Are you considering renting out a portion of your home? There may be some tax implications to consider – both for now and in the future.
Principal residence exemption
Often, when you sell your “principal residence” there is no resulting tax implication. This is because of the principal residence exemption, which allows an adjustment to the amount required to be reported as a gain on the sale of your home. In many cases, the principal residence exemption reduces the taxable gain to zero.
Change in use – deemed disposition
When you change a property from one use to another (either from personal use to re
ntal or vice versa), there is a deemed disposition of the portion that changes use. For example, if you decide to renovate your home to add a suite, and then you rent out the suite, the portion you are renting is deemed to be “disposed of”. The disposition is deemed to be at fair market value, which could result in a gain (often offset at this time by the principal residence exemption).
Adjusted cost base
When the change in use happens, it is important to get an accurate assessment of the fair market value of the home, and to allocate the fair market value on a reasonable basis between the principal residence portion and the rental portion of the home. The fair market value of the rental portion now becomes its “adjusted cost base”. The cost base of the rental portion would be subtracted from the proceeds in the future if you sell the home in order to determine your taxable capital gain. Once the rental portion has been segregated, costs incurred for large items related to the rental can be added to the cost base of the rental. These would need to be expenditures that would be considered capital in nature, such as the addition of a garage.
If you sell the house in the future, the proceeds related to the rental portion would not be sheltered by the principal residence exemption. This means that there could be an unexpected (and sometimes large) taxable capital gain when you sell your home. The proceeds of the sale would be allocated to both the principal residence and the rental portion of the home, and the adjusted cost base of each would be subtracted from the proceeds to calculate the gain related to each portion. The rental portion of the gain would be subject to tax, while the principal residence portion often would not be.
Tax on rental income
Once you are receiving income from the rental of a portion of your home, you are required to report it on your income tax return. You are also permitted to deduct most expenses related to earning the rental income. Some common expenses that may be incurred related to the rental are:
- costs of advertising the rental unit
- repairs and maintenance
- mortgage interest (not principal)
- property taxes
Capital cost allowance
Another deductible expense related to rental units is capital cost allowance. Capital cost allowance is an expense taken each year related to the depreciation of the rental. However, any capital cost allowance that you take will be deducted from the cost base of the rental unit. The implication of taking capital cost allowance is that the taxable capital gain when the rental unit is sold in the future could be much higher than expected if the cost base has been reduced through claiming capital cost allowance.
There may be opportunities for income splitting on rental units. If your spouse or children provide work related to earning the income, it may be possible to spread the income over two or more people.
Changing the use of a portion of your home from residence to rental can be more complicated than you think. Often times, no consideration is given to the tax consequences of such an adjustment, and taxpayers can be on the hook for thousands of dollars in taxes, either now or in the future. It’s a good idea to talk to your accountant in order to make the best use of the tax regulations related to rental units before you go ahead with the decision to start renting.
Written by: Chris Brien