Chapter 7: Income from Property

● Income from property: return on invested capital where little or no time, labour, or attention has been
expended by the investor in producing the return.

● Property income includes:

○ Dividend Income: The return on the investment in capital shares of public and private
corporations.

○ Interest Income: The return on investments in bank deposits, loans, mortgages, bonds, and
debentures.

○ Rental Income: The return on the ownership of real estate or other tangible property.

○ Royalty Income: The return on the ownership of properties such as patents and mineral rights.

Note:

● Property income is the annual or regular return received for allowing another party to use the property.

● To qualify as property income, interest must be earned in a relatively passive way, without significant
time, labour, or attention by the owner.

Exclusions from Property Income:

○ Gains or losses resulting from the sale of property (e.g., shares or real estate) are not property
income but capital gains or losses.

○ If a recapture of capital cost allowance (CCA) occurs, it is considered property income. Conversely,
a terminal loss is classified as a property loss.

● Business Income Distinction:

○ Interest income earned by financial institutions is classified as business income because it

involves significant effort to generate the income.

General Rules for Determining Property Income

● Property Income is determined on a Net basis ( Revenue - Expenses)

● Expenses incurred to earn property income can be deducted for tax purposes provided they are:

● incurred for the purpose of earning income that is taxable

● Not an expenditure of a capital nature,an expenditure the account capital,of depreciation and
amortization; not a reserve;

● Not a personal or living expense

● reasonable under the circumstances

Property Income and Taxation Year

● Taxation Year For Individuals → calendar year ( i.e Dec 31, 2024)
● Taxation Year For Corporation→ fiscal year end

Deduction of Interest Expense

General Rule and Exception

● Deductibility of Interest on Investment Loans:

○ Although interest on loans for capital purposes is typically non-deductible, an exception exists
when the loan is used to acquire property that generates property income (e.g., interest,
dividends, or rental income).

○ Examples of eligible investments include bonds, bank certificates, corporate shares, and real
estate.

● Documentation Requirement:

○ Taxpayers must document that the loan was specifically used for investment purposes to claim a
deduction for the interest.

○ Without clear proof, tax authorities may allocate the loan between personal and investment uses,
reducing the deductible amount.

Best Practices for Loan Management

● Maintain Separate Accounts:

○ To clearly establish loan purposes, use a dedicated bank account for investment activities.

○ Deposit loan funds in the investment account and ensure disbursements from this account are
exclusively for investments.

● Mortgage as Investment Loan:

○ Individuals can borrow against their personal residence to fund investments.

○ Interest on the portion of the mortgage used for investments is deductible if the purpose is
documented (e.g., through a separate account).

Maximizing After-Tax Cash Flow

● Use Cash for Personal Assets:

○ Excess cash should be used to acquire personal assets (e.g., cars, homes).

○ These assets can serve as collateral to obtain investment loans.

● Prioritize Repayment of Personal Loans:

 ○ Focus on repaying personal loans incurring non-deductible interest first.

○ Maintain separate loans for personal and investment purposes.

Illustrative Example

● A taxpayer borrows $7,000 to purchase shares and a personal car but deposits the loan into their general
account.

○ Without proper documentation, it becomes challenging to prove the loan’s purpose.

○ Allocating the loan to an investment-specific account clarifies its use for tax purposes.

Tax Impact of Mixing Loans and Investments

● Scenario: An individual has a $10,000 personal loan for a cottage and owns $10,000 in bonds, both at 10%
interest.

○ With a 45% tax rate, the after-tax return on the investment is negative (-$450), emphasizing the
importance of structuring loans to optimize tax efficiency.

Unique Features of Property Income

● Interest Income: compensation received for the use of borrowed funds.

