PRE on Property

Client bought property in late Oct 2020. There are 1 House used as client’s principal residence and 1 “cottage” rented from Jan1, 2021.
Both buildings are on the same property almost next to each other.
Purchase contract indicates 2 separate buildings on the land, with the total purchase cost.
As per local regulations, neither buildings could be separated and must remain as one property.
Each building has a FMV from Jan, 2021 from insurance issuer.
“Cottage” was never occupied by client and always producing rental income.
Considering the facts, could the “cottage” qualify as part of principal residence, with FMV deemed disposition on Sch 3 and filing 45(2).

Off the top of my head, I would think you could designate the cottage as a PR. The def’n of a principal residence in the Act talks about a dwelling and the subadjacent land but the main focus is on the dwelling. That would be either the cottage or the other building. Obviously, the other building doesn’t meet the def’n but the cottage should, from what you’ve described (as long as all other requirements are met).

Income Tax Folio S1-F3-C:

2.10 Another requirement is that the housing unit must be ordinarily inhabited in the year by the taxpayer or by his or her spouse or common-law partner, former spouse or common-law partner, or child.

So no, you can’t.

Sorry, I was reading too fast and missed the part where you said the client never lived in the property. @Rein is correct.

Just to be clear, the client lived in the “main house” from the beginning and still does.
The “cottage” is the rental unit and never occupied/inhabited by client.
But yes, “the unit ordinarily inhabited” criteria seems to indicate @Rein would be correct.

Bottom line is that the dwelling that was not rented is ok, as long as the client stayed there at some point each year (obviously not just a day trip).

Thanks Kevin, and yes client always occupied the “not rented dwelling” and still does.

I think there is more to it that needs to be considered. Legally, both buildings are on the same property/land, and depending on the size of both building, if they are equal in sizes, let say 50% each. CRA’s definition of “principally” is more than 50%, then the principal residence definition will not be met for the entire property, even if the owner lives in one of the building.

I find a lot of home owners, tried to claim as much expenses as possible, and never considered claiming more than 50% of the expenses, especially related to mortgages, might cause problem.

Partial change in use, maybe an option, but CRA might still deemed the entire property as income producing, not principal resident

The main building/home occupied by client is 1675 sq.f.
Stand alone, Rental unit is 1040 sq.f.
I think this would satisfy the principal residence criteria for the client’s home.

This property has not yet been sold, correct?

The property was purchased in 2020, with the house being occupied by the owner as their principal residence and a smaller structure (cottage) that has been rented out commencing in January 2021.
Up to this point there is no possibility of being able to sever the property into 2 separate lots, each with a dwelling.

I don’t see this as much different than renting out a portion of your house, renting out your detached garage, or an apartment on top of your garage (provided the rental space is under 50% usage as @jyliucpa has pointed out).

At the end of the day, it’s quite possible the entire property would be considered principal residence when eventually sold provided the rental portion is ancillary to the main use of the property, which is personal enjoyment.

I don’t think you need to complete the subsection 45(2) election for change of use. You would do that if the entire property was being changed from personal use to rental property. The election goes on a property by property basis, not an asset by asset (on the property) basis.

Firstly, thank you for your input @snoplowguy.
No the property was not sold and from her info , she doesn’t “intend” to sell anytime soon.
As you mentioned the fact the property cannot be severed had me wondering from the start.
It’s not as if she could draw a line between the 2 buildings and declare it severed.
The municipal taxes is one bill on the entire property. The sales’ contract is for the entire property with a paragraph describing “main/principal house and secondary dwelling”.
The rental unit’s square footage compared to her main dwelling would be apprx. 38% of total inhabited property.
So basically, a Sch3 to reflect the “deemed disposition” and change-of-use for the rental portion would be adequate ? (checking the “principal residence” option box).

Unless I misunderstand something, I think the only requirement is to file the T776 Rental Statement. I don’t see anything to be done with the Schedule 3 at this point as I don’t see a “deemed disposition” or a change of use. The schedule 3 would be completed when the property is sold.

