Converting a Principal Residence into a Rental Property
A real estate situation that I hear about often are people considering keeping their first home as a rental while moving onto their second personal residence. The upside is obvious, if they do it right, they get to keep an appreciating property along with the potential extra cash flow that rent brings in.
The Basics
As real estate investing is attractive partly due to the tax benefits, there is a tax rule that some people miss when converting their existing property into a rental.
If we take a step back for moment, CRA rules state that if money is borrowed to generate income, then the interest is tax deductible. This applies to rental real estate as well. As the rental mortgage (investment loan) is used to generate rental income, all interest charged on the mortgage is tax deductible in addition to other rental property expenses such as property/water tax, insurance and utilities (if you pay for them).
The Problem
All is well a good, but the devil is in the details. For most people, they want to get some cash out of their existing properties to put towards the new place. So they want to refinance their existing homes (ie. HELOC), convert it to a rental, use the HELOC for the new residence down payment, then assume that the mortgage+HELOC is tax deductible because it’s now a rental.
However, the new mortgage isn’t entirely tax deductible. Why? Because an investment loan is tax deductible depending on what the money is used for. So if the new borrowed amount is used to pay for a portion of a new principal residence, then the HELOC is not tax deductible.
There are strategies floating around supposedly circumventing this rule by transferring assets to a spouse, then buying back the property. To me, these schemes just send a red flag to CRA and raises the potential for audit.
The Solutions
What’s the right way to do it? Here’s my opinion - If you plan from the beginning that the house is going to be a rental when you move in future, then I would personally pay as little as possible on the mortgage throughout the years of living there, and save the difference as cash. The accumulated cash will serve as a down payment on the future new residence, leaving the rental mortgage untouched and converted to a tax deductible mortgage.
Another tidbit of info on a question I get often on the same topic, how does capital gains tax fall into the mix. Capital gains tax is only applicable when there is a profit when you sell. How is the profit determined? On the day of closing, the house to be converted should have an appraised value (if not get one). When you sell the rental in the future, your profit will be calculated as (future value – current closing appraised value).
For those of you who own real estate, do you keep your properties after you move?
35 Comments, Comment or Ping
1. mfd
This was our original plan when we bought our condo. We were really worried that mortgage prices were going to collapse and lose on the condo. So our intention was not to prepay the mortgage but rather put everything into savings. When it came time to buy a house we would use the savings as a down payment. If we didn’t end up losing on the condo then we would also sell the condo and put that towards the mortgage of the house. If we were losing money on the condo then we would just keep it as an investment.
Ultimately as time went by and we acclimated to condo living we decided that it would be more prudent to just pay off the mortgage. We also decided that a condo wasn’t the best investment opportunity and just let whatever happens to property values happen.
Sep 3rd, 2009 @ 9:45 am
2. DavidV
It’s an interesting point. I’m not sure if there is any solution, but it’s an interesting point. I currently own a duplex that I don’t plan on leaving for many years. But, it would make more sense (likely) to buy a new single family residence if I need to, rather than get convert my legal duplex to a single family residence. So it is problem that may come up in the future for me.
Sep 3rd, 2009 @ 10:20 am
3. No Debt Guy
We did refinance my girlfriend’s condo for a down payment on our house last year. She only claimed interest expense on the mortgage amount before the refinance.
I am confident that CCRA would be good with this if it ever came up.
Sep 3rd, 2009 @ 11:01 am
4. nobleea
I thought there was a technical interpretation set out by CRA that said that it didn’t matter what the money was used for, as long as it was mortgaged against a rental property.
Sep 3rd, 2009 @ 12:13 pm
5. Elbyron
nobleea, you have it backwards I’m afraid. It doesn’t matter what is used as collateral for the loan, it’s the direct use of borrowed funds that determines tax deductibility.
For more details on interest deductibility, please read:
http://www.cra-arc.gc.ca/E/pub/tp/it533/it533-e.html
Sep 3rd, 2009 @ 12:28 pm
6. canucktuary
FT, can you clarify when your original house should be appraised? ie. I’m planning on buying a condo in the next 8 months, living in it for 5 years and then converting the condo into a rental as I move to the suburbs and purchase a home.
