Personal Finance

Convert residence to rental property - Capital Gains tax payable?

  • Last Updated:
  • Nov 30th, 2015 1:10 am
[OP]
Deal Addict
Sep 1, 2003
1615 posts
50 upvotes
Anyone have any tips on lenders who will offer an interest-only payment option on an investment property mortgage/LOC? Doesn't make sense to be paying back principle on the property.... (Principle repayments are not tax deductible)

I was hoping to stay with my current National Bank All-In-One LOC which is still being offered @ Prime, but my advisor told me they won't issue it for investment properties.

Something else I just thought of - forget the switching houses thing for a second.... If I were to withdraw from my current LOC (using one of the sub accounts to keep it separate) the money needed for a downpayment on an investment property - would the interest on this amount be tax deductible, since it was used to make an investment?

I had only counted on the interest paid on the mortgage held against the investment property being deductible.... so perhaps my number crunching was a little off.
[OP]
Deal Addict
Sep 1, 2003
1615 posts
50 upvotes
squid wrote: I have a friend who is a tax lawyer who did the following when converting house to a rental property.

He first gifted his 1/2 interest to his wife. Tax free as it was a principal residence.

He then bought the house from his wife. His wife sold it at FMV and had a tax free gain as principal residence. She used proceeds to purchase new principal residence.

He now has a rental property with a new mortgage that CAN be written off as it was secured for an investment property. Apparently the original mortgage and any equity take out for new residence would not apply for tax deductions?

He did the two transactions the day before the new renters moved in.
Hey Squid, few more questions about your friend's scenario

1. Is it necessary to sell the house from one spouse to another at FMV? I'm finding that the less I 'buy' the house for, the easier it is for the rental business to generate a profit (necessary for CRA to allow interest deductions). Could using a below-FMV price cause problems? One I could forsee is that the CRA would use the lower purchase price as the basis for any future capital gains....

2. Does the new rental property mortgage have to be in one spouses name only if the title is? That would mean I would have to qualify on my own, not using our combined incomes - although this probably wouldn't be an issue - especially if I can set the 'purchase price' low enough :)
[OP]
Deal Addict
Sep 1, 2003
1615 posts
50 upvotes
Anyone have any thoughts on question 1 in particular?
Deal Fanatic
Aug 21, 2007
5897 posts
738 upvotes
Markham
pluto:

Per your question #1, the income tax act is a complicated beast. I am a CA student and even I cant say for sure without going back and consulting, but my gut tells me that yes you can sell below FMV (similar to gifting I suppose) but that if the CRA becomes aware of this, you will possibly be deemed to have disposed the property at FMV, creating a large capital gain for you, but that for your wife the ACB will be what she actually spent, so in essence you pay extra capital gains without the step up in the adjusted cost base for your wife. That is essentially how the CRA penalizes you for trying to circumvent the rules. In that kind of scenario you can see why it makes sense to sell at FMV.
Member
Aug 16, 2004
365 posts
82 upvotes
I'm in the same situation as Pluto, though my property is a condo, and I have already paid off the original mortgage. I will need the equity of the condo as down-payment on the new house, but the CRA website has a very clear example that shows that if you refinance a mortgage on rental property and use the money for personal use then it's not tax-deductible.
So what would happen if there was a pre-existing mortgage at the time I convert my principle residence into a rental property? It's not clear from the CRA website, but I phoned them and they said the mortgage interest would become tax-deductible starting at the time of the conversion. So can I just take out a new mortgage while I'm still living in the condo, keep the cash for a future down-payment, and when I convert it to rental then that mortgage interest will become tax-deductible?
I guess the key is that the new mortgage on the original property should come into effect no earlier than the day after I take possession of my new house so that there is no question of the tax deductability of the interest...
If an existing mortgage can become tax-deductable, then I think it makes more sense to have it come into effect PRIOR TO the day you take possession of the new house, or at least prior to the day you begin renting the original property!

I have also considered Squid's idea of selling/gifting the condo to my fianc
Jr. Member
Sep 6, 2008
155 posts
1 upvote
squid wrote: I have a friend who is a tax lawyer who did the following when converting house to a rental property.

