Personal Finance

Convert residence to rental property - Capital Gains tax payable?

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Newbie
Feb 2, 2009
2 posts
Do you think the difference is that the CRA considers converting a primary residence to a rental to be a deemed disposition? So in their view, you are already buying it from yourself at current market value.
Member
Aug 16, 2004
365 posts
82 upvotes
I think the "deemed disposition" rule is only for the purposes of calculating capital gains. Thus, if a person converts their principal residence to a rental and then later sells the property, the capital gains tax is calculated based on the value you were "deemed" to have bought it for - which is the market value at the time of conversion to rental. There is also a "deemed disposition" when you convert a rental back to a principal residence, so at the time of that conversion you would pay capital gains on the amount the property gained in value while it was a rental - though there are some exceptions.

In any case, I don't think this rule affects the deductibility of the mortgage interest. In general, the interest on a mortgage or HELOC is deductible if the borrowed money is directly used to purchase a rental property. Supposedly we are allowed to restructure ownership of assets to try to meet this "direct use" test, and so I'm hoping the squid maneuver will qualify as such restructuring.

I called the CRA today and was transferred to a 2nd tier guy, but he needed to do some research in order to answer my questions. I'm supposed to hear back tomorrow or Monday, but I'll bet it's just as likely that he'll never call.
Member
Aug 16, 2004
365 posts
82 upvotes
On a somewhat related note, does anyone know if the interest on borrowed money used to pay the down-payment for an investment property is considered tax-deductible?

I know pluto asked this earlier in this thread, but other than squid's opinion this hasn't really been answered.

Also, what about interest on borrowed money used for the principal portion of the mortgage payments? I know the principal portion itself is not tax-deductible, so my guess is that interest on loans used to pay non-deductible expenses is also non-deductible. Just as how interest on loans used to pay deductible expenses is also deductible.

I think down-payment and principal payments are not really the same thing, because the former is a cost of aquiring the property and the latter is just paying back a loan.
Newbie
Feb 27, 2007
33 posts
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!

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.
I have somewhat similar situation. This is an old post, so hopefully the originally posters will look at it.

In April I moved my mortgage from one bank to another, for a condo that we currently live in. At the new bank, it was not a mortgage, but a full HELOC. Since I now knew that I could borrow money back from the HELOC anytime I needed, I poured all my emergency funds into it, to reduce the interest paid.

And now in Sep we are planning to buy a house and convert the condo to a rental. I only in July learnt that I cannot deduct the interest that we would pay on the condo HELOC, as we will use some of it pay the downpayment for the new house and keep rest for other expenses.

Could I atleast argue that they don't ding me for the amount equal to the emergency funds that overpayed into my HELOC.

Is there anyway out for me to fully claim the interest paid on the 80% of the condo's appraised value that we would pull out, from the income the condo generates ?
We will be closing the new house purchase end of August.

I am surprised that even the broker at the big bank did not know about this. Even an accountant I spoke to did not warn me about this, but said that you know that your rental property mortgage is fully tax deductible, so maximize what you can borrow.
Member
Aug 16, 2004
365 posts
82 upvotes
Since you're closing in a little over a month, you won't have time to get a ruling from the CRA. So, you basically have two choices:
1) Squid Maneuver: Sell and re-purchase the condo at fair market value via a trusted third party, using a new mortgage or HELOC to buy it back. I noticed you said "we" a few times, so if one of you fully owns the condo then just sell it to the other person and don't bother with the buy-back. I ended up just selling my condo to my fiancee, and she took out a new mortgage to buy it from me. It is very clear that the money she borrowed was directly used to purchase a rental property.