When you refer to “day of closing” do you mean the day you buy the house, or the day you plan to convert it into a rental.
Very interesting post!
Sep 3rd, 2009 @ 12:29 pm
7. Elbyron
The solution to this tax problem is exactly what FT stated: simply to sell & re-buy your property, or even easier is to just sell to your spouse for fair market value. There is nothing illegal about this, and there’s no reason it would send up red flags to the CRA. In fact, the CRA bulletin I linked to above says in paragraph 15: “A taxpayer may restructure borrowings and the ownership of assets to meet the direct use test.”
There are a few court cases that back up the legitimacy of this method. Singleton is a good example, though he shuffled things via a partnership rather than selling & re-buying. A very good recent example is the case of Nina Sherle ( http://decision.tcc-cci.gc.ca/en/2009/2009tcc377/2009tcc377.html ), in which she failed to properly implement this maneuver and lost her case. She argued that she could have sold to a third party and re-purchased, and the judge agreed that she could have done so, but it’s only what you actually did that counts.
For anyone looking for more information on this maneuver, in which I named the “squid maneuver” after a user named squid who first brought this technique to my attention (his lawyer friend used it to convert a house to a rental property), please visit http://www.redflagdeals.com/forums/showthread.php?t=654404
I’ll answer any questions posted there, and I’ll also respond in the comments here for a few days.
Sep 3rd, 2009 @ 12:42 pm
8. FrugalTrader
canucktary, the appraisal should be done the day (or there abouts) that you convert the property into a rental. That way, you have the proper adjusted cost base for when you sell the rental in the future.
Sep 3rd, 2009 @ 2:22 pm
9. Adam
Interesting indeed. My guess would be that market timing would be paramount with the sale of a converted rental property, when related to capital gains.
Here is my question:
How does it work if you were to rent out your property for a period of time, maybe a few years, and then move back into it as your principal residence at a future date? How would capital gains be assessed in that situation?
Sep 3rd, 2009 @ 3:04 pm
10. Elbyron
Good question Adam.
The answer is that each time you convert between a rental property and a principal residence, there is a “deemed disposition”, which means for the purposes of calculating capital gains tax, it is treated as if you sold it. So, you would pay tax equal to 50% of the increase in value that occurred between the time it became a rental and the time it went back to principal residence.
Sep 3rd, 2009 @ 4:06 pm
11. Philbert
Great Post.
We actually just did exactly what you are explaining in your post this summer. We own a duplex and we used to live in one side and rented the other out. This summer we moved and are now renting both sides out. We used a HELC to get money for a downpayment on the new place. It really sucks that we can’t write off the interest, but thanks for clarifying.
Sep 3rd, 2009 @ 5:17 pm
12. comeleon99
I recently did this exact maneuver after reading about the “squid maneuver” mentioned previously on RFD. It turned out to be even better than just refinancing because I used the full proceeds of the sale of my townhouse to purchase my new house. Then I used a HELOC on the new house as a down payment for the repurchase of the townhouse. This way I have the same amount of total borrowing with the maximum amount eligible to write off the interest.
It does depend on you situation if the extra cost is worth it. I had aggressively payed down my mortgage on the townhouse before I learned that you couldn’t just refinance and buy a new house and still get the deduction. Because of the amount of equity I had built up I estimated that the extra legal fees in the sale and repurchase would be made back in the first years tax deduction.
Sep 3rd, 2009 @ 5:46 pm
13. Chet Kwapisinski
When it comes to claiming potential capital gains or losses it is important to understand what constitutes both a principal residence as well as what options may be available in addition to any restrictions to ensure that no compromises are made to forfeit the PRE (principal residence exemption) especially when change of use occurs. It can be a prudent choice for tax planning in concert with up to 3 elections that may be made and filed.
Please read the the T2091 to get a sense of what you can and cannot do.
