If you’re a Canadian homeowner considering renting out unused space like a basement or extra bedroom, it’s important to understand the tax implications and rules set by the Canada Revenue Agency (CRA). Whether you're looking to offset mortgage costs or generate additional income, being aware of these regulations can help you avoid potential pitfalls. Here’s a comprehensive guide to help you navigate the process.
Understanding the Principal Residence Exemption (PRE) and Capital Gains
When you decide to convert part of your principal residence into a rental property, it triggers certain tax events. Here’s what you need to know:
1. Conversion to Rental Property: When you start renting out a portion of your home, the CRA treats this as a "deemed disposition" of that portion at its fair market value (FMV). This means you are considered to have sold the rental part of your property at the current market value and immediately reacquired it at the same value.
2. Adjusted Cost Base (ACB): The FMV at the time of conversion becomes the new adjusted cost base (ACB) for the rental portion. This adjusted cost base is essential for calculating capital gains when you eventually sell the property. You’ll need to report any capital gain for the tax year in which the conversion took place.
3. Principal Residence Exemption (PRE): You can still claim the Principal Residence Exemption (PRE), which allows you to avoid paying tax on capital gains for your principal residence. However, if you sell the house later, the portion of the gain related to the rental area will be taxable for capital gains inclusion.
Changing the Entire Property to a Rental
1. Full House Conversion: If you decide to convert the entire house into a rental property, there’s a special tax election you can make. This election allows you to continue treating the house as your principal residence for up to four years, provided you don’t claim any depreciation (Capital Cost Allowance - CCA) for the rental period.
2. Principal Residence Criteria: This election is only valid if you don’t designate another property, like a vacation home, as your principal residence during this period. If you do, you cannot make this election.
3. Partial Use Not Allowed: This election isn’t available if you’re only renting out a part of your home, such as a single room or the basement. It applies only to the conversion of the entire property to a rental use.
Exceptions and Conditions
There are exceptions to the deemed disposition rule. According to the CRA, there’s no change in use if you meet all three of these conditions:
1. Ancillary Rental: The rental use must be "ancillary" to the main use of the property as your principal residence. This means the rental activity should be secondary or supplementary to your primary use of the home.
2. No Structural Changes: You shouldn’t make any structural changes to the property to accommodate the rental. Structural changes include permanent modifications like adding a kitchen or removing walls.
3. No Tax Depreciation: You shouldn’t deduct any tax depreciation (CCA) on the portion of the house you are renting out. Deducting CCA would indicate a change in use to the CRA.
If you meet these conditions, you won’t need to report a deemed disposition, and the property can remain eligible for the PRE.
Allocating Capital Gains
If you don’t meet the conditions for an exception, you’ll need to calculate the taxable capital gain for the portion of your home used as a rental when you sell it. This can be done based on the proportion of the home’s square footage or the number of rooms used for rental purposes. The CRA must consider your method of allocation reasonable.
What Does "Ancillary" Mean?
The CRA interprets "ancillary" to mean that the rental use is secondary to the primary purpose of the property as a residence. This means the rented space should not overshadow the main residential use of the home.
Structural Changes
Permanent changes to the property, such as adding a kitchen or altering the floor plan, are considered structural changes. These modifications indicate a more significant shift in the use of the property and can affect your eligibility for the PRE.
Final Tips
Navigating these rules can be complex and challenging. It’s highly recommended to consult with an accountant or tax professional before renting out part of your home. They can provide personalized advice and ensure you comply with all CRA regulations, helping you optimize your tax situation.
Additional Resources
For more detailed information, refer to the CRA’s official guides and publications or consult a professional advisor. Here are some useful resources:
Understanding these tax rules and conditions will help you make informed decisions about renting out your property. By being proactive and seeking professional advice, you can maximize your benefits and minimize any potential tax liabilities. Happy renting!
Case Study: Renting Out a Basement in Brampton
Background: Justin and Jagmeet bought their principal residence in Brampton in 2015 for $500,000. From January to March 2024, they constructed a legal basement suite. By April 2024, the house’s market value increased to $1,200,000. They plan to rent the basement to Mr. and Mrs. Freeland.
Key Tax Considerations and Steps:
Initial Purchase and Ownership:
Purchase Price (2015): $500,000
Current Market Value (April 2024): $1,200,000
Constructing the Basement Suite:
Construction Period: January to March 2024
Purpose: To rent it out to Mr. and Mrs. Freeland
Fair Market Value (FMV) Considerations:
As of April 2024, the house is valued at $1,200,000. The increase in value is $700,000.
Deemed Disposition:
When Justin and Jagmeet start renting out the basement, the CRA considers it a "deemed disposition" of that portion of the property at its FMV.
Adjusted Cost Base (ACB):
The new ACB for the rental portion will be the FMV at the time of conversion.
Steps and Tax Implications:
Calculating the New Adjusted Cost Base (ACB):
If the basement represents, for example, 25% of the total property, the value of the basement at the time of conversion is 25% of $1,200,000, which equals $300,000.
The original purchase price of the entire property was $500,000. The new ACB for the rental portion (basement) is 25% of this original cost, which equals $125,000.
Reporting Capital Gain:
The deemed disposition results in a capital gain for the portion of the house converted to rental use.
Capital Gain = FMV of the Rental Portion - ACB of the Rental Portion
Capital Gain = $300,000 (FMV) - $125,000 (ACB) = $175,000
Principal Residence Exemption (PRE):
Justin and Jagmeet can claim the PRE for the years they used the entire property as their principal residence (2015-2023).
However, for the period from April 2024 onward, the basement portion is not eligible for the PRE.
Conditions to Avoid Deemed Disposition:
To avoid the deemed disposition, they must meet these CRA conditions:
The rental use must be ancillary to the main use as their principal residence.
No structural changes made specifically for the rental.
No tax depreciation (CCA) claimed on the rental portion.
Example Calculation:
Scenario Without Meeting CRA Conditions:
Capital Gain on Rental Portion (Basement): $175,000
Taxable Capital Gain: 50% of the capital gain = 50% of $175,000 = $87,500
If this sale happens after June 25th 2024 the capital gains on the first $250,000 will be on 50% inclusion rate and then it will jump to 66.66% on capital gains above $250,000
Scenario Meeting CRA Conditions:
If Justin and Jagmeet meet all the conditions mentioned above, there is no deemed disposition, and they do not report any capital gain at the time of conversion.
Practical Steps for Justin and Jagmeet:
Documentation:
Keep detailed records of the construction costs and any improvements made.
Document the FMV of the property at the time of conversion.
Consult a Professional:
It’s highly recommended to consult with a tax professional or accountant to ensure compliance with CRA rules and to optimize their tax situation.
Filing Taxes:
Report the deemed disposition on their tax return if they don’t meet the CRA conditions.
Claim the PRE for the period before the conversion (2015-2023).
Conclusion:
Justin and Jagmeet’s decision to rent out their basement has several tax implications. Understanding and complying with CRA rules can help them manage their tax liabilities effectively. By meeting specific conditions, they might avoid reporting a capital gain on the conversion. Consulting with a tax professional is crucial to navigate these complexities and ensure they make the most of their rental income while staying compliant with tax regulations.