In the third installment of Dentons Canada’s series highlighting new tax proposals outlined in Budget 2024, we discuss proposed measures aimed at promoting investment in certain “purpose-built rental housing,” including an accelerated capital cost allowance and an exemption from the application of the excessive interest and financing expenses limitation (EIFEL) rules.

In order for real property to be eligible to benefit from these measures, it must be new purpose-built rental housing that is a residential complex with at least four private apartment units or 10 private rooms or suites, and in which at least 90% of residential units are held for long-term rental. These are the same conditions for eligibility under the temporary enhancement to the GST New Residential Rental Property Rebate.

Accelerated capital cost allowance for purpose-built rental housing

Currently, most residential real property can be depreciated for income tax purposes (called capital cost allowance, or CCA) at a rate of 4%. In order to incentivize the construction of affordable housing, Budget 2024 proposes to increase the CCA rate applicable to eligible purpose-built rental housing from 4% to 10%. Projects that convert existing non-residential real estate, such as an office building, into a residential complex would be eligible if the conditions above are met. The cost of a new addition to an existing structure would also be eligible for the accelerated rate. However, the accelerated rate would not apply to renovations of existing residential complexes. In addition, the accelerated investment incentive would continue to apply to property eligible for this accelerated CCA rate.

While more than doubling the potential tax deduction may seem like a significant benefit for taxpayers seeking to invest in purpose-built rental housing projects in Canada, it is important to note that CCA cannot be used to create or increase a loss from renting or leasing a rental property for most taxpayers. In a practical example, if a developer spends $10,000,000 on a building with a cap rate of 5% (meaning the gross rental income earned is expected to be $500,000 annually) and has other deductible expenses such as operating expenses, interest and property taxes that are approximately 70% of gross rental income, the net income before CCA would be $150,000. Accordingly, the maximum CCA the taxpayer could deduct in the year on this building would only be 1.5%. Therefore, the 10% accelerated CCA rate may not ultimately benefit the taxpayer at all. Even if the taxpayer had no other deductible expenses, the taxpayer would only be able to deduct CCA to cover gross rent, being 5% of the building’s cost in this example. Dentons’ review of the market showed very few instances where the full 10% rate may be available for deduction.    

At least for the first several years of investment, the CCA deduction should be large enough that the taxpayer does not have any taxable income and thus no tax payable. This will free up cash on an after-tax basis and taxpayers engaging in new projects may want to consider how to hold their development opportunities. Where the property is held in a corporation (which was historically often the case), any savings from not having to pay taxes at the corporate level may be lost when an individual shareholder must pay tax on dividends when cash is extracted from the corporation. Consideration should be given to whether it’s possible to make investments in purpose-built rental housing directly by individuals to take advantage of this additional, after-tax cash flow.

Exemption from interest deductibility limits for purpose-built rental housing

Bill C-59, which is currently before the House of Commons, includes legislative proposal to implement the EIFEL rules proposed in Budget 2021. Very generally, these rules limit the amount of net interest and financing expenses that may be deducted by certain taxpayers in computing taxable income to a certain percentage of “tax EBITDA”: 40% for taxpayers with taxation years beginning on or after October 1, 2023, and before January 1, 2024; and 30% for taxation years beginning on or after January 1, 2024. The rules will not apply to certain “excluded entities,” including Canadian-controlled private corporations whose taxable capital employed in Canada is less than $50 million; groups of corporations or trusts with net group interest expenses in Canada of $1 million or less; and certain groups that carry on all or substantially all of their business in Canada.

The EIFEL rules, if enacted, will provide an exemption for interest and financing expenses incurred in respect of arm’s length financing for certain public-private partnership infrastructure projects. Budget 2024 proposes to extend this exemption to also include an elective exemption for certain interest and financing expenses incurred before January 1, 2036, in respect of arm’s length financing used to build or acquire eligible purpose-built rental housing in Canada.

The extension of the exemption from the EIFEL rules is a welcome change and presumably is in recognition of the fact that, like public-private partnership infrastructure projects, real property development projects are typically highly levered. Because of this, property owners naturally incur more interest and financing expenses than other investments or projects. They are also typically undertaken by large property developers that likely would not otherwise qualify as an excluded entity.

It is clear that Budget 2024 is attempting to further motivate the building of additional purpose-built rental housing by proposing these changes to the Income Tax Act (Canada), which in addition to the previously announced GST New Residential Rental Property Rebate, should encourage development in the area. 

If you have any questions on how these new rules may apply to your situation, please contact a member of Dentons Canada’s Tax group.