Do you rent out your home or claim home office expenses as a self-employed individual?
One of the most well-known provisions in the Canadian Income Tax Act (“ITA”) allows taxpayers selling their Principal Residence (subject to certain conditions and criteria) to be exempt from any potential income tax on the capital gain realized on its disposition. This is known as the Principal Residence Exemption, or PRE.
Prior to 2016, any taxpayer that felt they qualified for the PRE did not have to report the sale of their home on their income tax return, as there was no income tax owing on the disposition. However, beginning in the 2016 tax year, individuals who sell their Primary Residence (PR) are required to report the disposition on their income tax return. If a taxpayer fails to report the sale of a PR, they may forfeit their entitlement to the PRE plus be subject to certain penalties.
It has been well reported that the purpose of the changes to PRE regulation by the Canada Revenue Agency (the “CRA”) is threefold:
- To improve general compliance and administration of the tax system.
- To collect more funds for the Government, through forfeited PRE treatment and penalties.
- To monitor individuals who purchase properties to flip while claiming the PRE. Such properties would likely not qualify for PRE treatment on disposition.
Points two and three have received the vast majority of the press on this topic. However, the consequences of point one should not be overlooked. Essentially, the taxpayer is now giving CRA more information to review on the disposition of a PR, which can assist the CRA in denying a PRE claim.
Under the ITA, a taxpayer may still be considered to have disposed a portion of their PR even if they still own the property. This occurs if a portion of the home, once fully used for personal use, is converted to a rental property (even if just one room), or for other business use. The ITA deems the taxpayer to have disposed of the business use portion of the property at its fair market value at the time of the conversion to its new use. While any gain on the “disposition” is income tax exempt at that time if it qualifies for the PRE, when the owner eventually sells their PR to a third-party, the portion of the home used as a rental property, or for other business use, may be taxable based on the accrued gain from the time of the change of use until its disposition.
Denial of PRE Claims
Prior to the new reporting requirements of 2016, the CRA was rarely informed of the sale of a PR, and thus would have no reason to verify the correct application of the PRE. Today, the CRA can audit the taxpayer to ensure the three criteria were met, and potentially deny some or all of the PRE claim.
There are two main instances where CRA can deny a taxpayer’s PRE claim in whole or in part:
1) A taxpayer rents out a portion of their home
As stated above, a taxpayer forfeits the PRE exemption on the portion of their home used as a rental property from the moment it is converted. However, the CRA has an administrative policy where it will allow continued PRE treatment on that portion of the home if it satisfies three conditions:
- The rental use of the home is ancillary in relation to its personal use.
The CRA has clarified that “ancillary” means secondary to the main purpose of the home as a personal residence. That being said, there is no threshold or percentage used to calculate such “ancillary” nature – instead, the particular circumstances need to be individually examined for each case. A good example of “ancillary” would be a homeowner who rents out the basement apartment of their residence. An owner who lives in the basement apartment and rents out the rest of the house, however, would not qualify for “ancillary” use.
- There are no structural changes to the home.
The CRA considers “structural changes” to be anything of a permanent nature, such as the installation of a separate entry or kitchen, or reconfiguring space by adding or removing walls. Again, as in condition number one, whether changes to a home are deemed “structural”, the CRA requires that the particulars of each case be individually examined.
- No tax depreciation is claimed against the rental income.
2) A taxpayer is self-employed and deducts a portion of their home for business use
A taxpayer may use a portion of his or her PR as an office, work space, or for the purpose of earning self-employment income. This includes using a spare bedroom as a home office, inventory storage in a basement, home daycare centers, or using one’s indoor swimming pool to conduct swimming lessons.
CRA’s administrative policy allows continued PRE treatment on the portion of the home used for business purposes – if it satisfies the three conditions mentioned above.
Practically speaking, it has been rare for the CRA to enforce this rule due to lack of information. This new reporting requirement by the taxpayer, however, now enables the CRA with the appropriate information to potentially deny the tax free treatment of the sale.
How we can help
Under the new 2016 requirement to report the sale of a PR on one’s tax return, CRA has more data at their fingertips, making it easier for them to audit the sale of a PR and potentially deny a claim on some or all of one’s PRE.
If you are earning, or have earned income in your home, and plan to sell in the near future, contact your Zeifmans advisor today or one of our real estate services professionals to learn more about effective tax planning solutions.
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This publication has been prepared for the use by Zeifmans LLP. The strategies, advice and technical content in this publication are provided for general information only. This publication is not intended to provide specific financial, tax, accounting or other advice for you, and should not be relied upon in that regard. Readers should consult with their professional advisor when planning to implement a strategy to ensure that individual circumstances have been considered properly and it is based on the latest available information. © Zeifmans LLP 2017. All rights reserved.