T2091(IND) Designation of a Property as a Principal Residence by an Individual (Other than a Personal Trust)
http://www.cra-arc.gc.ca/E/pbg/tf/t2091_ind/README.html
T2091(IND)-WS Principal Residence Worksheet
http://www.cra-arc.gc.ca/E/pbg/tf/t2091_ind_-ws/README.html
One option was mentioned earlier; however, under the ITA IIncome Tax Act) Section 45 where the principal residence is defined, there are 2 additional elections that may be made.
Election 2 allows you to ignore the deemed disposition normally required to be reported under the change of use rules. You can then choose to defer reporting any capital gain/loss until the time of actual disposition, or at a time you choose to rescind the election. In addition, you can choose to designate the property as a personal residence for up to four years after moving out of the residence. Other options may also exist depending on individual circumstance where these may be extended ie) transfer to a new location by an employer etc….
Election 3 allows basically the same in reverse ie) you can choose election when your convert a rental property back to a principal residence. In this scenario, there is a deemed disposition at FMV, but the capital gain can be deferred and reported when you actually sell the property. You can only do this as long as you never claimed capital cost allowance.
In our system as in many parts of our ITA the old cliche “the devil is in the details” applies.
Cheers
PS. In addition one should allows keep track of any capital improvements on properties to increase the ACB so that when properties are disposed, one minimizes potential gains and losses etc….
Sep 3rd, 2009 @ 7:53 pm
14. Elbyron
Philbert, it’s not too late! You can still benefit from buying & reselling the duplex. The technique is similar to the one recommended by the judge in the Sherle case. Sell the duplex for fair market value to a trusted friend, who may need to take out a new loan in order to pay off the HELOC since it’s non-assumable. The friend pays you the remainder (your current equity in the duplex) in the form of a Promissory Note. You then go and apply for a mortgage or new HELOC with which to buy back the property, for the same market value. The proceeds first go to pay off your friend’s loan, and the rest goes to your friend, who can then use it to pay back the Promissory Note to you. Apparently this back-and-forth exchange can be done without ever registering the land transfers, so it wouldn’t cost very much in legal fees.
Sep 3rd, 2009 @ 7:56 pm
15. Elbyron
Another option that simplifies this maneuver is to simply sell the property to your spouse. The only difficulty is that your spouse has to qualify for the mortgage without consideration to your income (only the buyer’s income can be counted). If the property is currently jointly owned, one of you will have to first sell their half-share to the other, so the title is solely in one person’s name. I would suggest setting it up so that the lower income earner ends up with the property, as they will be the one claiming all the rental income and deductions (and typically the income exceeds the deductions). Be sure that the property is specifically mentioned in its owner’s Will, since it will not be jointly owned anymore.
Sep 3rd, 2009 @ 8:04 pm
16. Subversive
When I bought my first property in 2003, I needed help to make the mortgage, so I rented the basement out. It had been partly converted to a basement suite. I lived there for around two years and finished the basement suite properly so it could be rented up and down. When I met my wife and we moved to Calgary, we kept the property and rented it out. It’s been a decent profit generator over the years, however last year in October we had to hire a property management company to take over the day to day management for us, as my wife was pregnant with our 2nd child and managing a property 90 minutes away was just not feasible anymore. As well, we had some horrible tenants who made us hate the entire business. When the management company took over, there were a number of things which needed to be fixed in order to bring the property up to standards, since we had not done a great job with regular maintenance, being 90 minutes away (had we done this maintenance properly all along, we would have had less cashflow to work with). We had to take out a line of credit to pay for all the maintenance as well as to deal with a vacancy from Nov to Feb in the basement suite. We’re just now finished paying off the LoC. The management company has eaten into our profits significantly, even though we got a very reasonable management fee of on 10%. In many cases if you need a single property managed it will cost closer to 15% of net rent. In any case, the management company has done a good job, but our monthly cashflow has shrunk significantly in the past year. This summer we refinanced into a very nice 3.67% assumable (with qualifying) mortgage and pulled some cash out. Our plan is now to list it targeting investors as we think the real estate market is about to take another downturn. We plan to take the remaining proceeds (~$30-40k, we estimate) and max out our TFSA’s as well as setup a bit of an emergency fund, something we’ve never done before. So, in conclusion, I would not personally pursue this tactic today if I were moving. I think I got extremely lucky in the timing of my purchase and that unless you are buying multi family properties (ie: 4 plexes or bigger), it’s extremely risky to own single family rental real estate in this economy. Short version: It worked out well for us, but I think it was way more luck than skill.
