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:

1. 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.
2. 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/

 

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/

A rent-to-own program is a win-win program for both the investor/landlord and the tenant/buyer.  It allows the investors to generate cash flow from a single family rental and provides the opportunity for otherwise unqualified buyers to purchase their homes over a period of time.

In a typical rent-to-own arrangement, there are (3) three streams of income.

1. Firstly, the tenant buyer pays a down payment in exchange for the option to purchase the property at the end of the contract.  Usually the term of the contract is two to three years.
2. Secondly, the tenant buyer also pays rent during this contract.  A portion of the rent is used to contribute to the purchase price at the end.  This is called rent credit.
3. Thirdly, at the end of the option contract, the tenant can choose to purchase the property at the preset purchase price.

As investors, how do we report the income from the rent to own arrangement?

This depends on your personal tax situation.  If rent-to-own is considered as a business, all three streams of income are required to be reported as income.  If the rent-to-own investment is capital in nature, these three streams of income are reported differently.

Let’s first look at how Canada Revenue Agency (CRA) determines whether the rent-to-own investment is a business or not.  CRA looks at the following criteria when they consider whether to classify the rent-to-own investment as business or capital in nature.

1. Is the rent-to-own transaction similar to the landlord’s “normal course of business”?
   • If the landlord is a full-time landlord without any other employment income, then the rent-to-own transaction is more likely to be treated as similar to the landlord’s normal course of business.
   • On the other hand, if the landlord has other full-time employment, it is more difficult for CRA to argue that the rent-to-own transaction is similar to the landlord’s normal course of business.
   • Be cautioned that one single factor can not be relied upon to conclude that the rent-to-own transaction is not to be considered as business income.
2. How frequently does the landlord invest in rent-to-own deals?
   • The more rent-to-own deals the landlord has, the more likely that the CRA considers it as a business.
3. Is this rent-to-own transaction an “adventure or concern in the nature of trade”?
   • An adventure or concern in the nature of trade is something a landlord habitually does that is capable of producing a profit, irrespective of the landlord’s own occupation.
   • There are 3 factors that CRA consider when determining whether the rent-to-own transaction is an adventure or concern in the nature of trade:
     • i.     Whether the landlord dealt with the property acquired by him in the same way as a dealer in such property
       • We need to compare the landlord’s conduct with what a dealer’s conduct would be for the rent-to-own deals.  The following factors are usually considered to determine whether the landlord’s conduct consistent with a dealer’s conduct –
         • If there is evidence of efforts, such as advertising, that were made to find or attract purchasers or that a sale took place within a short period of time, it is more likely CRA considers the landlord as a dealer.
         • The more renovations or extra steps that the landlord does to increase the marketability of the rent-to-own property, the more likely CRA considers him as a dealer.
         • If the landlord is a real estate agent or mortgage agent that has a commercial background in a similar business, the more likely CRA considers him as a dealer.
     • ii.     Whether the nature and quantity of the property excludes the possibility of generating income from the property other than selling it.
       • In a rent-to-own transaction, the nature of the property allows the landlord to rent it out to the tenants and hence supports the transaction as being capital in nature.
     • iii.     Whether the landlord’s intention is consistent with other evidence pointing to a trading motivation
       • The landlord’s intention to sell the property at a profit alone cannot be used by itself to determine whether he was involved in the adventure or concern in the nature of trade.  If one of the other above factors clearly shows that the landlord is engaged in the adventure or concern in the nature of trade, his intention can be viewed as corroborative evidence.
       • The investor’s intention can change over the period of time and can have more than one intention.  If the investor’s intention is to hold the rent-to-own investment as an investment (capital in nature), CRA also looks at the secondary intention if the investor is unable to fulfill the first intention.

Admittedly the criteria used by CRA to determine whether your rent-to-own investment is business or capital isn’t black and white.  As investors, you should definitely consult your professional advisor about your personal situation to make a reasonable and supported conclusion.

If you conclude that your rent-to-own investment is considered as a business, you are required to report the down payment, the rent and rent credit, and the ultimate sale of the building as income the year the proceeds are received for each of these components.

In the next post “Rent to Own Taxation (Part 2)“, I will discuss the tax implication when rent-to-own investment is considered as capital in nature.

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/