Housing market rental unit debt no solution to housing crisis

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One of the newest measures the federal Liberal government has taken to increase housing supply is to change the mortgage insurance rules to enable existing homeowners to take on more debt in order to create rental units within existing homes.

The new units must be fully self-contained units (such as basement suites with separate entrances, laneway homes) and meet municipal zoning requirements. There also cannot be more than four dwelling units, including the existing unit.

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I will stay in my tax lane and not address the obvious insanity of enticing an already indebted population to take on even more debt, with the carrot being the “incredible advantages” of becoming a landlord. But I will point out the complete disregard for the myriad complicated tax issues that come with such a housing conversion.

The first tax consideration that must be considered is the “change in use” rules of the Income Tax Act. The conditions required for the newly announced mortgage rules, which require a change in use from a wholly personal-use property to a partial rental property, would likely cause these rules to apply.

If so, the proportionate share of the property’s fair market value (usually computed by reference to area) that becomes a rental property is deemed disposed of at fair market value. Many Canadians are surprised by these income tax rules since there is no actual disposition of the home.

Such a deemed disposition will usually result in a gain that can often — but not always, depending on the facts — be offset by the individual’s available principal residence exemption if the property is personally held.

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There are some elections available in the right circumstances whereby the above gain can be deferred, but it is important to ensure that these are timely filed and properly considered.

The Canada Revenue Agency discusses these rules in Income Tax Folio S1-F3-C2. Paragraph 2.59 states: “It is the CRA’s practice not to apply the deemed disposition rule, but rather to consider that the entire property retains its nature as a principal residence, where all of the following conditions are met: the income-producing use is ancillary to the main use of the property as a residence; there is no structural change to the property; and no CCA is claimed on the property.”

However, it is doubtful that the above conditions could be met if a homeowner is making a structural change to add rental suites and obtaining financing to do so.

The second consideration is that from the conversion date forward, the taxpayer will be obligated to report any rental income. The taxpayer should be entitled to deduct most expenses related to the new rental operation — such as the newly incurred interest costs on the debt — subject to the many detailed rules and restrictions contained in the Income Tax Act.

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What about the ability to claim depreciation on the house (or “capital cost allowance,” as it is called in tax matters)? Sure, but only on the portion of the house that is rented. However, such claims can complicate the elections for deferrals previously discussed and eligibility for future principal residence exemption claims when the property is eventually sold.

The third consideration is that a future principal residence exemption claim on the eventual disposition of the property would only be available on the personal-use portion of the property, not the rental portion. Be mindful of that.

The fourth consideration is the possible GST/HST consequences. As noted by renowned commodity tax expert Noah Sarna, there could be significant GST/HST liabilities for people who construct a laneway home and rent it to a long-term tenant. The same outcome generally doesn’t flow from a basement suite. The CRA discusses these issues in GST/HST Info Sheet GI-168.

Confused? You’re not alone. These areas of income and commodity tax confuse even the most seasoned experts, who must carefully look at the resulting consequences of such conversions. I have spent years in my practice explaining to homeowners the tax complications of converting a principal residence. It is not simple.

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It is irresponsible for governments to release proposals with a lot of fanfare (to create the perception that they are solving a housing crisis) without any mention of the tax and other complications that will undoubtedly be created. I’m all for government incentives to help create entrepreneurs, but it needs to be done in a responsible manner with consequences fully thought through.

In my experience, landowners and developers understand housing issues and concerns better than most. A lot of them tell me that the main reason for the lack of affordable housing is the inability to properly plan for and implement urban boundary expansions.

The push to turn homeowners into landlords simply adds to the mountain of government interventions in our housing markets, such as the recent push for intensification within already crowded urban settings, the introduction of bans and taxes on foreign owners and numerous other silly taxation provisions.

Given that, is more government intervention the answer? Absolutely not. “Contrary to the vision of the left, it was the free market which produced affordable housing — before government intervention made housing unaffordable,” renowned economist Thomas Sowell has said.

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Some government intervention is inevitable, but it needs to be thoughtful. In the present case, I hope and trust that the people who go into debt to take advantage of this latest program will be well advised on both the financial and taxation consequences. It’s not pretty. This latest program is certainly not a game-changer.

Kim Moody, FCPA, FCA, TEP, is the founder of Moodys Tax/Moodys Private Client, a former chair of the Canadian Tax Foundation, former chair of the Society of Estate Practitioners (Canada) and has held many other leadership positions in the Canadian tax community. He can be reached at kgcm@kimgcmoody.com and his LinkedIn profile is https://www.linkedin.com/in/kimgcmoody. 

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