Capital Gains on In-Home Rental Units
Understand capital gains on in-home rental units: expert insights on taxes, deductions, and regulations. Stay informed with our comprehensive guide.
Many homeowners view in-home rental units as an attractive way to offset mortgage costs and earn extra income. While true, it is important to consider the tax consequences of the use and designation of property.
The term “principal residence” is used by the Canada Revenue Agency (“CRA”) to describe housing units acquired and used for residential purposes. This can include houses, cottages, condominiums, apartments, trailers, mobile homes, or houseboats. A home is designated as a principal residence upon the sale of some or all of it. Canadian can use Form T2091(IND) to designate their property as a principal residence.
The principal residence designation is important because it allows homeowners to sell or dispose of their property without having to pay the capital gains that would otherwise be associated with the sale. A capital gain refers to the amount accrued when a property is sold for a higher price than it was purchased at. Typically, Canadians are required to pay a capital gain tax on 50% of the amount accrued. For example, if you bought your house for $500,000 and sold it for $1,000,000, you would have a capital gain of $500,000. Of that $500,000, 50% would be taxable ($250,000). However, the principal residence exemption allows homeowners to sell their property without paying the otherwise applicable capital gain tax, so long as the property was used solely as a principal residence for every year of its possession.
Can homes with rental units be considered principal residences?
Typically, this will depend on what portion of the home is being used for rental purposes. If the entire home is rented out, it will likely not be considered a principal residence. If part of the home is used for residence and another part is used as a rental unit, the CRA will consider the home to have both designations. Essentially, the part used as your personal residence will count as the “principal residence”, whereas the part used as a rental unit will be considered an income-generating property.
If part of a home qualifies as the principal residence and another part is used to produce or earn income, the CRA requires capital gains taxes to be paid on the portion of the home that produces income. To do so, the home must be “split” between the two designations. The split can be done using square meters, floors to the home, or the number of rooms, so long as the split is reasonable and backed up with documentation/evidence to illustrate its validity.
What happens when you create or reclaim an in-home rental unit?
At any time, a homeowner may wish to create an in-home rental unit, or conversely, may wish to reclaim their in-home unit for personal use. Normally, when a property undergoes a change of use, the taxpayer is considered to have disposed of and immediately reacquired the property at fair market value (“FMV”). As a result, the taxpayer is expected to pay capital gains tax on 50% of the deemed disposition.
Fortunately, the CRA has contemplated this scenario. Prior to March 19, 2019, Canadians could not elect to avoid a deemed disposition relating to the change of use of part of their property. From March 19, 2019, onwards, Canadians can elect, under sections 45(2) or 45(3) of the Income Tax Act (“ITA”) that the deemed disposition does not apply. The election will remain in effect until it is rescinded or upon the sale of the home.
When changing a portion of the home from personal use to income-generating, taxpayers can elect under s. 45(2). In addition to avoiding or delaying the deemed disposition, the s. 45(2) election also allows a homeowner to claim the principal residence exemption for 4 more years while generating income.
Conversely, when reclaiming an income-generating space as a principal residence, taxpayers can elect under s. 45(3). This election will have the opposite effect, where in addition to avoiding or delaying the deemed disposition, the homeowner can claim the principal residence exemption for the 4 years prior to the change in use. Homeowners can only use the section 45(2) and 45(3) elections so long as they did not claim any Capital Cost Allowance (“CCA”) on the property.
If the home is later sold, the FMV of the property will be calculated as of the date the change in use occurred. For example, if a change of use occurred in 2020 and the taxpayer elected under ss. 45(2) or 45(3) to delay the recapture of capital gains until the home’s disposition, then upon sale of the home (at whichever future date), the taxpayer would pay a capital gain tax on 50% of the difference between the home’s FMV in 2020 and its purchase price for the portion/percentage of the home that was generating income.
There are some cases, where the CRA will consider the entire property to maintain its designation as a principal residence despite its use for income-producing purposes. To maintain the principal residence designation, the following conditions must be met:
- The production of income is ancillary to the main use of the property as a residence;
- There is no structural change to the property; and
- Capital cost allowance was not claimed on the property.
Commonly, ventures such as in-home day cares, or other in-home businesses, may meet the above requirements.
If the home was bought with established in-home units, and no structural changes were made, nor were any CCA deductions claimed, the CRA may deem the property to have been a principal residence for its entire use, so long as the rental units were ancillary to its use as a primary residence.
The determination of a property’s designation is a complex and fact-specific process. We suggest you consult an experienced tax lawyer before making a s. 45(2) or 45(3) election. To talk to an experienced tax lawyer, please contact us today!
This article provides information of a general nature only. It does not provide legal advice nor can it or should it be relied upon. All tax situations are specific to their facts and will differ from the situations in the articles. If you have specific legal questions, you should consult a lawyer.