Economic recessions, painful though they may be, are the cradles of creativity. As people lose their jobs, many will finally embark on a long-held dream of self-employment. The allure of setting their own hours and reaping the rewards of their hard work drives many to start their own home-based businesses.
That business can be a rental property, a pottery studio in the garage or consultant’s office run from the spare bedroom.
Whatever the enterprise, novice entrepreneurs would be well advised to acquaint themselves with the tax rules. There are many tempting traps that offer nice tax savings today but leave a hefty penalty many years in the future when the house is sold.
As with most tax advice, the first rule is to check with the experts. Canadian tax laws are reasonably straightforward, but the rule book is thick enough to use as a stepstool, with lots of exceptions and exemptions that can make a real difference to the tax statement at the end of the year.
At first glance, there are many generous tax incentives for a home-based business. Canadians are able to write off part of the cost of running the business and part of the mortgage interest, heating, insurance and renovation bills and so on.
But Toronto chartered accountant Jeanne Amodeo-Sparling explains that the picture gets a little murkier, and sometimes downright messy, when one is tempted by the rules that govern capital gains and depreciation. This is where novices wish they had checked with an expert before grabbing that tempting write-off.
First Things First
Any look at the tax implications of running a home business starts with the principal residence. The rule is simple: you don’t pay tax on capital gains realized on the sale of your home.
The principal residence can be a house, boat, cottage, trailer or condo unit, located anywhere in the world. You don’t even have to live there, as long as a member of your family—or your ex-spouse—does.
Too few home-business owners are aware of the four-year rule, and that is a pity. Under the tax rules, you can move out of the house, rent it out or run a business for four years and still claim the principal residence exemption. The four-year rule can be stretched to five years because partial years—whether a day or a month—count as a full year.
You can’t flip the principal residence too often or the Canada Revenue Agency may deem the client to be operating a real estate business.
If you own multiple residences, you can claim the capital gains exemption for whichever unit saves you the most money, as long as you designate only one principal residence each year.
Most home-business owners know that they can write off part of their housing costs—the business portion of the cost of heating, lighting, insurance, mortgage interest and so on—but you can’t take the write-offs and then claim the capital gains exemption for the same space.
Given the rapid rise in home values in some parts of the country, Amodeo-Sparling says it may be best to forget the utility write-offs and just go for the capital gains exemption. This will save far more money when you sell the house.
If you live in a city where real estate values are rising slowly, the capital gains exemption becomes less important. You may prefer to divide up the housing costs—and the capital gains exemption—on the basis of square footage. If one-quarter of the house is used for the business, the owner may write off one-quarter of his or her expenses and forgo one-quarter of his or her capital gains exemption.
There are a few points to keep in mind. The business shouldn’t occupy more than one-third of the home. Also, when dividing up the space, the front parlour normally gets a higher weighting than the basement, the attic or the garage.
Working space must be permanent and dedicated to the business to be claimed as a business expense; you can’t simply wipe off the kitchen table and work on the business after the kids go to bed.
Retired chartered accountant Rod Duncan offers several useful pointers. Some home-business owners may decide to incorporate the business and pay rent to their lower-income spouse as owner of the house. But incorporation is an expensive, time-consuming process that small business owners may wish to avoid.
Duncan says business owners could spread their costs by operating two businesses out of the same home. One business could be a not-for-profit entity, while the other would provide the income.
The capital cost allowance—CCA—is a subject that sounds more complicated than it really is. Simply put, business owners may write off the value of their building and certain equipment over a number of years, using a depreciation rate that is based on the normal lifespan of the equipment. A house is deemed to lose 4% of its value every year, while a car loses 30% and a new computer 100%.
As in most aspects of tax law, home-business owners should check the small print carefully. Home-office expenses and depreciation may be used to take profits down to zero but may not be used to create a loss for that year. To compensate, any losses can be carried forward and used to defray taxes in the future.
Capital Gains Versus Depreciation
A more difficult decision involves the choice between the CCA and a capital gains exemption: you can’t take both for the same space. You can, however, use the CCA for the part of the home where you work and the capital gains exemption on the part where you live.
Duncan advises against the CCA depreciation in most cases. The reason is simple: if the homeowner goes the CCA route, he would likely trade the lucrative capital gains exemption for a CCA depreciation rate of only 4% a year, a sum that is hardly worth the bother.
Also, Ottawa reserves the right to claw back the entire CCA depreciation allowance if the building is sold at a profit, which can be expensive.
Most of these rules apply to any sort of home business, whether it is an office or a daycare centre. Farms are an entity all to themselves with their own very complicated rules, and rental units have slightly different rules that landlords are advised to bone up on. Of course, any home business is normally subject to the usual income tax rules.