June 21, 2017

How to Handle Taxes When Renting Out Your Basement Income Suite

If you believe Scott McGillivray, real-estate entrepreneur and host of the long-running HGTV Income Property show, secondary income suites are a great way to get started in the real estate investment business.

Since a tenant is paying down part of your mortgage, incorporating an income-producing element makes your house more affordable, may allow you to live in a house/area that you couldn’t otherwise afford, and can often add a lot of value to your property, he maintains.

While that can mean something as simple as renting a room in your house to a foreign exchange student, more and more Toronto condo and house owners are creating income suites to capitalize on tight rental market and create some passive income. Perhaps you’re thinking of joining them?

Bylaws on Basement Flats Can Vary

Of course, you’ll first have to fund a significant renovation – which may also require a zoning change and dealing with your city’s bylaws and regulations. Although bylaws across Ontario are generally similar, each municipality has its own variations so don’t take anything for granted.

You’ll also have to let your insurance company know that you’ll be renting out your basement as this will increase your insurance risk. By not disclosing this information, the insurance company could refuse to pay a claim if, say, there was a fire.

Tax Rules on Income Suites Often Unclear

What’s more, despite the fact that you are definitely allowed to write off some of the expenses you’d be paying for anyway, you can easily run into tax trouble with the Canada Revenue Agency if you’re not careful. The first thing to remember is that all your net rental income is taxable – at the same rate that you pay on ordinary income.

The total rental income from your suite is usually reported on a calendar-year basis, using Form T776 when you file your tax return – but it’s the net number that really matters. To offset the rent you collect, you can deduct the costs of advertising for tenants, as well as a portion of your mortgage interest, property taxes, insurance, utilities, repairs and maintenance. You can’t, however, write off the cost of your own labour to look after things.

Principal Residence Exemption at Risk

But that’s not where the big tax liability lurks. If you rent out too much of your home or tear it apart to accommodate more tenants, for instance, you could jeopardize your ability to claim the capital gains tax exemption on a principal residence. This could be an important factor if you hope to sell your home on a tax-free basis in the future.

Here’s the good news: As long as you meet the following tests you’ll be able to continue designating the entire property as your principal residence. First, the rental portion has to be “ancillary” in relation to the overall use of the property. In other words, the tenant’s space has to be a lot less than yours. In addition, you can’t have made any significant structural changes to the property or deducted any capital cost allowance – in other words, depreciation for tax purposes – on the portion of your home that you’re renting out.

When reviewing structural changes, CRA will be primarily interested in more permanent modifications, such as installing a separate entry for tenants, adding a second kitchen or moving walls around. That means creating an elaborate self-contained income suite like McGillivray often does will generally result in capital gains tax upon sale.

CRA Increasingly on the Lookout

If you are considered to have changed the use of your home from a personal-use property to an income-producing one, you’ll be deemed to have sold, and subsequently repurchased it, at fair market value at the time of the change in use. You’ll be expected to report this transaction and, if the property has gone up in value, there could be some tax to pay as a result since the principal residence exemption is no longer available to you.

In the past, much of this activity went unnoticed since there was no easy way of tracking just who was doing what to their home. However, now that you’re required to report the sale of a principal residence on your tax return to be eligible for the capital gains exemption, it will be much easier for the CRA to check up on all this, matching reported rental income to your home’s status upon sale.

The bottom line: Before you start ripping up the basement, have a talk with a tax pro to ensure you’re clear on where you stand.