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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?

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FrugalTrader About the author: FrugalTrader is the founder and editor of Million Dollar Journey (est. 2006). Through various financial strategies outlined on this site, he grew his net worth from $200,000 in 2006 to $1,000,000 by 2014. You can read more about him here.

{ 11 comments… add one }

  • bonnie October 2, 2011, 2:30 pm

    so interesting to read the articles as I am just starting out looking at real estate as an investment. I am fortunate to own a single family dwelling outright and have a line of credit attached to the property that is less than 8,000.00. I am moving into my partner’s home and will rent out my house (if I sell my house, I’ll lose in this market). I intended to use the line of credit to put a down payment on another rental property – either a condo or a house. So – technically, I will not be living in a principle residence that I own. Not sure what the implications are for that. Before all this takes place, I’m trying to learn all I can so I make the right decisions and have as much info as is available.

  • Sher September 7, 2013, 2:53 pm


    I am buying a new built home as an investment where position will be given in 6 months from now. I would like to rent this property out or sell it right away. What implications in terms of tax will occur? The home salesperson told me that the CRA will ask me to pay the maximum $24,000 hst as it is not my personal residence. He advised me to wait 6 months to rent or sell. However, that will mean I have to pay out of my pocket for 6 months which I don’t want to do. I live with my parents and our current home is owned by them. What advise can you provide?

  • Danielle September 7, 2013, 9:21 pm

    Hi Sher, your best bet would be to live in it for a short period then rent it out with the plan to sell it. If you sold it when you took possession you’d have to pay the max HST as you mentioned. But as a personal residence you get a credit back. If you rent it out for a year you’d still get the gain on the sale but your mortgage balance would be lower because the tenants would be paying your mortgage

    The other option would be to live in it for a year and the gain would be tax sheltered but you’d have to pay out of pocket for that.

    It depends on how big the gain is going to be – the bigger it is the more it makes sense for you to move in as principal residence because you’d want to shelter the gain. Hope that helps.

  • cmjxj October 24, 2013, 6:54 pm

    when selling a rental property that was converted from a principle mnortgage is the cost to close the property (real estate fee, closing costs, lawyer, mortgage penalty (if any)) deducted from the selling price?

    i.e. if original price or appraised value when converting the principle to rental = $200k, selling price = $260k, closing costs = $20k. Is the capital gains calculated on $240-$200 or $260-$200?

  • Dan October 24, 2013, 10:12 pm

    @cmjxj the portion related to when it was a rental property is the capital gain that is taxable. So if the property was worth $200k when it was converted from a principal residence to a rental and then sold for $260k, the gain is $60k of which half is taxable (net of fees of course)

  • akatsiya January 25, 2014, 3:27 pm

    Smart people out there

    would you please tell me when I convert my personal property into rental property should I notify bank about the change?
    Can it affect the terms of the existing mortgage? Since money lent by bank was given towards personal, not rental property.

  • Bluegirl March 13, 2014, 7:52 pm

    Currently have a single family bungalow rental with half decent tenants. Mortgage coming up for renewal next month. Property was appraised prior to the current mortgage at 190,000, 5 yrs ago. Mortgage balance is $153000. Can I borrow the maximum on this property to go towards my principal residence or does anyone see a better way for free up some cash? Thanks in advance.
    PS If I had to do it again, I wouldn’t. Added stress to life! It’s always something.

  • Paul Unosawa March 13, 2014, 10:42 pm

    Hey you could speak to your mortgage broker or lawyer about it but what I have is two investment properties with 5% down, which technically I cannot use for investment purposes but I did mention to the lender that I intend to live in it, unless it comes to foreclosure it usually would not be an issue, but again get legal advice before doing anything.

  • Dan @ Our Big Fat Wallet March 13, 2014, 11:34 pm

    @akatsiya I moved from a condo and rather than selling I converted it to a rental. At that point I called the lender. They said technically they could call the loan but didn’t care because I had a good credit history. From what they said their main concern is that no payments are missed and the conversion from principal residence to rental was noted but didn’t affect anything.

    @Bluegirl I’m pretty sure you can borrow up to 80% (this may have changed recently). But assuming $190k value this means $152k can be borrowed so you’d be maxed out as is (unless value has gone up since 5 yrs ago)

  • Al September 17, 2015, 2:54 pm

    Question: I am thinking about buying a second property which would be my primary residence and would rent out my first property. I have a line of credit I can use for a down payment. However, when I approach a bank etc about qualifying for another mortgage, would be my second mortgage I would hold then, how does one qualify for this. Would my income need to support both mortgages or would the bank take into consideration that I would be generating income from my “rental” property in their calculations even if I had not yet secured tenants. Also, I imagine that house insurance would need to change on my first property to reflect the change to rental status. And if that is the case, would they notify the mortgage company of this change. Last question, is it wise to notify your mortgage company of the plans to change status to rental or are they just happy that payments are still being made.

  • Landlord newbie November 26, 2015, 2:03 pm

    Should you pay an appraiser when you change the first property to rental? Wish there was a step by step list of things to do when converting principal residence to rental income property

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