○ For loans made without interest

■ If the addition payment of principal reflects the normal rate of interest that would have
been charged on the particular transaction → treated as interest income

■ If the addition payment of principal is greater than the normal rate of interest that
would have been → treated as capital gain

● Recognition of Income

○ All corporations, private and public, must recognize income according to the normal rules for
profit determination and do so on an accrual basis. This means that a corporation must include
interest even though the interest may not have been received and may not be receivable until
some future time

○ For individuals, when the cash or receivable method is unqualified, can use the anniversary day
accrual rule ( Overriding rule over other methods)

■ anniversary day accrual method requires that interest income be recognized for every
12-month period from the date the investment was made

● Foreign Interest: Recognition in Canadian Dollars: Interest earned on foreign investments is recognized in
Canadian dollars following the same methods used for domestic interest income.
 ● Full Inclusion in Income: The full amount of interest earned, before any foreign tax withholding, must be
included in property income. Canadian taxpayers can reduce their Canadian tax liability on this foreign
income using a foreign tax credit.

● Foreign Tax Credit Limitations:

● The credit only applies to Canadian taxes payable in the same year the foreign taxes were withheld.

● If taxpayers recognize foreign interest income earlier (e.g., via the accrual method), they may face
Canadian taxes before receiving the interest and before foreign taxes are withheld, limiting the credit's
applicability.

Alternative: Treating Foreign Tax as an Expense:

● If the foreign tax credit cannot be used, taxpayers can treat the withheld foreign tax as an expense against
property income.

● However, this creates a degree of double taxation (tax paid in both Canada and the foreign country).

Life Insurance Policies and Tax Treatment

● Types of Life Insurance Policies:

○ Whole Life Insurance: Includes both a savings component (which accumulates interest) and a life
insurance protection component.

○ Term Life Insurance: Provides only life insurance protection, without a savings component.

● Tax Treatment of Earnings: For policies issued after 1989, earnings from the savings component (interest
returns) are taxed similarly to other investment income, meaning they must be reported annually.

Expenses that are allowed as deductions from Interest Income:

● Interest Expense On Loans Used To Acquire Interest-bearing investments

● Investment Counselling Fees

● Costs incurred to obtain a loan, such as legal fees, mortgage appraisal fees, and registration fees
(amortized over five years at the rate of one-fifth per year)

● Fees Paid To Managers Of Investment Portfolios

● Fees paid to a financial institution for holding securities; the cost of a safety deposit box is not deductible

● Accounting fees for record-keeping and determination income from property

● Reserves or complete deductions for interest income that has been accrued but is not collectible because
of the debtor’s inability to pay

Note: If the expenses incurred are greater than the interest income, a property loss is created that can be used to
offset the taxpayer’s other income sources
Dividend Income

● Dividend Income: Dividends are the returns provided on the investment in shares of a corporation; they
reflect the distribution of a portion of the corporation’s profits to the shareholders.

○ Can be earned by individuals or corporations

● Note: Corporate earnings are taxed in the hands of the shareholder, either as dividends (property income)
or as capital gains, depending on whether or not the corporate profits are distributed.

Dividends Received by Corporations

● Dividends paid by one Canadian corporation to another are included in the recipient’s net income when
received.

● A corporation’s taxable income is reduced by dividends received from other taxable Canadian
corporations, ensuring those dividends are not taxed again.

● Dividends from foreign corporations are excluded from taxable income only if the foreign corporation
qualifies as a foreign affiliate.

● A foreign corporation qualifies if the Canadian corporation owns at least 10% of its equity.

Dividends Received by Individuals

● Inclusion of Dividends in Income:

○ Dividends earned by individuals on taxable Canadian corporate shares are included in their net
income for tax purposes when received.

● Gross-Up for Different Corporations:

○ Public Corporations: Dividends from Canadian public corporations are grossed-up by 138%.

○ Private Corporations:

■ If the private corporation's income is investment income or eligible for a low tax rate
(e.g., small business deduction), the dividend is grossed-up by 115%.

■ If the private corporation's income is not eligible for a low tax rate, the dividend is
grossed-up by 138%.

● Dividend Tax Credit:

○ The individual taxpayer’s tax on the grossed-up dividend is reduced by a dividend tax credit,
which compensates for the corporate taxes already paid on the income. The credit is roughly
equal to the gross-up and helps eliminate double taxation.
● Corporate Tax Rate Assumptions:
○ The gross-up assumes corporate tax rates of 13% (for non-eligible dividends) or 27.5% (for eligible
dividends), but this may not always align with actual corporate tax rates, affecting the overall tax
impact.
 Foreign Dividends: Dividends from foreign corporations are not subject to gross-up or dividend tax credit. They
are taxed based on the actual amount received, similar to foreign interest income.

