The real estate market’s meteoric growth over the last several years has created higher equity for many Canadian property owners. But taking advantage of that equity can create tax problems. Caution is advised if you purchased a property as a rental property several years ago. It has likely appreciated significantly in value. The mortgage interest on the rental property is likely tax-deductible currently. If you choose to refinance that rental property and put that money to work elsewhere, you will no longer qualify for a full interest deduction.
Caution is again advised if you purchased a property as your principal residence several years ago and no longer have a mortgage, but you decide to upsize or downsize and move into that new home and convert your original principal residence to a rental property. You might think you could put a mortgage on your original home and use the proceeds to pay for your new home expecting to deduct the interest on the newly converted rental property, but that is not the case. Rules exist and are clear on mortgage deductibility. You should become familiar with these rules by checking the Income Tax Act. A good place to start is Income Tax Folio S3-F6-C1, Interest Deductibility, as CRA talks about its position based on several past court rulings. So, attention is required as borrowed money that was tax-deductible in the past may not qualify in the future.
Consideration should be given when home improvements or repairs are made and the tax consequences of those decisions. If the home improvements are completed prior to the conversion to a rental property, that will create a higher adjusted cost base (ACB). This higher cost base will potentially reduce the capital gains tax with a future sale (if that price is higher than the ACB at the time of conversion). These home improvements and repairs will not qualify for a tax deduction if done prior to the conversion and calculation of the ACB. If on the other hand, these repairs and improvements are made after the conversion and ACB is set, they should qualify for deductibility but will increase the capital gains tax at the time of sale.
While it is not covered in this blog, it is important to also keep in mind that there are potentially other tax consequences when switching your principal residence to a rental income property.
As well, we would be remiss if we did not consider the impact of all taxes as they relate to your current and future income situation. By that we mean if this is a long-term plan and you are currently working and in a high tax bracket, deductibility now has its benefits. By the same token, if you plan to sell the property at a time when your income is significantly less (like retirement) that should be part of the calculation before deciding on a strategy that suits you best.
These are just a few reasons why we recommend the importance of obtaining professional tax and planning advice prior to initiating these types of changes. With solid planning you can prevent some of these tax issues while you can decide what works best in your specific situation.