Q: I have purchased a new home and have moved into it. I have finished part of the basement into a legal suite. I have not rented it out yet. My question is, if I rent the suite out will I be able to claim the primary residence tax exemption when I sell my home?
—Donna and Gerry
A: Congratulations Donna and Gerry on both your new home and becoming landlords! What exciting steps to take towards your personal financial goals.
Before we launch into an answer, it’s good to recap what taxation issues arise when it comes to property. In general, all Canadians must pay capital gains tax on real property when it is sold. The gain portion is the difference between the purchase price and your sale price (assuming it went up). This applies to all real property sold in Canada. However, for your principal residence, you can use the capital gains exemption to avoid having to pay the capital gains tax owed. It’s known as primary residence tax exemption (or PRE in finance-speak) and it’s one of the most powerful and advantageous tax-planning tools we have as Canadians. It allows us to shelter 100% of the profit we earn when we sell our primary home. This can be substantial, particularly for people that bought a house decades ago prior to the massive increases in real estate values across most of this country.
With respect to your situation, the Canada Revenue Agency does recognize situations where a primary residence is partly rented. For instance, the CRA will impose a divided use rule for properties that are equally divided into personal and rental units, such as a triplex. In this situation, the CRA recognizes that you would “ordinarily inhabit” a third of the triplex as your primary residence while renting out the remaining two units. As a result, the CRA should allow you to tax-shelter a third of the profit earned when you sell the complex. Better still, the CRA should consider the rental income ancillary to your personal use, meaning the profit on the complex is taxed as a capital gain and not as business income. Keep in mind, that you must report all the rental earnings in each tax year and pay the required income tax on these earnings. You may declare expenses, such as maintenance, as a tax deduction to help reduce the income that is considered taxable.
In your situation, however, the home isn’t equally divided, so it is harder to determine exactly how much is used for personal use and how much is used to earn a secondary income. In this situation, the CRA states that as long as there were no structural changes to the building to accommodate the rental and as long as you do not claim the capital cost allowance on the units or buildings, the home can still qualify for the principal residence tax exemption.
But there are caveats. In a 2009 court case (Boulet v. Queen), a property owner was denied the PRE for a home he built with a basement suite. This case has been cited as evidence that the CRA is starting to deny the PRE on homes with secondary suites, but that’s not entirely accurate. If you read this 2009 case you will notice that the homeowner’s secondary suite situation was discovered because of a tax audit on his business. In other words, the CRA already suspected that this person was not paying his taxes and opted to look into the situation a bit closer. What they discovered was a three-floor house with a basement suite that had its own municipal address. From the taxman’s point of view: This unit was a business. It was not ancillary income but a way to profit without paying taxes. You can see how and why this property owner was denied the PRE.
In your case, I would assume that the basement suite is a mortgage-helper—a way to supplement the costs of owning a home in Canada. As long as you pay the required income tax on the rental income, the CRA will probably not consider this a breach of tax rules and regulations and you should still qualify for the PRE.
In general, the CRA does not appear to oppose earning money from secondary suites located in primary homes. What they are cracking down on are people that are using the tax exemptions to hide or shelter business income. Get a good accountant. Pay for some quality advice and you can stay on the right side of the taxman, while still enjoying the benefits of being a part-time landlord.
Just to be clear, however, I’d like to sum up what actually qualifies for the principal residence exemption. According to the CRA, the “housing unit” must be “ordinarily inhabited” in any given year by either you, your spouse (or common-law partner), your former spouse (or common-law partner) or your child. The exemption limits that no more than a half hectare of land can be exempt from tax unless the land was necessary for the use and enjoyment of the primary residence. Each family unit (this includes you, your spouse and any child under age 18) may designate only one property as a principal residence per year, since 1982. The housing unit is not restricted to a detached home but can include a multiplex, cottage, mobile home, condo, trailer, houseboat, among other residential options. Keep in mind, though, it cannot shelter the entire property from tax, if you do not use the entire property. So a triplex would still be subject to tax on two-thirds of the profit, as you normally inhabit one-third for your primary residence. Finally, even properties that are turned into rental units may qualify for the PRE. This option can help shelter up to four years of earnings, while the property is a rental unit and potentially longer if you or your spouse needed to move at least 40 kilometres to be closer to a new place of employment.
Keep in mind that while further rules and exemptions exist, this is a good starting point. Good luck on your new adventure as landlords.
Romana King is an award-winning personal finance writer, a real estate expert and speaker. She is the current Director of Content at Zolo.ca
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