Renting Part of your Home? Watch Your Tax Bill

Renting out the basement, or even just a room, in one’s home has long been a great way to tap into an additional stream of income to improve cash flow, enhance savings or reduce debt.

However, increased CRA scrutiny of sales of principal residences, combined with new rules about rental properties, has made this tried-and-true strategy much more complex and risky for the average Canadian.

If you have clients hoping to rent out part of their home, or already doing so to offset mortgage costs, be sure to advise them that this could have serious tax implications down the road. This issue affects homeowners in the hottest and most expensive real estate markets in the country in particular—where the costs of entry are high—but no one renting out part of their principal residence is immune from these new rules.

Until recently, the sale of a principal residence, and any gains made from the sale, have always been tax-exempt in Canada. But don’t count on that being the case any longer if you are making rental income from your property. CRA’s recent “change of use” rules state that if you change all or part of your principal residence to a rental or business operation, you are deemed to have sold all or part of your property (even if you did not actually sell it) at fair market value, and to have reacquired it at that same amount. Any resulting capital gain or loss must be reported in the year the change of use occurs.

What does this mean for homeowners who rent out part of their home?

• You have to split the selling price and the adjusted cost base between the part of the home used as a principal residence and the part used for other purposes, such as rental or a business. You can use square footage or number of rooms to calculate the proportion, but it has to be considered “reasonable” by CRA.
• If the property was solely a principal residence before the change of use, no tax is paid on any gain accrued in those years; however, any gains realized in years after the change of use must be reported and will be taxable upon the sale of the property.
• The change of use rules do not apply if you do not make any structural changes to the property to make it more suitable for rental purposes or if the part you rent is small in relation to the size of the whole property. However, these exemptions can be tricky, as they are subject to interpretation by, and the discretion of, CRA.
• If you change your entire principal residence to a rental property, you can elect to designate the property as your principal residence for up to four years (even if you are not using it as such) and you will not be subject to the change of use rules—as long as you do not designate any other property as your principal residence during that time and you do not claim any tax depreciation against the rental income.

In addition to the complex change of use rules they have recently imposed, CRA now requires taxpayers to report every sale of a principal residence on their tax return to be eligible for the principal residence tax-free exemption. So, it is very easy now for the CRA to identify who has sold their home, whether they had been earning any rental or business income while owning the property as a principal residence, and to determine whether any tax is due on disposition.

It’s getting trickier, if not harder, for Canadians to rent out part of their home to boost their income. Make any of your clients who are considering this strategy aware of the potential tax pitfalls and discuss with them other ways to manage cash flow and reduce debt.

There are a number or Knowledge Bureau courses that can enhance your knowledge and skills in this area:

• Debt and Cash Flow Management
• Tax Strategies for Financial Advisors
• Tax Planning for Corporate Owner-Managers
• Real Wealth Manager^TM
• Advising Family Businesses

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