2) As of the time of conversion to a rental unit, you can begin claiming deductions for the interest on the current HELOC, provided you have not withdrawn any funds from it besides the initial use of paying out the old mortgage. Do not use this HELOC to obtain a down-payment on your new house, or things will get really messy if this ever comes to court. Instead, ask the bank for a sub-account, or second line of credit against the condo. This will make it a lot easier to track what is deductible and what is not deductible. Assuming your current HELOC balance is less than 80% of the condo's value, you're not able to obtain the full tax benefit possible with scenario 1, because some of the condo's value will be borrowed for a non-deductible purpose.

I suppose a third option is to borrow against the current HELOC for the down-payment, and try to claim the full interest amount as a deduction. If you get audited though, you'll have a fight in court. You'll have to argue that the additional money was borrowed so that the condo could be converted into a rental property, despite the fact that the direct use of the funds was to buy your personal property.
Newbie
Feb 27, 2007
33 posts
Hi bjserink,

Thanks for the reply.

I did some number crunching to see how much money I would have borrowed if I were to just withdraw my 80% allowed from condo to pay some of it for the new home downpayment versus selling the condo and using those funds to pay more than 20% on the new house. And then borrowing from the LOC that I will have against the new house, to pay for a little over 20% of condo's value(assuming I buy it back) value and taking a mortgage for the remaining amount.

In the case of the assumed selling and buying back of the condo, I would actually be able to claim interest deduction for the amount that I withdraw from now home LOC plus the condo mortgage AND this amount would be higher, if I just proceeded the normal way.

If CRA is all about logic and making sure people do not do steps to purposefully evade taxes, then I don't see how they will not allow one to claim mortgage interested deduction on the condo LOC once it is converted to a rental.
This rule just makes no sense to me.

In fact, I feel if they were to see that a sale was done to a spouse(the we in my post was for my spouse, we jointly own the condo and will jointly own the new house), they might see that as a way to evade taxes.

I checked the Real Estate lawyer, in Ontario atleast there is no LTT to be paid for selling your 50% of share to your wife. We just pay the lawyer $500 bucks for fee and disbursement.

The problem is that my wife is not working, so she will not be able to get a mortgage for the condo, if done just in her name.

Both the condo and the new home's financing is done on the basis of my credit and job history.

Would it make sense if I withdrew all the amount I am allowed in my condo HELOC while it is still a principle residence for another month and put into an eSavings account like the one with ING etc and then closer to the home's closing date, use some of it to pay for the home's downpayment. I will not need the entire amount, as it more than needed.
Member
Aug 16, 2004
365 posts
82 upvotes
I think what you're proposing is using a LOC on the new home to pay the down-payment on the condo buy-back, and then claiming the interest on this LOC as well as the condo mortgage interest. I've done a lot of research on this subject but have not been able to determine whether or not you are allowed to deduct for a loan used for the down-payment of a rental property. It seems to me that you should be able to, but I couldn't find any case studies or anything to support this, nor to contradict it.

Using the squid maneuver is not evading taxes, it's considered restructuring your ownership of assets in order to meet the direct use test. This restructuring is clearly allowed according to bulletin IT533. This bulletin also explains the direct use test in more detail and gives some examples. It is this test that determines the deductibility of the interest payments on a loan, and when you apply it to your situation it seems like the direct use of the additional money borrowed from the condo's LOC is being applied toward your own personal home and thus does not qualify. Even if you withdraw the funds before the conversion and hold them in a savings account, they will still be traced to the what they get used for in the end (read the section of the bulletin on tracing/linking borrowed money). Of course, doing this early withdrawl strategy might make it harder for an auditor to catch you.

Look at it this way: you're not trying to intentionally cheat the tax system; it's fair and reasonable that you should be able to have the full equity of your condo in a tax deductible mortgage. A court judge would probably side with you, or at least wouldn't punish you for trying to claim interest that you shouldn't have been. The worst that can happen is that they'll audit you and make you pay the income tax on the amount that should have been taxable. If it's going to cost you $500 to buy the 50% share of the condo from your spouse, the squid maneuver might not save you a whole lot of money, especially because its cost is all up-front while the benefit of the tax deduction is spread out over a long time.

