According to a recent Stats Canada report, almost 1.4 million Canadian households reported having property rental income. That’s a significant portion of the population.. Given that rents increased on average across Canada by 11% in 2022 (and by considerably more in big cities, such as Toronto and Vancouver), it’s understandable why investing in property is so popular.
However, there are a lot of tax implications to consider when deciding to rent out a property, particularly one that used to be your primary residence. How much income tax will you pay on rental income? What tax deductions on rental property are available? And how does capital gains tax on rental property work? Knowing the answers to these questions is important so you don’t fall foul of the CRA, and also so that you can get a good idea of the margins of profitability involved in renting out properties.
How is rental income taxed in Canada?
On the whole, you’ll need to pay income tax on rental income. The tax rate on rental income in Canada is the same as your marginal tax rate (the tax rate you pay on your next dollar of income), since your net rental income would be in addition to your other sources of income (such as your salary, business income and investment income).
If you own the property with someone else, the income is split among each owner, depending on their share of ownership, and each person will pay tax according to their own marginal tax rate. If the property is owned with your spouse, the split in net rental income will be proportional to how much each spouse contributed to the purchase of the property.
If your rental property is held by a corporation that you own, tax on rental income gets a little more complex. We’ll discuss that further on in this article.
Tax deductions on rental property
Before you pay income tax on rental income, you’ll be able to claim certain expenses to lower the amount of taxable rental income you have to report on your tax return (this amount is then called your net rental income). It’s important to know all of the expenses you can include to reduce the amount of tax paid as much as possible. These are some of the most common tax deductions on rental property:
Utilities: If you, rather than your tenants, are responsible for paying for gas, hydro, oil, water and/or cable, you can deduct these expenses.
Property taxes: These can be deducted for the time period your property was rented out or available for rent.
Insurance: You can deduct your insurance premiums for the rental property, but if you paid for several years’ worth of premiums all at once, you can only claim the amount that pays for the current year’s coverage.
Repairs/maintenance: The costs of any minor repairs or ongoing maintenance (both for the building and land), can be claimed as deductions against rental income. However, in the current year, you can’t deduct the costs of repairs that exend the useful life of the property or improve it beyond its original condition. These would be considered capital costs (see the capital cost section below).
Professional fees: These include legal services related to renting out the property (like preparing leases and collecting overdue rent), however it doesn’t include legal fees you paid when you bought the property (these are added to the capital cost of the property itself).
Advertising: Expenses for advertising the property to find tenants can be deducted, for either digital or traditional media.
Management and administration fees: If you hire a company to manage your property, collect rent and find tenants, their fees are a deductible expense.
Salaries, wages, benefits: If you employ people to help look after your rental property, such as a superintendent, etc., these expenses can all be deducted. You cannot, however, deduct the value of your own labour.
Understanding capital cost allowance
Your buildings, equipment and furniture are classified as depreciable property. The initial cost of these properties can’t be deducted all at once when calculating net rental income, but you can deduct a portion of the cost each year, over a period of several years. This is called capital cost allowance. The amount of capital cost allowance that can be deducted annually depends on each type of depreciable property.
Tax implications of turning a principal residence into a rental property
When you sell a home that was only ever used as your principal residence, you won’t have to pay tax on the capital gains if you sell it for more than you paid (as long as you didn’t claim the principal residence exemption against another personal use property while you owned it). This is not the case for rental properties, however, which are subject to tax on capital gains when you sell them and which are not eligible for the principal residence exemption.
Therefore, if you change the status of the entire property you own from your principal residence to a rental property (or vice versa), there is a set of complex tax rules that comes into play. From a tax perspective, the property is deemed to have been “sold” at its current market value, at the time of the change in use. This market value becomes its new tax cost base (also known as adjusted cost base). This is the value of the property that will be used to calculate potential capital gains or losses, going forward. You would have to report your property’s deemed disposition (change in status) on your tax return.
When you turn your principal residence into a rental property, you might be able to take advantage of a special tax election which would avoid the deemed dispositon at market value at the time of the change in use. The cost base of the property would remain unchanged (so it would not be reset to the market value at the time of the change in use).
The election would also allow you to designate the property as your principal residence for up to four more years, even if you don’t live there, but you can’t claim another property as your principal residence during that time. If you then move back into your home within four years, you won’t be required to pay any immediate capital gains tax for this second change in use.
You won’t be able to claim any capital cost allowance, however, and you would still need to declare net rental income.
If, on the other hand, you convert a rental property into your personal home, you can choose to make a similar tax election to defer tax on the unrealized capital gains until you sell the property (which defers the tax bill, it does not eliminate it). This option is only available if you haven’t previously claimed capital cost allowance on the property.
Tax implications of renting out part of your principal residence
You may be subject to the change of use rules, as outlined above, if you start renting out part of your home, however there are some circumstances in which you might not need to do this.
To avoid the deemed dispositon at market value of the converted portion of the property, there are some conditions you’ll need to meet. You can’t change your property structurally or claim capital cost allowance on the newly rented portion, nor can the rental part of the building be considered a separate unit. If these conditions are met, you won’t be subject to the partial change in use rules.
If these conditions are not met, you would have to declare a partial change of use for tax purposes and pay tax on capital gains on the part of your home that you start to rent out (usually calculated using the rented square footage as a percentage of the home’s overall size or on the number of rooms used for each purpose, as long as the split is reasonable).
Alternatively, you could file a tax election (as above) so that the deemed disposition that normally arises on the partial change in use does not apply, deferring the realization of the gain until a later sale.
Capital gains tax on rental property
When you sell a rental property, there will likely be either a capital gain or loss, plus any previously claimed capital cost allowance could be recaptured. While a capital gain is only 50% taxable, recapture of capital cost allowance is fully taxable.
The capital gain (or loss) will be the sum of the selling price (proceeds minus the costs to sell your property, such as realtor and legal fees), minus the capital cost of the property when you originally bought it.
Recapture will be the lesser of the cost of the depreciable property, including capital improvements (of the building, not the land) and the proceeds, minus the undepreciated capital cost. Here’s an example:
Lizette sells her rental property for $500,000 ($300,000 for the land and $200,000 for the building).
She bought it for $250,000 ($150,000 for the land and $100,000 for the building) 10 years ago. She made $50,000 of capital improvements over the years, for a total capital cost of $150,000 for the land and $150,000 for the building.
The undepreciated capital cost at the time of sale is $75,000.
It cost her $20,000 to sell it.
Capital gain = $500,000 - $20,000 - $300,000 = $180,000.
Taxable capital gain (50%) = $90,000.
Recapture of capital cost allowance = ($100,000 + $50,000) - $75,000 = $75,000
Tax owing when property sold (at Lizette’s tax rate of 40%) = ($90,000 + $75,000) X 40% = $66,000
As with all tax situations, you should consult with your accountant or tax specialist.
Does it make sense to own a rental property inside a corporation?
While incorporating an active business can often make sense from a tax perspective, it would rarely be advisable in this case, even if you own several properties. Rental property is considered passive, rather than active income, so you could actually end up paying more tax on rental income overall (by the time the after-tax net rental income is paid to you personally).
Is renting out a property the right choice for you?
If you’re considering renting out a property you own, or buying a property to rent, it makes sense to discuss your plans with your IG Advisor first. They’ll be able to help you work out the best way to finance the purchase, the tax consequences involved and how it would fit in with your overall financial plan. If you don’t have an IG Advisor, you can find one here.