Online platforms such as Airbnb have made it easier for people to rent a portion of their homes to earn rental income. If your client is considering dabbling in the rental market using their principal residence, it’s important for them to be aware of the tax implications.
Deemed disposition due to change in use
When your client begins using a portion of their principal residence to earn rental income, a deemed disposition occurs under paragraph 45(1)(c) of the Income Tax Act (ITA).
The deemed proceeds are calculated as the percentage of property converted from personal use to income-producing (based on square footage) multiplied by the property’s fair market value at that time. Any capital gains realized from the deemed disposition are usually exempt from tax if the principal residence exemption is available. Regardless, to avoid penalties your client must report the deemed disposition using Form T2091 and Schedule 3 of their tax return in the year the change in use occurs.
Your client is also deemed to have reacquired the same portion of property at a cost equal to the deemed proceeds. The rented portion of the property is no longer eligible for the principal residence exemption. Therefore, your client must keep track of the new cost base to calculate capital gains accurately on a future deemed disposition or actual sale of the whole property. The special election under subsection 45(2) to extend the eligibility of the principal residence exemption isn’t available when there is only a partial change in use (i.e., only a portion of the property is being rented and the remainder will continue to be used as a primary residence).
To illustrate, let’s look at Jihan’s situation. He owns a home in Toronto with an unfinished basement. Due to a high demand for rental units in his neighbourhood, he decides to renovate his basement into a one-bedroom suite with a separate entrance to earn extra income. Jihan’s basement represents 20% of the total square footage of his home. He purchased the home for $700,000, and it’s valued at $1.5 million.
When Jihan begins to use his basement to earn rental income, he’s deemed to have disposed of 20% of his home for $300,000 (20% × $1.5 million) due to the change in use. If Jihan claims the principal residence exemption on the deemed disposition, his taxable income for the year wouldn’t be impacted.
Jihan’s new cost basis in the home would be $860,000, which is the total of $300,000 from the deemed disposition plus $560,000 for the remainder of the property (80% × $700,000). This cost basis will be used to determine capital gains on a future sale or disposition of the property.
Exception to deemed disposition
There is an exception available from these deemed disposition rules when the following three conditions are met:1
- The income-producing use is ancillary to the main use of the property as a residence.
- There is no structural change to the property.
- No capital cost allowance (CCA) is claimed on the property.
“Ancillary” isn’t a defined term in the ITA but is generally interpreted to mean “subordinate” or “secondary” to the primary purpose. A bright-line test hasn’t been defined in terms of a specific percentage or threshold to determine if the income-producing use is secondary to the primary use as a residence. The CRA reviews the facts in each case to determine if this condition is met.
“Structural change” refers to making the property more suitable for income-producing purposes in a permanent way. For example, installing a separate entry or kitchen, or adding/moving/removing walls or making other changes to convert a portion of the residence into a self-contained unit would take your client offside.
The third condition states that CCA cannot be claimed on the portion of the property used for producing income. If CCA is claimed at any time in the future, the deemed disposition rule would apply retroactively to the time when the change in use occurred.
To ensure that the above three conditions are satisfied, your client should work with their tax advisor before renting their property.
1 Income Tax Folio S1-F3-C2, Principal Residence, paragraph 2.59.