Creating Rental Space on Your Property

Have you been thinking about building rental space on your property?

British Columbia is poised for growth in small-scale multi-unit housing (SSMUH) following recent zoning changes that permit such developments on single-family and duplex lots.

These changes allow for each lot to have at least one secondary suite, or detached accessory dwelling unit (ADU) such as a laneway home. Larger lots near frequent transit may have up to six units that could include row homes, triplexes, and townhouses.

Government incentives such as the BC Secondary Suite Incentive Program and the Multigenerational Home Renovation Tax Credit are expected to further encourage this housing densification.

While public guidance regarding construction requirements and processes is readily available to homeowners considering SSMUH, information on income tax and sales tax implications is less accessible. Many homeowners may not encounter tax consequences until they eventually sell their property.

This blog explores the income tax implications if you are a homeowner who builds a self-contained laneway home or secondary suite on the same property as your principal residence, to rent to arm’s length tenants.

GST considerations and tax reporting requirements related to rental operations will not be covered here.

Principal Residence Exemption (PRE)

The PRE allows Canadian-resident individuals to shelter income taxes payable on gains from the sale of a principal residence. It applies to one “housing unit” per family per tax year and requires the home to be “ordinarily inhabited” by the owner or qualifying family members (generally their spouse or children).

“Housing unit” is not defined in the Income Tax Act, therefore one must look to its ordinary meaning and the Canada Revenue Agency’s (CRA’s) administrative position.

In determining whether there is one or more housing units on a property, the CRA considers factors such as:

• Integration: Are the units sufficiently integrated such that the living accommodation of one unit cannot be enjoyed without access to the other unit?
• Separate features: Do they have separate municipal addresses, exterior entrances, kitchens, bathrooms and utility accounts?
• Functionality: Can the unit function independently as a residence?

The addition of a self-contained secondary suite or ADU raises the question of whether a property has more than one housing unit, which would limit the PRE claim.

Separate Housing Units

The CRA considers a self-contained unit with its own entrance, kitchen, and bathroom to be a separate housing unit, if it can be enjoyed and “ordinarily inhabited” separate from the main home without access to it. This may be the case even if both units are on the same legal title, are in the same structure, or are located on a single legal lot that cannot be subdivided.  

One Housing Unit

The CRA may consider a secondary suite within the main home, to be part of the main home as one housing unit, if:

• The income-producing use of the suite is ancillary to the main use of the home,
• There is no structural change, and
• No Capital Cost Allowance (CCA) has been claimed on the suite.

This includes suites that are structurally integrated with the main home and used for personal rather than income-earning purposes.

Renting a Newly Constructed Unit on Your Property

Let’s consider a homeowner who builds a self-contained laneway home or secondary suite (the “Unit”) on the same property (the “Property”) as their principal residence (the “Home”) and on completion, rents it to arm’s length tenants.

Change in Use

A portion of the Property will be considered to have changed from personal use to income-producing use when the Unit is rented out. This “change in use” triggers a deemed disposition for tax purposes, for the portion of the Property associated with the Unit and any land that “contributes to the use and enjoyment” of the Unit as a residence.

Reporting the Disposition

The “disposition” must be reported on the homeowner’s income tax return for that year, even if the PRE claim is available – see Changes to the CRA Principal Residence Rules Since 2016. Failure to report the disposition allows the CRA to reassess that return indefinitely.

Homeowners must use reasonable effort to determine the fair market value (FMV) of the portion of the Property disposed of. This may be based on comparable sales or a prorated portion of the Property’s overall value.

The construction costs and a prorated portion of the original Property cost (plus improvements) can be deducted from the FMV to arrive at the capital gain

The PRE may offset the resulting gain if the Property on which the Home is situated met the “ordinarily inhabited” rule and no other housing unit had been designated as a principal residence by the family for those tax years. The FMV of the Unit becomes its new cost, for purposes of a future sale.

Designating a Property as a Principal Residence

To claim the PRE on a housing unit, homeowners must designate it as their principal residence by filing Form T2091(IND) Designation of a Property as a Principal Residence by an Individual (Other Than a Personal Trust) with the income tax return where the disposition is reported. Late designations may either be denied or result in penalties of up to $8,000.

Election to Defer the Gain

Homeowners can defer the deemed disposition and associated gain by electing under subsection 45(2) of the Income Tax Act, instead of claiming the PRE. This election, made by filing a letter with the income tax return, ensures the “change in use” does not occur for tax purposes.

The gain is deferred until the Property is sold, the election is rescinded, or CCA is claimed on the Unit. While this election is in force, the Unit may retain PRE eligibility for up to four years even if it is not “ordinarily inhabited”, provided no other property is designated as a principal residence during that time.

Actual Sale

On subsequent sale of the Property, the sale proceeds would need to be apportioned reasonably between the Home and the Unit to calculate their respective capital gain.

Home Portion

The PRE may be used to reduce the gain for each year of ownership that:

• the Home was “ordinarily inhabited” by the owner and qualifying family members, and
• no other property (except for the portion of the Property relating to the Unit) was designated as a principal residence by them during those years.

Unit Portion

The gain would essentially be the appreciation in the Unit’s value since construction was completed (construction costs and FMV upon change in use were added to its cost) and would not be eligible for the PRE (not “ordinarily inhabited” by the owner or qualifying members). If the subsection 45(2) election was made to defer the gain upon change in use, that portion of the gain may be eligible for the PRE; however the FMV at that time is not added to its cost to calculate the gain on actual sale.

Consequences  

A homeowner who is unaware of a change in use and fails to report the disposition for tax purposes can be reassessed ad infinitum.

Reporting after the due date could result in substantial interest charges on unpaid taxes or late-filing penalties, depending on whether a late PRE designation or subsection 45(2) election is permitted. Transparency legislation has provided the CRA with better access to information on real estate activities, which increases the risks of non-reporting.

Still Have Questions?

This blog illustrates the complexities involved in only one fact-specific SSMUH situation. Many other scenarios, each with their own permutations, may lead to different income tax consequences and options.

To navigate these complexities, you should seek professional advice before undertaking SSMUH activities on your home property. Being proactive will allow you to make informed decisions where options are available, and to meet your tax reporting obligations in a timely manner.

You should also consider other potential implications not covered here, such as the GST, whether to report rental income, and available rental deductions.

Please contact our Manning Elliott tax team if you require assistance.

Our Manning Elliott blog includes up-to-date articles frequently concerning the most recent changes to provincial and federal legislation. 

NOTE: Tax laws are complex and are subject to frequent change. The contents of this Manning Elliott article are not intended to represent legal or tax advice. Please consult your tax adviser before employing any strategies that may have been discussed within this article.