Whether it is to help defray mortgage costs or to create a little incremental income, many Canadians are eyeing unused space like a basement or extra bedroom and thinking about how handy that rent money would come in every month.  If so, there are some CRA rules that will apply.

If this property is your principal residence and you intend to claim the Principal Residence Exemption (PRE), the tax folks will look very carefully at the transaction when you eventually sell the property at a profit. 

The tax rules provide that if you convert a part of your principal residence (even a single room) to a rental property, you have disposed of the property at its fair market value.  At that same time, you reacquired the property at the new value which becomes your new adjusted cost base (ACB).  This means you will need to report the capital gain for the tax year in which the change happened. While this change allows you to qualify for the PRE, when you eventually sell the house, part of the gain may be taxable.

One option is to change the classification of the entire house to rental property.  If you do that there is a special tax election to let you claim the house as your principal residence if you relinquish any tax depreciation for the rental company.  This is only valid if you claim this as your principal residence.  If you decide to call some other property your principal residence, like a vacation home, the option is off the table.  Also, note that this is not permitted for only a partial change in use like a single room or basement.

 There is a reprieve, however.  The CRA says that there is no change in use if you meet three conditions:

•  The rental is “ancillary” to the home's use as your principal residence.

•  There are no “structural changes” made.

•  You don't deduct any tax depreciation on the portion of the house you are renting out.

If you don't meet these standards, when you sell the house that now has a rental unit, you have to calculate the tax for the portion that was used as rental against the wholesale price.  This can be based on square meters or feet, or a number of rooms.  However, the CRA must consider the allocation “reasonable”.  Otherwise, you need to report any capital gains on the portion that you rented out.

The CRA offers publications on how they interpret some of these rules.  Recently they said that to be considered “ancillary,” the space must be “subordinate or secondary to a more important or primary purpose”.  It also says that it will review each case separately to decide if the percentage used is appropriate to the taxation or not.

Structural changes are considered if they are permanent, like adding a kitchen area or removing or adding walls.  Again, the CRA will review the individual facts and circumstances to make their determination.

If all of this sounds confusing and complicated, it is.  The best way to proceed is to discuss your ideas with an accountant in Mississauga before putting the “for rent” sign outside your door.

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