Me, I only paid $375 to my real estate lawyer to have her process the condo's sale (to my spouse) and register the mortgage. She did the contract for free because we also used her to purchase the house.

I'm not trying to persuade you one way or the other, just share with you my experience and research on this issue. The choice is yours.
Banned
Jun 16, 2009
19 posts
Toronto
Hi bjserink,

Did you have to pay any land transfer taxes using the squid method? Was there a problem getting another mortgage or could you 're-use' the old one?

Edit: For those in Ontario, do we still get hit with the Transfer Tax if we sell it to a mutual party then buy it back?
Member
Aug 16, 2004
365 posts
82 upvotes
I did not have to pay any land transfer taxes because I live in Alberta. In provinces where they apply, I imagine that you would have to pay them for each sale of the property, though perhaps not if you're only buying a half-share. I'm not familiar with the LTT rules so I can't really help you there.

I did not have an old mortgage to re-negotiate, as the original one was entirely paid off. We did have a small problem with the new mortgage though. For the new house, we were assuming the previous owner's mortgage held with RBC (6 months remaining on it), and wanted to keep the accounts together. So my fiancee applied for the condo's mortgage with RBC as well. Some stupid person in the credit department there saw the mortgage application for the house under her name (though half was being covered by me, they didn't care), and so they totalled up the house and condo loans as her total debt-load and it was deemed too high for her income to support. Because of their stupidity, they lost not one, but two mortgages... she got the condo mortgage with TD without any trouble, and now that the RBC mortgage is up for renewal we're transferring it to ATB. This is partly to get away from RBC but mainly to take advantage of a 3.5% 5-year rate we were offered by ATB.
Newbie
Feb 27, 2007
33 posts
bjserink wrote: I think what you're proposing is using a LOC on the new home to pay the down-payment on the condo buy-back, and then claiming the interest on this LOC as well as the condo mortgage interest. I've done a lot of research on this subject but have not been able to determine whether or not you are allowed to deduct for a loan used for the down-payment of a rental property. It seems to me that you should be able to, but I couldn't find any case studies or anything to support this, nor to contradict it.

Using the squid maneuver is not evading taxes, it's considered restructuring your ownership of assets in order to meet the direct use test. This restructuring is clearly allowed according to bulletin IT533. This bulletin also explains the direct use test in more detail and gives some examples. It is this test that determines the deductibility of the interest payments on a loan, and when you apply it to your situation it seems like the direct use of the additional money borrowed from the condo's LOC is being applied toward your own personal home and thus does not qualify. Even if you withdraw the funds before the conversion and hold them in a savings account, they will still be traced to the what they get used for in the end (read the section of the bulletin on tracing/linking borrowed money). Of course, doing this early withdrawl strategy might make it harder for an auditor to catch you.

Look at it this way: you're not trying to intentionally cheat the tax system; it's fair and reasonable that you should be able to have the full equity of your condo in a tax deductible mortgage. A court judge would probably side with you, or at least wouldn't punish you for trying to claim interest that you shouldn't have been. The worst that can happen is that they'll audit you and make you pay the income tax on the amount that should have been taxable. If it's going to cost you $500 to buy the 50% share of the condo from your spouse, the squid maneuver might not save you a whole lot of money, especially because its cost is all up-front while the benefit of the tax deduction is spread out over a long time.

Me, I only paid $375 to my real estate lawyer to have her process the condo's sale (to my spouse) and register the mortgage. She did the contract for free because we also used her to purchase the house.

I'm not trying to persuade you one way or the other, just share with you my experience and research on this issue. The choice is yours.
Hi bjserink,

Yes, you interpreted my previous post correctly.
And thanks for the link to that bulletin. It's interesting how I saw myself convincing that I can deduct interest from income when I read certain sections of the bulletin and then again reading something else in that bulletin I feel I cannot.

