Investing in real estate can be a good way to grow your money. However, if you want to learn more about the tax consequences of renting out a property you own, read this post.
Which is more tax-beneficial, business income or rental income?
Business income has more favorable tax treatment and tax credit than rental income. The government doesn’t require taxpayers to prove they started their business with the intention of making a profit. In addition, a taxpayer can claim tax credits, such as claiming home office expenses and claiming CCA if the business runs in a loss position.
Compared to your business income, rental income has a less favorable tax treatment. In today’s real estate market, burdened with high purchase prices, large mortgage payments and taxes for vacant property, most property owner rent out their rental unit at a low monthly payment without expecting to make a profit. What they care about is the future capital gain. When you rent out your property, CRA will closely examine how commercial your rental activities are. They are especially prone to review individuals with high income and large rental losses. If CRA determines that your purpose of renting out your place is just to share the cost and claim rental loss without the genuine expectation of a profit, they will deny any rental expense deduction you claimed on your T776. (Hustak v The Queen, 2018 TCC 19) .
If you’re unsure whether your rental income is business or property income, think about the number and types of services you provide for the tenant of the rental unit. In most cases, you are earning an income from your property if you provide tenants with basic services, such as heat, light, and laundry facilities. However, if you provide additional services like security and meals to tenants, you may be carrying on a business, such as Airbnb. The more services you provide, the greater the chance that your rental operation is a business.
From a principal residence to a rental property
If a property is purchased for personal use and then changed to rental or business, it will be considered a deemed disposition. The deemed disposition needs to be reported to CRA, and the capital gain is triggered. However, the taxpayer can avoid triggering capital gain by making Section 45 (2) selection. If Section 45 (2) selection was granted by CRA, the home is considered as a principal residence for up to four subsequent tax year, as long as taxpayer is a resident of Canada. In other words, you may deem a revenue-generating property as your principal residence. 45(2) section selection cannot be made if CCA has been claimed on the property.
What are the benefits of making an election under section 45(2)? Let’s see an example.
Paul lived in his property in Ontario for a period of time from 2016 to 2018. In 2018, he moved to another province and rented out his property. In 2021, he sold the property. The market value is as:
2016 (purchased and lived in)
—– 500k FMV
2018 (moved out and rent it out)
—– 650k FMV
2021 (sold out)
—– 900k FMV
- if without section 45(2) election, the deemed deposition happened on the Year 2018.
(650k-500k)x50%=75k is tax-free for the property owner
(900k-650k)x50%=125k is included in taxable income
- If Paul made section 45(2) election, there were not the deemed deposition happened on the Year 2018
(900k-500k)x50% = 200k is tax free for property owner
From Rental Property to Principal Residence
If a property is purchased for business use and then changed to personal use, it will be considered deemed disposition and reacquisition at fair market value for tax purposes, and the capital gain is triggered. However, the taxpayer can choose section 45(3) to prevent the deemed disposition and reacquisition from happening.
What are the benefits of making an election under section 45(3)? Let’s see an example.
Rebeca’s family bought a house in 2004 and rented it out till 2009. They moved back to this house and lived there till the 2015 year. They sold the house in 2015
2005 (purchased and rented out)
—– 350k FMV
2009 (moved back and lived in)
—– 450k FMV
2015 (sold out)
—– 600k FMV
- If without section 45 (3) selection, the deemed acquisition happened on 2009. The acquisition cost is FMV 450K
(450K-350K)X50%=50K will be included in taxable income
(600k-450K)x50%=75K is tax-free
- if section 45 (3) selection was made
(600K-350K) x50% = 125k is tax free
What are the tax implications for converting part of a principal residence to a rental property or vice versa?
If you started to use part of your principal residence for rental or business purposes, the CRA usually considers you changed its use unless all of these conditions apply:
– Your rental or business usage is relatively small compared to your principal residence
– No structural changes were made to make it more suitable for rental or business property standards
– You haven’t deducted any CCA on the part used for rental or business purposes.
If these conditions are not met, the deemed disposition will happen on the portion of the property changing in use. Capital gain was triggered. You need to file T2091 and S3
Since March 19, 2019, you are allowed to elect to avoid the deemed disposition on a partial change in the use of a property. That means in relation to a partial change of use of your property, section 45 (2) and section 45(3) elections are applicable also.
The rental expense can be claimed
The bellowing is rental expenses you can claim:
– Property tax
– Repair Costs
– Mortgage interests
– Vehicle expense (if you are responsible for repair or maintenance and the vehicle is used for delivering tools and materials)
– CCA of your property (not recommended )
– Travel costs
– Professional fee
Real estate tends to be the main reservoir for family fortune, and therefore proper planning for taxes is crucial. Please feel free to contact me with any questions you may have in this area.