Coach Houses and the Principal Residence Exemption

In communities where rental accommodation is scarce, more and more homeowners are building a second dwelling on their lot and renting out that “coach house” or “carriage house”.  Many have not thought about the tax consequences, though, and they could be complicated.  The key question:  will your tax exempt principal residence status be affected by this second dwelling?

The good news is, maybe not.  CRA will allow you to rent out a portion of your home and continue to designate your home as your principal residence if you meet all of the following criteria:

• You do not make structural alterations to the property to convert to a rental,
• You do not claim CCA on the rental portion,
• You report the rental income, and
• The rented use of the property is ancillary to the use of the property as your residence.

If you build a coach house to be used for rental purposes, you’ll be offside on the first of these criteria.  This means that the coach house will not be part of your principal residence.  As such, any increase in value of the coach house over the cost of constructing it will be taxable as a capital gain when the property is sold.  The original house and the land will remain eligible for the principal residence exemption.

But, what happens if you purchase a property with the coach house already built?  In this situation, you won’t be offside on the first criterion because you did not make the structural alterations.

So if you report the rental income from the coach house and don’t claim CCA, the coach house may just be part of your tax-exempt principal residence.  The last criterion has been interpreted by CRA to mean that no more than 40% of the property is rented.  In this case, the whole property can be designated as your principal residence, so long as the coach house (plus any part of the main house that is rented) is no more than 40% of the livable area of the home.

As most coach houses are smaller than the main house, renting an existing coach house will not prevent the whole property from being designated as your principal residence.  However, if you turn the tables and live in the coach house and rent the main house, you will be offside on the last criterion and so only the coach house would qualify as your principal residence.  The increase in value of the rented main house would result in a taxable capital gain.

Learn more about the principal residence exemption at the DAW Workshops in Toronto, Ottawa and Winnipeg next week, or online in T1 Professional Tax Preparation – Advanced and in Tax Strategies for Financial Advisors.

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