Many Canadian homeowners consider renting out their basements to generate extra income, but concerns often arise about how this might affect your Principal Residence Exemption (PRE) when it comes time to sell.
What is Principal Residence Exemption?
The Principal Residence Exemption (PRE) is a tax provision in Canada that allows homeowners to avoid paying capital gains tax on the sale of their primary residence. By designating a property as a principal residence, homeowners can potentially save thousands of dollars in taxes when they sell, making the PRE one of the most valuable tax breaks available to Canadian taxpayers.
How can you avoid losing PRE if you rent out your basement?
From a Canadian tax perspective, renting out your basement doesn’t necessarily disqualify you from claiming the principal residence exemption, but there are important factors to consider.
The Canada Revenue Agency (CRA) generally allows homeowners to maintain their principal residence exemption even when renting out a portion of their home, provided certain conditions are met:
- The rental use is ancillary to the main use of the property as a residence
- There are no structural changes to the property to accommodate the rental.
- No Capital Cost Allowance (CCA) is claimed on the property
If these conditions are satisfied, the CRA typically considers the entire property to retain its nature as a principal residence. This means you can still benefit from the tax-free capital gains when you sell your home.
What does it mean for Rental Use to be ‘Ancillary’?
CRA considers several factors when assessing whether the rental use of a basement is “ancillary” to the main use as a principal residence in order to be able to claim the principal residence exemption:
- Percentage of space used: While there’s no specific threshold, the CRA generally becomes more concerned when the rental portion exceeds 25-40% of the total floor area. When it reaches 50% or more, it’s more likely to be considered non-ancillary.
- Income proportion: The CRA looks at what fraction of income you derive from rent compared to the overall costs of running the house. For example, if your housing costs are $2,000 and you rent the basement for $1,000, this 50/50 split could be considered a grey area.
- Primary purpose: The CRA generally interprets “ancillary” as being “subordinate or secondary to a more important or primary purpose”. The main use of the property should still be as your principal residence.
How does CRA define ‘Structural Changes’?
The CRA generally interprets structural changes as modifications of a more permanent nature that make the property more suitable for rental or business purposes. Some examples include:
- Installing a separate entry for tenants
- Adding a second kitchen
- Reconfiguring space by adding, moving, or removing walls
- Converting a portion of the home into a separate, self-contained domestic establishment (housing unit)
These changes are typically more significant than minor alterations and are intended to make the space more suitable for rental use. The CRA will evaluate each case individually, considering all the particular facts and circumstances when assessing for principal residence exemption.
To protect your principal residence exemption status:
- Avoid making significant structural changes to create the rental space.
- Don’t claim CCA on the rented portion of your home.
- Ensure the rental use remains secondary to your use of the property as your primary residence.
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