He first gifted his 1/2 interest to his wife. Tax free as it was a principal residence.

He then bought the house from his wife. His wife sold it at FMV and had a tax free gain as principal residence. She used proceeds to purchase new principal residence.

He now has a rental property with a new mortgage that CAN be written off as it was secured for an investment property. Apparently the original mortgage and any equity take out for new residence would not apply for tax deductions?

He did the two transactions the day before the new renters moved in.
That sounds like a lot of legal fees and land transfer taxes.
Member
Feb 19, 2008
415 posts
4 upvotes
pluto wrote: If I were to withdraw from my current LOC (using one of the sub accounts to keep it separate) the money needed for a downpayment on an investment property - would the interest on this amount be tax deductible, since it was used to make an investment?
I think the sub account taken out to buy an investment should be tax deductible.
Member
Feb 19, 2008
415 posts
4 upvotes
pluto wrote: Hey Squid, few more questions about your friend's scenario

1. Is it necessary to sell the house from one spouse to another at FMV? I'm finding that the less I 'buy' the house for, the easier it is for the rental business to generate a profit (necessary for CRA to allow interest deductions). Could using a below-FMV price cause problems? One I could forsee is that the CRA would use the lower purchase price as the basis for any future capital gains....

2. Does the new rental property mortgage have to be in one spouses name only if the title is? That would mean I would have to qualify on my own, not using our combined incomes - although this probably wouldn't be an issue - especially if I can set the 'purchase price' low enough :)
For 1. I defer to the CA student, but you would likely want the transfer to be at the highest level you could support with an appraisal, as that would all be capital gain exempt principal residence. In other words, you want the initial cost to be as high as possible when starting as a rental property, right?

2. Both incomes could probably guarantee the loan if that was needed.
Member
Feb 19, 2008
415 posts
4 upvotes
bjserink wrote: I phoned them (CRA) and they said the mortgage interest would become tax-deductible starting at the time of the conversion. So can I just take out a new mortgage while I'm still living in the condo, keep the cash for a future down-payment, and when I convert it to rental then that mortgage interest will become tax-deductible?

I am no lawyer. I was just repeating what an acquaintance, who happens to be a tax lawyer, said he did to make a tax deduction air tight. I suppose he is concerned that since the existing mortgage was for personal reasons, CRA at some point will rule these mortgages are not tax deductible. Did CRA give you a ruling on paper?
Member
Feb 19, 2008
415 posts
4 upvotes
suidmach wrote: That sounds like a lot of legal fees and land transfer taxes.
He's a lawyer, so I guess not too much fees. Since it was transferred between spouses as a gift, no LTT.
Deal Addict
Dec 28, 2006
2454 posts
117 upvotes
Saskatoon
bjserink wrote: I'm in the same situation as Pluto, though my property is a condo, and I have already paid off the original mortgage.

So what would happen if there was a pre-existing mortgage at the time I convert my principle residence into a rental property? ...

So can I just take out a new mortgage while I'm still living in the condo, keep the cash for a future down-payment, and when I convert it to rental then that mortgage interest will become tax-deductible?
No. You cannot deduct the interest unless you borrow to purchase an investment that has the potential to earn income, interest or dividends.

Since you already own the condo, you cannot mortgage it to buy a personal residence and have that interest be deductable.

You can refer to the Sinha decision from the Federal Court in 1990. He received money as a gift, used it to invest and then deducted his mortgage interest. His argument was that he "could have" paid off the mortgage and borrowed against the equity to invest and be able to deduct the interest. The court said that if he had done that he could have deducted the interest. It did not matter what he "could have" done but what was actually done with the borrowed money. Since the money borrowed was not used for a deductable purpose, he lost his appeal.

If you borrow against the equity in the condo you own, and use that money to purchase another rental property, you would have deductable interest. If you use it to purchase a personal residence it will not be.
Member
Aug 16, 2004
365 posts
82 upvotes
The Sinha decision shows that an opportunity to borrow for investment purposes does not mean that you can claim your mortgage interest - this is pretty obvious anyway. However, it does not answer the question: "Does a pre-existing mortgage on a primary residence become tax-deductible when you convert it into a rental property?"
This is the question I posed to the CRA, and they said yes (on the phone, but I might try to get it in writing now). My mortgage broker also says yes. She also says that as long as I currently own one property, we can tell the mortgage lender that the property is owner occupied (which is true right now) to get a 75% loan ratio, as opposed to 50% for rented. If the status of the unit changes later, we can notify the lender but they can't take back what they've loaned.