So given this, I have decided to simply atleast move the money that I overpaid into the LOC in last 3-4 months, since moving the mortgage from a back into this LOC in another bank, into a savings account.

I will then use these savings account proceeds plus whatever else that will remain in the LOC for downpayment of the new house and claim interest deduction on the now converted condo.

End of the day, when I saw how much interest amount I am claiming, it is not much, if they come back in future and tell me, no you cannot do it. It is not worth the hassle for me to do any ownership structuring , if not needed. I guess, I can do this ownership re-structuring in the future as well, to continue claiming interest deduction from that point forward. It's not like I am doing all this on purpose, the rules are so complex for a common man to understand. Here I am making investments to have affordable rentals available in the market and they better not think I am doing something wrong.
Banned
Jun 16, 2009
19 posts
Toronto
I want to designate my principal residence as a rental property, and plan to file a 'change in use' with the CRA. As a result, if I took money off my HELOC as a down-payment on my new (personal) property, and then filed a change in use, could I still claim the mortgage interest as a deduction?

My reasoning is this: when you have a change in use, you have technically sold and then bought back the unit. Thus, when I bought back the unit, I would have used the money from the HELOC to buy my investment property.


Does this make sense? Is this not the same as the Squid method?
Newbie
Jul 28, 2009
5 posts
Lethbridge
jbainton,
I am in the same situation right now and am planning on doing the squid maneuver. It is my understanding that when there is a change of use the 'deemed sale' is for capital gains calculations only. It is not a technical sale and repurchase. Therefore using your HELOC for the down payment on your new house will not pass the Direct Use Test mentioned in IT-533.
The squid maneuver follows IT-533 para.15 http://www.cra-arc.gc.ca/E/pub/tp/it533/it533-e.html
[QUOTE]A taxpayer may restructure borrowings and the
ownership of assets to meet the direct use test.[/QUOTE]
Newbie
Feb 27, 2007
33 posts
comeleon99 wrote: jbainton,
I am in the same situation right now and am planning on doing the squid maneuver. It is my understanding that when there is a change of use the 'deemed sale' is for capital gains calculations only. It is not a technical sale and repurchase. Therefore using your HELOC for the down payment on your new house will not pass the Direct Use Test mentioned in IT-533.
The squid maneuver follows IT-533 para.15 http://www.cra-arc.gc.ca/E/pub/tp/it533/it533-e.html
Can someone explain to me how to do this so called squid maneuver/restructure borrowings and the ownership of assets to meet the direct use test, in my case.

Condo is jointly owned with my wife. Principle use right now, will convert to investment a month from now, at which time a new house becomes the principle residence. Condo mortgage is a full HELOC. Planning to fully withdraw from it(80% of assessed value by bank).

If I sell my 50% share to wife while it is still principle residence, do we have to show as if she gave me money to buy my share ?
Also, if later I take a loan to buy back the condo from her fully on my name, do we have to show transfer of funds ?
I am in Ontario, so transactions between spouses do not involve LTT, only lawyers fee, which comes to $500 for each such sale.
Banned
Jun 16, 2009
19 posts
Toronto
Does anyone know if it is possible to avoid the LTT in Ontario if I am the only one on the title?
Newbie
Jul 28, 2009
5 posts
Lethbridge
merimarzi wrote: If I sell my 50% share to wife while it is still principle residence, do we have to show as if she gave me money to buy my share ?
Also, if later I take a loan to buy back the condo from her fully on my name, do we have to show transfer of funds ?
I think you could gift your share to your wife, but when you buy it back you need to show a transfer of funds so that when/if CRA audits you they can follow the money directly to the rental, for the purpose of earning income.
My accountant counseled me to sell and repurchase from a third party since the transaction with the spouse is not arms-length, though if the transaction is at Fair Market Value you should be okay.
Banned
Jun 16, 2009
19 posts
Toronto
comeleon99 wrote: I think you could gift your share to your wife, but when you buy it back you need to show a transfer of funds so that when/if CRA audits you they can follow the money directly to the rental, for the purpose of earning income.
My accountant counseled me to sell and repurchase from a third party since the transaction with the spouse is not arms-length, though if the transaction is at Fair Market Value you should be okay.
This would be easy to do in Alberta, but in Ontario (and Toronto specifically), you will get hit with 4 x LTT. So, on a $180,000 property, it would work out to $6,000 in land transfer taxes alone.