Sep 3rd, 2009 @ 10:40 pm
17. Kevin
I have always been interested in owning a rental property, but wasn’t sure if you have to claim the rent money you get as income. If you do have to claim it, does writing off the interest on the loan allow you come out ahead?
Sep 4th, 2009 @ 1:01 am
18. canucktuary
Thanks FT and Elbyron!
Sep 4th, 2009 @ 11:18 am
19. Elmo
I have used this strategy recently. Hopefully it will work out well. It does suck that the amount of the HELOC is not tax deductable, but there are usually negatives and risks no matter what type of investing you do. We did have cash to put down on the new house as well, our 5 year mortgage term was up so we didn’t pay any penalties, and we got a 5 year fixed rate for both houses at 3.69%.
Basically we bought our first home, knowing that we would keep it as an investment. We were actually renting the basement apartment in this house, and our Landlord mentioned that he was selling his properties and retiring. WE had lived there for 2 years with no problems. So we bought it, and he gave us a below market value price, don’t ask me why, but he did. It already had a basement apartment, all the windows had been upgraded to vinyl. (The market value of the house has almost doubled in 5 years).
I have a friend, who is a home inspector (and has his own contracting company), inspect the home throroughly before we bought it…….just to be sure.
It was great, all we had to do was move upstairs, and rent the downstairs. We have had a long-term tennant (4 years so far), who says she is never going to move.
We have gradually done work on the house over that period of time, bit-by-bit, so that we could get the work done in cash and didn’t have to use any credit, I also did as much of the work myself as I could (i.e. upgrade the deck, minor plastering, painting, bathroom Renos). Plus my father is a red seal certified carpenter…so that helps too. Make sure there is cold beer in the fridge, and a steak on the bbq and it’s all good.
Our first baby was born last year, and we felt that we were “outgrowing” our current home, but we waited a year for the 5 year fixed term to be over so that we wouldn’t be penalized by the bank.
We are currently trying to get tennants for the 3 bedroom upstairs part of the house. I posted an add yesterday and have already received 18 responses. The mortgage (including insurance,and all fees) is approx 850 per month, downstairs appartment is renting for approx $500 pou, and upstairs will be rented for $1100 pou……any suggestions on what to do with the extra money? First year I am planning on just saving the cash for emergency funds for the property. I was thinking that after the first year I would do some more investing and put chunks of cash down on the mortgage of our new house.
About a month ago we bought a newer, bigger, nicer, house. And we actually bought it $10,000 below the asking price by using the same real estate agent as the seller, and also by being flexible on the closing date. They had a new baby, and wanted to stay there a bit longer than 30 days….so we waited 60 days.
Also the Real Estate agent did a horrible job of advertising the house,he didn’t list the hardwood flooring, ceramic tile, the whole house was pre-wired with high end speakers/audio equpment, all rooms wired for internet etc……none of this was listed. So this worked out in our favour.
I think keeping Real Estate as a rental is usually a good idea as long as you bought the investment below market value, or at least not during a housing boom when houses tend to be overprice. You should do a check on the rental vacancies, high = bad, low = good:) Picking a house that isn’t need of a lot of repair is also key. It needs to be in a good location close to bus Routes, Grocery Stores, Schools etc. And you have to be extremely ‘picky’ about your tennants. Proof of emplyment, 2-3 references, credit check, lease contract (done properly by a lawyer), no smokers, no pets, and post dated cheques are requirments that I have.
Luck never hurts either.
Sep 4th, 2009 @ 12:00 pm
20. London Rental Man
I was not aware about the “tax deductible mortgage” so far. Is that also possible for the UK or is that only in the states?
