Tax Implications of Rental Properties

My financial planner with IG Private Wealth sent me some valuable information regarding Tax Implications on Rental Properties. It is quite a lengthy article and also addresses, how rental income is taxed, tax deductions on rental properties and capital cost allowance.

I have copied two important sections below that are worth sharing.

Tax implications of turning a principal residence into a rental property

When you sell a home that was only ever used as your principal residence, you won’t have to pay tax on the capital gains if you sell it for more than you paid (as long as you didn’t claim the principal residence exemption against another personal use property while you owned it). This is not the case for rental properties, however, which are subject to tax on capital gains when you sell them and which are not eligible for the principal residence exemption.

Therefore, if you change the status of the entire property you own from your principal residence to a rental property (or vice versa), there is a set of complex tax rules that comes into play. From a tax perspective, the property is deemed to have been “sold” at its current market value, at the time of the change in use. This market value becomes its new tax cost base (also known as adjusted cost base). This is the value of the property that will be used to calculate potential capital gains or losses, going forward. You would have to report your property’s deemed disposition (change in status) on your tax return.

When you turn your principal residence into a rental property, you might be able to take advantage of a special tax election which would avoid the deemed dispositon at market value at the time of the change in use. The cost base of the property would remain unchanged (so it would not be reset to the market value at the time of the change in use).

The election would also allow you to designate the property as your principal residence for up to four more years, even if you don’t live there, but you can’t claim another property as your principal residence during that time. If you then move back into your home within four years, you won’t be required to pay any immediate capital gains tax for this second change in use.

You won’t be able to claim any capital cost allowance, however, and you would still need to declare net rental income.

If, on the other hand, you convert a rental property into your personal home, you can choose to make a similar tax election to defer tax on the unrealized capital gains until you sell the property (which defers the tax bill, it does not eliminate it). This option is only available if you haven’t previously claimed capital cost allowance on the property.

Tax implications of renting out part of your principal residence:

You may be subject to the change of use rules, as outlined above, if you start renting out part of your home, however there are some circumstances in which you might not need to do this.

To avoid the deemed disposition at market value of the converted portion of the property, there are some conditions you’ll need to meet. You can’t change your property structurally or claim capital cost allowance on the newly rented portion, nor can the rental part of the building be considered a separate unit. If these conditions are met, you won’t be subject to the partial change in use rules.

If these conditions are not met, you would have to declare a partial change of use for tax purposes and pay tax on capital gains on the part of your home that you start to rent out (usually calculated using the rented square footage as a percentage of the home’s overall size or on the number of rooms used for each purpose, as long as the split is reasonable).

Alternatively, you could file a tax election (as above) so that the deemed disposition that normally arises on the partial change in use does not apply, deferring the realization of the gain until a later sale.

Capital gains tax on rental property:

When you sell a rental property, there will likely be either a capital gain or loss, plus any previously claimed capital cost allowance could be recaptured. While a capital gain is only 50% taxable, recapture of capital cost allowance is fully taxable.

The capital gain (or loss) will be the sum of the selling price (proceeds minus the costs to sell your property, such as realtor and legal fees), minus the capital cost of the property when you originally bought it.

Recapture will be the lesser of the cost of the depreciable property, including capital improvements (of the building, not the land) and the proceeds, minus the undepreciated capital cost. Here’s an example:

Lizette sells her rental property for $500,000 ($300,000 for the land and $200,000 for the building).
She bought it for $250,000 ($150,000 for the land and $100,000 for the building) 10 years ago. She made $50,000 of capital improvements over the years, for a total capital cost of $150,000 for the land and $150,000 for the building.
The undepreciated capital cost at the time of sale is $75,000.
It cost her $20,000 to sell it.
Capital gain = $500,000 - $20,000 - $300,000 = $180,000.
Taxable capital gain (50%) = $90,000.
Recapture of capital cost allowance = ($100,000 + $50,000) - $75,000 = $75,000
Tax owing when property sold (at Lizette’s tax rate of 40%) = ($90,000 + $75,000) X 40% = $66,000

As with all tax situations, you should consult with your accountant or tax specialist.