If you’ve recently taken out a hefty mortgage to buy a home in one of Canada’s overheated property markets, one way to ease the burden of those monthly payments is to consider renting out a room or even the entire basement of your home.
But before you decide to take on a tenant in your principal residence, it’s important to familiarize yourself with the change-in-use rules, which could limit the availability of the principal residence exemption (PRE) if you decide to sell your home for a profit.
Under the Income Tax Act, you can be considered to have disposed of either part or all of your principal residence even if you didn’t sell it to a third party. This can happen if you convert part (like a room or basement), or all of your principal residence into a rental property.
The tax rules state that if you alter the use of your property, you’re deemed to have disposed of the property at its fair market value, and to have immediately reacquired the property for the same amount. This becomes your new tax cost or adjusted cost base (ACB).
As a result, the general rule is that upon such a change in usage, you’re required to report the resulting capital gain in the tax year that the change-in-use occurs. While any initial gain resulting from the deemed disposition related to the change-in-use may qualify for the principal residence exemption, the concern is that when you subsequently sell your home to a third-party, part of the gain might be taxable.
However, if you change your entire principal residence to a rental property, there is a special tax election you can make that would allow you to designate the property as your principal residence for up to four years, even if you aren’t using your property as your principal residence. This is provided you don’t claim any tax depreciation against your rental income. You can only do this if you don’t designate any other property as your principal residence during this period.
While this election is not available for a partial change-in-use, the Canadian Revenue Agency (CRA) has a long withstanding administrative policy wherein it will consider you to have not changed your home’s use if you meet these three conditions:The rental use of the property is “ancillary” in relation to its use as your principal residence
- You don’t make any structural changes to the property
- You don’t deduct any tax depreciation on the portion of your home you’re using for rental purposes.