Sep 4th, 2009 @ 12:33 pm
21. Elbyron
Kevin:
Yes, you are required to claim all rental income, which is added with (and taxed with) your regular income. You can offset this extra income by deducting interest on any kind of loan that was DIRECTLY used to purchase the property, as well as deducting any regular occurring expenses such as condo fees, utilities, and regular maintenance (not including upgrades). You can also claim Capital Cost Allowance, see this post for details: http://www.milliondollarjourney.com/how-capital-cost-allowance-works-cca.htm
Typically, your rental income should exceed expenses so that you earn a profit, and the amount of this net earning is basically what you’ll pay income tax on. If you lost money, perhaps due to not having a renter for a couple months, your deduction may exceed the income and allow you to “come out ahead” in the taxes. But you have to be careful. To claim the full deductions, you must be renting at fair market value (no discount for family members) and you must have an expectation of profit (so you can’t claim if you choose not to advertise the empty property).
London Rental Man:
Sorry, I’m not familiar with UK tax laws, but you could ask your tax agency whether or not loans used to aquire rental property are tax deductible, as they are in the US and Canada.
Sep 4th, 2009 @ 2:49 pm
22. cmjxj
What if the converted property from principle to rental is joint owned. Can one person (lower incomed) claim all the rental income and deductables? or does all of it have to be split? My wife and I will be going through all of this in the next month, great timing FT, thanks for the information guys/gals.
Sep 4th, 2009 @ 7:11 pm
23. Elbyron
I believe this works the same as a joint investment account. One person can claim all the deductions, but they also have to claim all the income. Or you can split both the deductions and income by some percentage (like 50/50), as long as you never change that percentage.
I’m not 100% certain on this though.
Sep 4th, 2009 @ 7:16 pm
24. Mark in Nepean
We have a rental property…but its not without its challenges.
If you have a rental unit, IMO, you have to be prepared to stomach the hard times when things go wrong (and things will).
Our plan is to have the renters pay off our mortgage over the next 5 years…until the unit is almost paid off. We’ll take the equity (and the small capital gains hit) and our equity will be used to buy as many dividend-paying stocks as we can.
What do folks think of that strategy??? FT???
cmjxj – we did exactly the same thing about 2 years ago. Yes, you can have one person “claim” all rental incomes and expenses, but you can’t go back-and-forth with ownership. Either you enter a partnership (50/50, other) and claim so on your tax return, or, you enter it as 100% ownership. Flip-flopping will surely cause the tax-man to audit you and explain yourself.
Needed to say, you don’t want that….
I would advise you to claim it as 50/50 with your wife and take advantage of other income tax-deduction measures (RRSPs, spousal plans, other) to lower the taxable income for the highest earner.
Cheers!
Sep 4th, 2009 @ 9:36 pm
25. FrugalTrader
Mark, when you say that you’ll “take the equity” do you mean in the form of a HELOC? If that is the case, then I don’t believe there is any capital gains tax owed.
cmj, as other have mentioned, you can “choose” who claims the expenses and the income. The key is to keep it consistent throughout the years. When we were landlords, we simply spilt everything 50/50 because for us, it wasn’t always clear who would make more money in any given year.
Sep 4th, 2009 @ 10:39 pm
26. Mark in Nepean
Hi FT,
Either a HELOC, or we’ll decide to pay the capital gains outright and then take the money leftover and put it into dividend-payers. I haven’t decided which yet….time will tell. Capital gains shouldn’t be too bad since the property hasn’t skyrocketed in price since conversion from principle to rental unit.
Thoughts?
Good post. Certainly lots of folks in real estate, or considering…
Sep 5th, 2009 @ 8:53 am
27. FrugalTrader
Mark, my understanding is that capital gains are only due when you “sell” the property. Do you know differently? Or do you mean that you’ll simply put some money aside for when capital gains are due in the future?
Sep 5th, 2009 @ 9:55 am
28. Sampson
@ Mark, if you are only 5 years from paying the mortgage off, then is there a reason you aren’t using the equity within the home now in the form of a HELOC? Just wondering why you want to wait until the home is ‘paid off’ before borrowing against it again.
Or as FT alludes to, you are thinking of selling the property? If that’s the case, do you believe the housing market in your area to be strong over the next 5 years?