On a related note, I'm hoping that I can get an LOC using other equity (maybe my employee stocks and/or my TFSA), and somehow use this to "buy" the remaining 25% of my condo, effectively maxing out its equity with all the interest being tax deductible. Any suggestions on how this could work? Would I actually have to implement the "squid maneuver"; the gifting & buying back process mentioned above?

Squid - I know it was actually your friend's idea, but you get the credit for posting it here :D
Deal Addict
Dec 28, 2006
2454 posts
117 upvotes
Saskatoon
bjserink wrote: The Sinha decision shows that an opportunity to borrow for investment purposes does not mean that you can claim your mortgage interest - this is pretty obvious anyway. However, it does not answer the question: "Does a pre-existing mortgage on a primary residence become tax-deductible when you convert it into a rental property?"
This is the question I posed to the CRA, and they said yes (on the phone, but I might try to get it in writing now).
But your other post said
bjserink wrote: though my property is a condo, and I have already paid off the original mortgage.
Since you already own it, you are not borrowing any money to purchase it.

The Sinha case said that it was the actual use that the borrowed money is used for that determines deductability.

If you own a property as a PR with a mortgage, and then convert it to a rental property, then the interest would be deductable.

If you mortgage a property that you already own, what you do with the money is what matters. You cannot just mortgage a property you already own, convert it to a rental, then use those funds to buy a PR and magically the interest is deductable.
Member
Aug 16, 2004
365 posts
82 upvotes
I think I see what you're saying. A pre-existing mortgage can become tax-deductible, but only if that particular mortgage was used to purchase the property. In my situation, the new mortgage might not be considered to be used to buy it (though the point could be argued that this conversion is considered as if I sold and bought the property). I think maybe I will just play it safe, and use the squid maneuver.
Member
Aug 16, 2004
365 posts
82 upvotes
Upon hearing of my situation, an accountant stated that he believes that I should be able to deduct the mortgage interest even though the borrowed money is being directly used to purchase personal property. He justifies this by the fact that the purpose of the loan is to allow me to use my condo as a rental property, and thus it has an indirect effect on my income earning capacity. There is no question that the direct use test would show that the borrowed money was used for personal property. However, I did some research and found that according to paragraph 22 in bulletin IT533, there are certain circumstances that the courts have allowed an exception to the direct use test. So far, I have not been able to find any court cases that ruled on a situation exactly like mine, where I am borrowing money so that I am indirectly able to get rental income. However, the Bronfman Trust case has some similarities. In it, the Trust borrowed money to retain income-earning properties which it otherwise would have sold in order to make the capital allocations to the beneficiary. Though their direct use of the borrowed money is different than mine, it is still ineligible. And like them, I want to borrow money to avoid selling property that could later provide me with an expectation of income. The Supreme Court judge said that
there has been a trend towards attempting to ascertain the true commercial and practical nature of the taxpayer's transactions ... Assessment of taxpayers' transactions with an eye to commercial and economic realities, rather than juristic classification of form, may help to avoid the inequity of tax liability being dependent upon the taxpayer's sophistication at manipulating a sequence of events to achieve a patina of compliance with the apparent prerequisites for a tax deduction.
Despite this, the judge ruled against the Trust, stating
It is not lightly to be assumed that an actual and direct use of borrowed money is any less real than the abstract and remote indirect uses which have, on occasion, been advanced by taxpayers in an effort to achieve a favourable characterization. In particular, I believe that despite the fact that it can be characterized as indirectly preserving income, borrowing money for an ineligible direct purpose ought not entitle a taxpayer to deduct interest payments.
Therefore, I have to conclude that the risk of being punished for attempting to deduct the mortgage interest this way is too high.

