Why should the taxman get it?

IMG_1972As a real estate investor, some day you may want to move out of your current residence. But you might want to hang on to that property and rent it out.

From an investment standpoint, this makes good sense. But from the point of the taxman, you want to do your due diligence in minimizing the taxes you’ll be paying.

Changing a property from a primary residence to a revenue property is considered to be a change in the property’s use. When a property’s use changes, that property has effectively been sold (even though no transaction has occurred) at fair market value from its original purpose to its new purpose.

We are going to discuss this. But first, a couple of disclaimers.

If you actually change the use of the property, you have 4 years to change the designated use of the property unless you designate a new property as your primary residence. Of course, if you elect to postpone making that designation, you are still required to declare your rental income (sorry) and you can’t claim any capital cost allowance.

If you are changing provinces, you will need a new health care card. That is implicitly a change of residence. Which means you need to change the property’s designated use.

If you or your spouse’s employer requires you to relocate for work, and at the end of the work term you move back to the original residence (or you die before that can happen) and the primary residence is at least 40 km further than your new, temporary residence, you can keep the original residence as your primary residence.

This article assumes that we are actually changing the desigated use of the property.

When the property was your permanent residence, it was exempt from capital gains. So for simple math, if you purchased your property for $100,000 10 years ago, and it’s now worth $200,000, you don’t have to pay a capital gain tax on that $100,000. Hurray! Tax free money!

Now let’s suppose that at the value of $200,000, you decide to move out and rent the house to tenants. And suppose that you do this for the next 10 years, then sell it for $300,000.

Since it’s now an investment property, you have realized a capital gain. You just made another $100,000. But now, it’s taxable.

Although there’s not going to be any dispute of the end value of the property (what it sold for) the actual starting value can be a bit more difficult to evaluate, especially 10 years after the change in designation. And this is a very important number, because it’s what will be used to calculate the capital gain. So how do we come up with a number that will satisfy everyone?

Some people think it’s adequate to obtain documentation of other properties that are for sale that are similar to yours at the time of a change of use. I have discussed this with the CRA, and although they might use this as a benchmark, this type of document can easily be manipulated so it may not stand up to the CRA “smell test.

A professional appraisal will stand up to the smell test. Appraisals might be done for mortgagors or insurance companies. If not, hire an appraiser yourself to come up with a value.

If you fail to come up with a reasonable value for the property at the time of its change of use designation, CRA will take on that task for you. Although they aren’t necessarily out to gauge you, they will have their work cut out going back 10 years to find what properties similar to yours were selling for. The number may work out favourably, but do you want to take that chance for the cost of an appraisal? It’s always better to be in control of the information.

No one wants to be surprised by an unexpected tax bill when they dispose of their assets.