Homeowners and landlords beware

Anyone who owns a house, or is a landlord, should be aware that the use of your home may create an unexpected income tax liability.

Normally when you sell a home you will not have to pay taxes if it was your ‘principal residence’. The ‘principal residence exemption’ rule gives you a break by not requiring you to pay taxes on the portion of the gain eligible for the exemption.

So what if you lived in a home for a period of time, then decided to rent it out? Or what if you move into a home that you had previously rented? How do the principal residence rules apply in these situations?

Consider the situation where you have been trying to sell your home unsuccessfully and decide to rent it out. This would be considered a change in use of the property from personal use to income producing rental property. For tax purposes, this ‘change in use’ results in a ‘deemed disposition’ and has the same tax consequences as if you had sold it. If the fair market value of this home at the time of this ‘change in use’ is greater than the amount you purchased it for, the difference would be considered a capital gain. One half of that gain is taxable. If the principal residence exemption applies it can eliminate all or a portion of the tax on the gain. But relying on the principal residence exemption to shelter the tax on the ‘change in use’ may not be the best course of action.

For example, in the event that you own another property, such as a vacation property that has appreciated more in value than the home you have begun to rent out, you might prefer to use the principal residence exemption to shelter gains on the eventual sale of the vacation property. The result of not using the principal residence exemption to shelter the gain on the home that you have begun to rent out is that it will create a tax liability now. In this case you may consider an election that can be filed to deem the disposition on the ‘change in use’ to not have occurred. By filing this election you will defer having to pay the tax until the rental property is actually sold or you rescind the election.

Now let’s assume you decide to move into a property that you own but was previously rented out. In this case you will again have a ‘change in use.’ The change will be from income producing rental property to personal use. This will trigger the same ‘deemed disposition’ rules if the ‘deemed disposition’ results in a gain, the gain likely cannot be sheltered by the principal residence exemption. Under certain conditions a similar election can be filed to deem the disposition not to have occurred and defer the tax on that gain.

Another common situation is one where you have begun to rent out a room or suite in your current residence. This is also considered a ‘change in use’ but the Canada Revenue Agency will generally not apply the ‘change in use’ rule provided certain conditions are met.

It is important that you, as a home owner, appreciate the complexity of these rules. If you are in a situation similar to any of the scenarios discussed above it is important you discuss these issues with your accountant. A failure to comply with these rules could result in a substantial tax bill. Conversely, with sound advice ahead of time, these rules present a planning opportunity that can provide significant tax savings.

This article is written by or on behalf of an outsourced columnist and does not necessarily reflect the views of Castanet.