable deposit and rent credit as capital gains, the investor is required to file an amended return to reduce the capital gain to zero.
- In the year the tenant buyer exercises the option to purchase the house, the investor is required to report the sum of non-refundable down payment, the rent credit, together with the actual cash proceeds from the sale as the sale price, less the cost of the acquisition of the house as capital gain.
That’s all you really need to know about rent-to-own taxation. You should be able to determine whether your rent-to-own transactions are a business or capital in nature, and understand how to report each of the three types of income received during the transaction.
If you have any questions about rent-to-own taxation or require further clarification, please contact me (Cherry) directly.
The above is a guest post by Cherry Chan, Chartered Professional Accountant. Cherry specializes in real estate taxation and has many great posts on the subject on her blog. For more info or to contact Cherry, visit her website at: http://cccpa.ca/