Paragraph 15 of bulletin IT533 says that a taxpayer may restructure borrowings and the ownership of assets to meet the direct use test. I interpret this to mean that I am free to manipulate the ownership of the condo in order to meet the direct use test, or in other words, I am allowed to gift the condo to my fianc
Sr. Member
User avatar
Aug 10, 2005
538 posts
22 upvotes
I believe what you proposed mirrors the process mentioned by squid in post #10, it's basically the same.

side note: if you read the few paragraphs just after 22, the CRA actually says what exceptions they were referring to, and they are not applicable to your situation.

the past Supreme Court case has indicated that you would meet the direct use criteria if you go with the proposed transactions (sell and repurchase), and CRA will not see it as evasion. And no, you don't have to wait a certain period of time.

risks are .. you are gifting your asset away to a someone you haven't married yet :D
also, bank usually requires higher down payment for rentals, so you gotta find more than 20% for the mortgages
depending on your financial strength, you may or may not be able to get two mortgages (for rental and your primary residence)
Deal Addict
Sep 17, 2002
1091 posts
476 upvotes
bjserink situation is exactly like mine:

Purchased a condo 10 years ago and it almost doubled since then.

Mortgage was recently paid in full and thinking of renting it out.

My marrital status is common law, 10 years.

Questions.
Does anyone if it's easy to gift to a common law spouse?

What would be costs be to transfer then buy back? Last time we bought property the cost was around $5K, expect cost would be double now.

Is it better to setup a Trust/Corporation - initial costs would be high but tax rate would be lower than my current 45-46% over the long run.

Any recommendations for a tax accountant/lawyer in GTA?

Likely be doing this a few more times with other family members.
Newbie
Feb 2, 2009
2 posts
I spoke with CRA yesterday about a similar situation. We have a small mortgage left on our current residence and are planning to take out a HELOC on it and use the money as a down payment on a new home and retain the other for a rental. I was assured by CRA that the interest on the HELOC (he said it would also apply if we were to re-mortgage) would be tax deductible because without said loan/LOC we would not otherwise be able to have the rental property. He said there is nothing in the tax code that speaks directly to the situation when I asked for something in writing, but he assured me that it was ok. I just took down his name and the time of my call for future records. This sure beats the squid maneuver, and will save on legal fees!

Also, there was another post that said otherwise, but our bank is allowing us to take 80% equity out of our current home even though it will become a rental.
Deal Addict
Dec 28, 2006
2454 posts
117 upvotes
Saskatoon
frosty peach wrote: I spoke with CRA yesterday about a similar situation. We have a small mortgage left on our current residence and are planning to take out a HELOC on it and use the money as a down payment on a new home and retain the other for a rental. I was assured by CRA that the interest on the HELOC (he said it would also apply if we were to re-mortgage) would be tax deductible because without said loan/LOC we would not otherwise be able to have the rental property. He said there is nothing in the tax code that speaks directly to the situation when I asked for something in writing, but he assured me that it was ok. I just took down his name and the time of my call for future records. This sure beats the squid maneuver, and will save on legal fees!
You better get it in writing. Because I would bet money that if you get audited you will be hooped. If you borrow money and don't use it to invest you cannot deduct the interest. Period. You can see the Sinha decision I referenced above. The courts have been quite clear, it is the actual use of the money you borrow that will determine interest deductability. Since you are borrowing from the HELOC to purchase a personal residence you are out of luck.

Interest is only deductable if the investment you make with the borrowed funds can produce income, interest, or dividends. Since your personal residence cannot produce any of those, the interest is not deductable.
Member
Aug 16, 2004
365 posts
82 upvotes
I agree - get it in writing, and not just from the guy on the phone at the CRA. You need to request a ruling, and wait a few months for it. Of course, by then it's probably too late to try the squid maneuver, all the ruling will tell you is whether or not you are allowed to deduct the HELOC interest on your 2009 tax return.

The maneuver isn't that expensive, it's going to cost me about $150 for the two title transfers, plus $325 for legal fees associated with obtaining the new mortgage. Though, my mortgage broker is going to try to convince the bank to pay the legal fees, or at least see if the bank has their own legal folks who might be cheaper.

I just talked to my lawyer today, and she thinks the CRA might see the squid maneuver as fraud, so I'm going to call them tomorrow and get their opinion, plus find out how to request a ruling on it.

Top