Lets imagine for a moment you purchased a home that had an apartment in the basement. You lived upstairs and rented out downstairs. There is no deemed disposition or change of use to report unless you move out of the house or sell the house. I don’t see this situation as being too much different except the apartment is in a separate building.

Make sure no Capital Cost Allowance is claimed on any of the structures though.

I must have an erroneous interpretation of the following CRA chapter:

# Changing part of your principal residence to a rental or business property or vice versa

Before March 19, 2019, you could not elect to avoid the deemed disposition that occurs on a partial change in the use of a property. However, starting on March 19, 2019, the budget proposes that depending on your situation, you can elect under subsection 45(2) or 45(3) of the Income Tax Act that the deemed disposition that normally arises on a partial change in use of property not apply.

Even if you do not make the election, if you started to use part of your principal residence for rental or business purposes, the CRA usually considers you to have changed the use of that part of your principal residence unless all of the following conditions apply:

** your rental or business use of the property is relatively small in relation to its use as your principal residence*
** you do not make any structural changes to the property to make it more suitable for rental or business purposes*
** you do not deduct any CCA on the part you are using for rental or business purposes*

Generally, if you do not meet all of the above conditions, you will have a deemed disposition of the portion of property that had the change of use, and immediately after, you will be deemed to have reacquired that portion of property. The proceeds of disposition and the cost of the reacquisition will be equal to the proportionate share of the FMV of the property, determined at that time. Additionally, in the year the partial change in use occurs, you can make a principal residence designation (for the portion of the property that had the change in use), by completing page 2 of Schedule 3, Capital Gains (or Losses) and page 1 of Form T2091 (IND), Designation of a Property as a Principal Residence by an Individual (Other Than a Personal Trust).

I can’t honestly say that the rental portion of the property is “small”.
As for CCA on structures … that would not happen …

A lot of the time, we, as practitioner, don’t make determination of any kind. Based on the size concern that you are asking. There is no definition of “Small” in the income tax act under the principal residence section. And even the 50% threshold, it’s not stated in the ITA, it’s just what we know CRA’s view on “principally”.

But there are other things that might need to consider to, if CRA questions it, that’s if your client is living there with a spouse only, there is obvious no need to have the other cottage, then it may not even qualifies as principal residence

If you choose to make that Election @taxwave then you will certainly be calculating a capital gain on the rental portion of the property when the property is eventually sold. That election isn’t to treat the entire property as principal residence, that election functions to “defer” the capital gain that occurs on a change of use. The election would be confirming change of use from personal to rental and essentially validate the rental part of the property is not small in relation to it’s use as a principal residence.

If there is no deemed disposition then there is no need to file the election.

There is an exception available from these deemed disposition rules when the following three 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.
  • No capital cost allowance (CCA) is claimed on the property.

“Ancillary” isn’t a defined term in the ITA but is generally interpreted to mean “subordinate” or “secondary” to the primary purpose. A bright-line test hasn’t been defined in terms of a specific percentage or threshold to determine if the income-producing use is secondary to the primary use as a residence. The CRA reviews the facts in each case to determine if this condition is met.

I guess my interpretation could be in fact, somewhat “near-sighted”. Maybe over-thinking the scenario.
But your explanation makes a lot of sense to me … I value the knowledge and foresight.
The ability to look at situation from a different angle … which at times escapes us.
I definitely appreciate your time spent on the post.

I think I would approach it in the same way as @snoplowguy. The reason why the ITA expanded the definition of s45(2) to include partial change in use was for people with duplexes and triplexes where the rental use was clearly not ancillary.

Don’t ever take CCA on the rental portion. And also consider the portion of land allocated to each building when you are determining whether the cottage is considered “ancillary”.

I see it more of a trend now, in Vancouver, people are buying a houses less than half a hectare, and turn them into duplex, laneway houses, triplex or even fourplex, legally, it’s still one property, and the owner still lives in one of the unit, but the intent, is clearly for rental income with those housing structure , the principal residence exemption is really questionable for those.