What happens when you start renting out your home? Understanding how the income tax act looks the situation can help you avoid an un-expected tax bill.
When you sell your principal residence, you generally will not incur a capital gain because of the rule that exempts the principal residence from tax. However, converting all or a portion of your principal residence to a rental property triggers a deemed disposition for tax purposes.
Overview of Change In Use Rules
These rules are known as the change-in-use rules and ensure that any change in use from income producing to personal or the reverse creates a taxable disposition at fair market value. While the capital gains are fully taxable, the superficial loss rules apply to deny any capital losses.
Changing A Principal Residence To A Rental
If you decide to move out of your principal residence and rent the entire home, you are considered to have sold your home at fair market value even though it really hasn’t changed ownership. The capital gain may be eliminated by the principal residence exemption if the home had always been your principal residence.
You can make an election (under s.45(2)) not to have changed use and avoid the deemed disposition for up to four years. This election also allows you to continue to claim the property as your principal residence (as long as you don’t claim another property as one).
To make this election, you are required to report the net rental income or business income you generate and you cannot have claimed capital cost allowance (CCA) as a deduction.
Extending The Four Year Limit
If you meet certain conditions, you may be allowed to extend the election out of the deemed disposition indefinitely. However, you must meet all of the following conditions:
- You live away from your principal residence because your (or your spouses) employer wants you to relocate,
- You and your spouse are not related to the employer,
- Your temporary home is more than 40km away from your principal residence, and
- You return to the original home
- While you or your spouse are still with the same employer,
- Before the end of the year after your employment ended, or
- Your die during the employment term.
Renting Out A Portion Of Your Home
What happens if you only rent a portion of the home?
Normally, you are considered to have changed the use of part of the property when you begin renting. However, you cannot claim the s.45(2) election out of the deemed disposition explained above.
Luckily, you can still avoid the deemed disposition and continue to claim the principal residence exemption on the entire property if:
- the rental portion is small in relation to the overall principal residence,
- you do not make any structural changes to make the property more suitable for renting, such as adding a separate entrance, and
- you do not claim capital cost allowance.
If you don’t meet all of these conditions, you may have a partial capital gain and will have to allocate the taxable portion to the part of the house you rented. The CRA will accept any reasonable allocation such as square footage allocation or number of rooms.
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