Stock Dividends:

● Stock dividends are considered taxable dividends for individuals, subject to the gross-up and dividend tax
credit.

● Stock dividends represent reinvested earnings into shares, and any sale of those shares is taxed as a capital
gain based on the paid-up capital.

Rental Income

● Rental Income: Compensation received for allowing another party to use a tangible property
● Deductible Expenses from Rental Income:
○ Interest expenses incurred on loans used to acquire the rental property or to fund repairs and
improvements

○ costs incurred to obtain loan financing, such as mortgage fees, legal fees, and appraisal fees
(amortized over five years at one-fifth of the cost per year)

○ insurance expense

○ property taxes

○ repairstothepropertyofanon-capital nature

○ maintenance costs,such as cleaning,lawncare,and snow garbage removal

○ utility costs(heat,power,and water)

○ landscaping costs around a building,even though such costs maybe a capital nature

○ capital cost allowance on the building as well as on other related tangible assets,such as furniture
and equipment salaries and wages paid to employees who supervise and/or maintain the
property

○ propertymanagementfeespaidtoanindependentpropertymanagementorganization

○ accounting costs for record-keeping and income determination

○ costs incurred to collect rents

○ advertising

Note: Expenses are dependent on the type of lease agreement.

● Gross Lease: In a gross lease, the tenant pays only a fixed rent amount. The owner (landlord) is
responsible for covering all expenses related to the property (e.g., maintenance, taxes, insurance).
 ● Net Lease: In a net lease, the tenant pays a basic rent plus additional costs associated with the property's
operation (e.g., maintenance, property taxes, insurance). The owner is only responsible for financing costs.

Special Rules for Capital Cost Allowance (CCA):

● CCA on rental properties is limited to prevent the creation or increase of a net loss from all rental
properties combined.

● Each rental building with a cost of $50,000 or more must be held in a separate CCA class, unlike the usual
practice of pooling similar assets.

Royalty Income:

● Royalties earned from owned intangible properties like trademarks, copyrights, and patents are treated as
property income when the owner has acquired these properties through purchase, gift, or inheritance.

● Royalties for intellectual property are generally passive and require minimal effort to earn.

● If an individual or business creates the intellectual property (e.g., an author or musician), the royalties are
considered business income because of the effort involved in earning it.

Impact on Investment Decisions:

● Tax treatment of dividends, rental income, and capital gains varies, affecting after-tax yields and
investment decisions.

● Interest-bearing securities: Taxed when earned, typically every 12 months.

● Corporate shares: Dividends are taxed when received, with a dividend tax credit reducing the effective tax
rate. Capital gains are taxed when realized, with half of the gain included in taxable income.

● Real estate investments: Rental income is fully taxable annually, but capital gains are taxed only when the
property is sold. Capital cost allowance (CCA) allows depreciation deductions, reducing annual taxable
income, but this is recaptured upon sale.

● Tax treatment significantly impacts long-term investment returns (e.g., shares may compound better than
bonds over time due to tax treatment differences).

Business Organization Structure:

● The structure may aim to shield appreciating assets from business risks, or to separate rental income from
business income, which has distinct tax treatments.

● For example, if rental properties are held in a separate corporation, recapture of CCA taxes may occur
when disposing of properties, affecting cash available for reinvestment.
Corporate Financing:

● The tax treatment of property income impacts the cost of corporate financing. Corporations must consider
how investment returns are taxed in investors' hands, which influences the design of securities and
financing strategies.

Splitting Property Income Among Family Members:

● To reduce the overall family tax burden, family members with lower tax rates might hold investments to
benefit from lower taxation on property income.

● However, the Income Tax Act has anti-avoidance provisions that prevent income splitting by attributing
income back to the original owner (e.g., through gifts, loans, or trusts).

● Certain types of income splitting are allowed, which are discussed in more detail in other chapters.