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.
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).
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.
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?