Introduction: the tax classification of repairs and maintenance expense
For many Canadians it has become a common investment to supplement one's income by purchasing real estate and renting those properties to generate rental income. Taxpayers must include a T776 Form as a part of their T1 income tax return for each year they are operating rental businesses. Of course owning a rental property means inevitably that the property will experience normal wear and tear or even the occasional significant incidence of damage requiring some repair expenses. Unfortunately not all of these expenses will be deductible in the year they are incurred. This is because some of these kinds of outlays will be considered current expenses while others will more properly characterized as capital acquisitions to be depreciated in future years.
Current expenses will be currently deductible and will have the effect of reducing taxable income in the year. The capital spending will have tax consequences in two ways. Firstly, the property will be of a prescribed class of depreciable property and thus the taxpayer may make a claim of capital cost allowance in each taxation year the property is owned. Second, upon the sale of the property, regardless of whether the property is of a depreciable nature or not, the outlay will have an impact on the final measure of any capital gain or loss experienced on the disposition.
Guidelines Provided by the Canada Revenue Agency
To determine whether any given repair or maintenance expense is considered capital or current in nature, the CRA provides a set of questions to consider:
- Does the expense provide a lasting benefit?
- Does the expense maintain or improve the property?
- Is the expense for a part of a property or for a separate asset?
- What is the value of the expense?
- Is the expense for repairs to the used property that you acquired made to put it in a suitable condition for use?
- Is the expense for repairs made to an asset in order to sell it?
A capital expense will be one which creates a lasting benefit, one that improves the property beyond what its initial value was, or extends the property beyond its initial capacity or purpose. A current expense will be one where the benefit is 'used up' within the tax year, one that merely maintains the value of the property, or replaces the damaged portion of the existing property to bring it back to its original state.
If after these first three considerations it remains unclear whether the outlays are capital or current in nature, one should consider the relative magnitude of the repair costs to the value of the asset. If the cost of the repair is nearly the entire value of asset it is much more likely to be characterized as a capital acquisition. If the outlay was made to make the property suitable for use, it is likely that the outlay has improved the property and thus it is capital in nature. Likewise, if the repair cost were undertaken in order to sell the property, it is also likely that these have been improvements and will be characterized as capital.
Case Law Discussion of Repair and Maintanence Expense in Canadian Courts
Unfortunately the CRA guidelines are very general. The history of this subject when considered by the Tax Court of Canada demonstrates the inadequacy of these guidelines. For example, in the case of The Queen v Donohue Normick Inc., 96 DTC 6061, the court stated that "each case is sui generis and no test is decisive in all cases when it comes to determining whether an expenditure is capital or current in nature. It is a question of fact and often a question of degree". Because of this ambiguity a great many cases have come before the courts disputing this issue and as a result there is a large body of case law available to illuminate the issue where the factual circumstances of the taxpayer are not novel.
In the case of Canada Steamship Lines Limited v MNR, 66 DDTC 5205 (Ex. Ct.), the court held that the replacement of decks, bulkheads and one of the ship's boilers constituted a repair and thus deductible as current expenses. The repairs were extensive and substantial in costs, and according to the CRA guidelines would be a capital outlay, however the Court concluded that it was a typical kind of ship repair and that the replacement was because of wear and tear. In this regard the Court stated:
Things used in a business to earn the income – land, buildings, plant, machinery, motor vehicles, ships – are capital assets. Money laid out to acquire such assets constitutes an outlay of capital. By the same token, money laid out to upgrade such an asset – to make it something different in kind from what it was – is an outlay of capital. On the other hand, an expenditures for the purpose of repairing the physical effects of use of such an asset in the business – whether resulting from wear and tear or accident – is not an outlay of capital. It is a current expense
In the case of Gold Bar Developments Ltd. v. MNR (1987), 87 DTC 5152 (F.C.), the taxpayer had done extensive repairs to the exterior of a residential rental property because bricks were falling loose. After inspection of the problem it was discovered that the issue arose due to faulty workmanship some 10 years previous by the initial construction company. Instead of using the same brick veneer as was used when the building was initially constructed, the taxpayer cured the defect by replacing it with metal cladding. By the CRA guidelines this would have constituted an improvement and thus a capital expenditure. However, the court in this instance found otherwise stating:
I do not think the solution to this problem can be found in the effect of the expenditure. It is expected that repairs to capital asset should improve it. Where the source of the income is a residential apartment building, that is always the case, especially where the repairs are substantial. Nor do I find the "once in a lifetime" approach of much assistance. The more substantial the repair, the less likely it is to recur (certainly the fervent hope of the building owner) but it remains a repair expenditure nonetheless.
I think it is more helpful to emphasize the purpose of the outlay by the taxpayer. What was in the mind of the taxpayer in formulating the decision to spend this money at this time? Was it to improve the capital asset, to make it different, to make it better? That kind of decision involves a very important elective component – a choice or option which is not present in the genuine repair crisis.
It is not in dispute that the plaintiff discovered in 1979 that the bricks were coming loose and falling on the ground around the building used by the tenants and passersby. Obviously, it was a risk that would be unacceptable to the public, but also one likely to meet a reaction from city officials, in the extreme even closure of the premises. In the circumstances, I cannot conclude that the plaintiff had any real choice. To ignore that condition would certainly have brought about a reduction in the occupation, or in rental income.
The court found that the intention of the taxpayer was to repair the building which had be become dangerous rather than to improve the asset. Because the taxpayer had gone beyond merely replacing what had fallen off, and made the building not only fully resistant to the problem of falling bricks, but also substantially improved the appearance of the building did not necessarily make an expenditure on account of capital. Once the decision to repair is forced upon a taxpayer, it is not required that they should ignore advancements in building techniques and technology in carrying out the work.
Other cases have offered different elements to consider then what is offered in the CRA guidelines. For example an often cited characteristic is frequency of expense. If the expense is of a type that happens but once in a life time it is much more likely a capital expenditure than a current one. In M.N.R. v Haddon Hall Realty Inc. (1961) ¸ the Supreme Court of Canada stated:
... Among the tests which may be used in order to determine whether an expenditure is an income expense or a capital outlay, it has been held that an expenditure made once and for all with a view to bringing into existence an asset or an advantage for the enduring benefit of a trade is of a capital nature. Expenditures to replace capital assets which have become worn-out or obsolete are something quite different from those ordinary annual expenditures for repairs which fall naturally into the category of income disbursements
While the Supreme Court in this case was acknowledging the element of frequency, it was willing to dismiss its significance where the context of the repair shapes the interpretation of the facts in such a way that frequency is either overshadowed by other considerations or necessarily characterised as frequent relative to the lifetime of the asset.
Tax Tip for your Business: When Claiming Repair Expenses Don't go it Alone
Clearly, consideration of whether repairs undertaken on a property are current expenses or capital outlays, as with many tax issues, all comes down to the facts of the situation. While for making the repairs it may be safe to take a do-it-yourself approach, when it comes to tax law interpretation this is never a prudent course of action. If you ever find yourself needing to file a return that includes expenses for repairs or maintenance costs it is a must to seek out legal counsel from an experienced Canadian tax lawyer with expertise in tax law and experience with the CRA tax audit process. Seeking out legal opinion in advance can help a taxpayer avoid paying penalties and interest after an auditor reviews and denies expenses inappropriately claimed.