Tax traps to avoid when converting your home to a rental property
My name is Aman, and I am a Chartered Professional Accountant. In this article, I will explain the tax implications of converting your home into an income property.
Most Canadians recognize the principal residence exemption as one of the most critical tax breaks available to them. However, in many situations – such as when a family owns multiple residences, the change in the use of a home from personal to income-producing (or vice-versa), or a marriage breakdown – the optimal use of the principal residence exemption is somewhat more complicated. In this video, I will use Mark’s story to explain.
With help from his bank, Mark purchased his principal residence in 2016 for $400,000. Mark owned and lived in his home from 2016 to 2017, and in 2018, the home was valued at 450,000; however, he found that the old house wasn’t really satisfying his needs anymore, and he was looking to move to a bigger and better home. The old home had increased substantially in value. He anticipates the real estate market will continue to appreciate and expects his home to be worth $550,000 in five years, so he decided to keep the house and rent it out.
Mark had heard from his friend that if he changes the use of his home, i.e. if he converts his home to rental property, he has to pay a heavy amount in taxes. Mark got very worried and felt it was unfair that he had to pay tax without selling his house.
Mark decided to go to his Chartered Professional Accountant. The accountant studied his case, and since Mark converted his principal residence into an income property, the accountant told mark that he is subject to the change in use rules and is deemed to have disposed of the home at fair market value ($450,000).
The accountant presented two scenarios in front of Mark :
The first option was that Mark uses the Principal residence exemption to shelter the tax on the capital gain of $50,000 ($450,000 − $400,000). If he sold the property in five years for his anticipated $550,000 price, he had to pay tax on 50% of the increase in value of $100,000 ($550,000 − $450,000).
Subsection 45(2) election filed: The change in use is deemed not to have occurred by filing the election. Instead, the disposition can be deferred until the property is sold. Assuming he sold the property in five years for $550,000, the exemption can be used to shelter the entire $150,000 capital gain because of the four additional years he could designate the property by filing the election (as well as the “one-plus” provided by the PRE formula).
Mark was delighted that he consulted the accountant to save tax and followed his advice to file the election by attaching a signed letter to his tax return for the year in which the change in use occurred. For the election to remain in force, on his accountant’s advice, Mark did not claim depreciation (CCA) on the property and reported all net rental income on her tax return.
The best part about this election is that Mark could continue to designate the property as his principal residence for an additional four tax years while the property was being used to earn rental income.
Mark had now gained clarity on how the real estate transactions need to be structured to save the tax dollars.