Sep 5th, 2009 @ 11:47 am
29. Mark in Nepean
Hey FT-
Correct…capital gains only due when you “sell” the property.
Hey Sampson-
No, no real reason we aren’t using the equity within the rental now (we don’t have an existing HELOC)….maybe we should. Do you think this is a better method, pull the equity out now vs. waiting to buy dividend-payers???
Again, my strategy was the following…
1) get the rental mortgage almost paid off (via renters) in another 5+ years
2) sell the rental
3) pay capital gains, as required, should be ~$10,000 @ FMV
4) take the equity/value of the rental (hopefully close to $200,000) and buy a whack of CDN dividend-payers (adding these payers to my existing non-registered DRIP portfolio stocks).
Regarding # 2) above, the market should be consistently growing, no major spikes nor major valleys I predict.
The only reason I’m not sure about the HELOC, is a) we enough to pay with our principle residence (no need to borrow more) and b) don’t you have to pay back the principle at some point (end of draw period) AND interest??
If you guys know the details, I would love to hear about them to improve our situation….
Cheers!
Sep 5th, 2009 @ 6:06 pm
30. FrugalTrader
Mark, the question is, do you “want” to sell your rental in 5 years? If not, you can keep your rental AND buy dividend payers by using a HELOC on the rental while keeping everything tax deductible. If you are worried about the extra cash flow required to pay back the HELOC, you can leave some space in the HELOC so that it can pay for itself (capitalize the interest).
Sep 5th, 2009 @ 8:34 pm
31. Sean
So which is the smarter method? Pay into the existing house, then pull the equity for the down payment on the new place? Or make minimum payments onto the current mortgage & save a cash down payment for the new place?
Sep 6th, 2009 @ 9:26 pm
32. Mark in Nepean
Hey FT,
Hard to say….if we want to sell the rental in 5 years. It was the strategy, but who knows what time will bring….
Yes, keeping the rental, creating a HELOC from it seems very attractive.
I think I’ll need to talk to some banks about this – find out more, how it would work, etc. Keeping my interest payments on the HELOC tax deductible seems like a good idea, and like you said, I could buy more dividend-payers
this way.
True, I am concerned about the extra cash flow required to pay-back the HELOC, but I don’t have to borrow any more than I want to, right?
FT or Sampson – are there certain (best) HELOC products and banks that I could look into? I want to do my research. Thanks.
Sep 7th, 2009 @ 10:44 am
33. FrugalTrader
Most banks can offer a HELOC on your rental providing that you have at least 20% equity. So if your property is worth $100k, and you owe $50k, then they can offer a HELOC of $30k. IMO, it might be a good idea to wait until renewal to get a readvancable product so that you can tap into the equity as the renters pay down the mortgage. I believe that HELOC rates are around prime + 1% (today).
With regards to cash flow, if it’s a concern, then you can get the HELOC to pay for itself.
Sep 7th, 2009 @ 11:04 am
34. used tires
I’ve always been scared to get into Real estate investing for the purposes of renting it. I guess I am scared of all the possibly costs that can come associated with it. Bad tenants, repairs that need to be done to the property, things like that have always kept me away from renting a residence. Although I have debated in the past purchasing a 2 story building, residing in the first floor and renting the second floor.
Till then,
Jean
Sep 7th, 2009 @ 11:36 pm
35. Prophet
I live in a parsonage and turned my principle residence into a rental. I have family renting from me. I’m planning on leaving the parsonage and purchase another home as my principle residence. My wife is a stay at home mom and homeschools are children. My questions are the following:
1. Since my wife earns no income other than the govt’s child tax benefit, should I claim all rental income in her name – that way she can claim all expenses?
2. Who decides how much is considered a fair rent – if I’m being paid in cash every month, how will the gov’t know how much I’m charging for rent and what I should be claiming? I’m of the mindset, the goven’t makes too much off our hard earned sweat, and I don’t want to give them a penny more than I have too.
Any and all advice would be much appreciated — thanks Kindly!
Oct 16th, 2009 @ 5:40 pm
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