I spoke with my accountant, and he recommended that I just take the interest on the portion which I have never paid off of my HELOC. It may not be everything, but at least it is a decent portion for me to make it worth it. He said it is basically the same thing as if you assumed a mortgage...just keep paying it down. So...that is my plan.
Newbie
Feb 27, 2007
33 posts
jbainton wrote: This would be easy to do in Alberta, but in Ontario (and Toronto specifically), you will get hit with 4 x LTT. So, on a $180,000 property, it would work out to $6,000 in land transfer taxes alone.

I spoke with my accountant, and he recommended that I just take the interest on the portion which I have never paid off of my HELOC. It may not be everything, but at least it is a decent portion for me to make it worth it. He said it is basically the same thing as if you assumed a mortgage...just keep paying it down. So...that is my plan.
Yes, I am in Toronto, so doing this sale and re-purchase with a third-party and paying LTT is just not worth it. The amount of taxes I have to pay if I were told this interest deduction is not allowed, would be less than LTT !!

I did not quite get what you meant by....
I spoke with my accountant, and he recommended that I just take the interest on the portion which I have never paid off of my HELOC. It may not be everything, but at least it is a decent portion for me to make it worth it. He said it is basically the same thing as if you assumed a mortgage...just keep paying it down. So...that is my plan.
So is he saying if you transferred your mortgage from one bank to another and at the new bank it was a full HELOC, then take interest deduction on the amount at the time of transfer and not anything above that ?

Also, why would you keep paying down a mortgage on an investement property if you had funds and had still a mortgage on a principle residence, which is interest non-deductible.
Banned
Jun 16, 2009
19 posts
Toronto
merimarzi wrote: So is he saying if you transferred your mortgage from one bank to another and at the new bank it was a full HELOC, then take interest deduction on the amount at the time of transfer and not anything above that ?

Also, why would you keep paying down a mortgage on an investement property if you had funds and had still a mortgage on a principle residence, which is interest non-deductible.

He is saying that the lowest amount that I paid it down to, I can claim interest on it. That money has always been 'funding' that purchase. This is similar to if you had a mortgage and were making regular payments and then decided to turn it into a rental - the interest payments would become deductible on anything you had not paid off. The same situation is being applied here.

For example, say I have a $150k HELOC, and the lowest level it ever got to was exactly $100k, then I could claim basically the interest on the $100k.


With regards to your second question, I understand that you have to show that the interest is decreasing overtime (similar to a mortgage). I plan on taking that deductible amount above and making a monthly payment equivalent to my interest rate (on the HELOC) and a 25yr amortization.
Newbie
Sep 6, 2006
12 posts
Would this scenario meet the CRAs requirements for a tax deductible Mortgage.

1. Pay off Mortgage on Principal Residence
2. Take HELOC on Principal Residence. Use this for 20% Downpayment on Rental Property.
3. Take HELOC on Rental Property for 80%

Both HELOCs should now be tax deductible?
Member
Aug 16, 2004
365 posts
82 upvotes
2. Take HELOC on Principal Residence. Use this for 20% Downpayment on Rental Property.
I have not been able to confirm if money borrowed for downpayment of a rental property is tax deductible or not. This was asked previously in this thread but has not really been answered.
3. Take HELOC on Rental Property for 80%
And use it for what? It doesn't matter what you use to secure the loan, the only thing relevant to tax-deductibility is the direct use of the borrowed money. If you use it to purchase another rental property, then yes. If you use it for your own personal property, then no.

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