2016-0673231E5 Principal residence exemption and secondary suites

Principal Issues: Clarification on the factors used to determine if the CRA’s administrative policy for not having the change-in-use rules under paragraph 45(1)(c) apply.

Position: A partial change in use of the taxpayer’s principal residence technically occurs for income tax purposes under paragraph 45(1)(c) unless the administrative position in Income Tax Folio S1-F3-C2, Principal Residence, applies.

Reasons: The law and the CRA’s administrative position in Income Tax Folio S1-F3-C2, "Principal Residence".

Author: Posadovsky, Tom
Section: 45(1)(c)

XXXXXXXXXX                                                                                                                                   2016-067323
                                                                                                                                                           T. Posadovsky

February 28, 2017

Dear XXXXXXXXXX

Re:   Principal Residence Exemption and Secondary Suites

We are writing in response to your email of October 25, 2016, wherein you requested our views on the application of the “change-in-use rules” in paragraph 45(1)(c) of the Income Tax Act (the “Act”).  We apologize for the delay in our response.

In your email, you asked whether a housing unit owned by an individual will qualify as the individual’s principal residence for the purposes of the principal residence exemption where a portion of that housing unit is used to earn rental income.  In particular, you want us to clarify the Canada Revenue Agency’s (“CRA’s”) interpretation of “ancillary” and “structural change” in the context of the partial change-in-use rules.

Our Comments

This technical interpretation provides general comments about the provisions of the Act and related legislation (where referenced).  It does not confirm the income tax treatment of a particular situation involving a specific taxpayer but is intended to assist you in making that determination.  The income tax treatment of a particular transaction proposed by a specific taxpayer will only be confirmed by this Directorate in the context of an advance income tax ruling request submitted in the manner set out in Information Circular IC 70-6R7, Advance Income Tax Rulings and Technical Interpretations.

The CRA’s general views on claiming the principal residence exemption are set out in Income Tax Folio S1-F3-C2, Principal Residence.  If a property qualifies as a taxpayer’s principal residence, an exemption can be claimed under paragraph 40(2)(b) of the Act to reduce or eliminate any capital gain otherwise realized on the disposition of the property.  The term “principal residence” is defined in section 54 of the Act.  Generally, in order for a housing unit owned by a taxpayer to qualify as the taxpayer’s principal residence for a taxation year, it must be demonstrated, among other things, that the housing unit was ordinarily inhabited in the year by the taxpayer, the taxpayer’s spouse or common-law partner, former spouse or common-law partner, or child of the taxpayer.

Where a taxpayer has converted a part of his or her principal residence to an income-producing use, paragraph 45(1)(c) of the Act deems a disposition (and reacquisition) of that part of the property to have taken place (such portion is usually calculated on the basis of the area involved) for proceeds equal to its proportionate share of the property’s fair market value.  However, it is the CRA’s practice not to apply the change-in-use rules in these circumstances where all of the following conditions are met:

a)    the income-producing use is ancillary to the main use of the property as a residence;
b)    there is no structural change to the property to make it more suitable for rental or business purposes; and
c)    no capital cost allowance (CCA) is claimed on the property.

These conditions could be met, for example, where a taxpayer carries on a business of caring for children in the home, rents one or more rooms in the home, or has an office or other work space in the home which is used in connection with business or employment.

Ancillary use

The CRA’s above-described administrative practice not to apply the change-in-use rules depends, in part, on whether the income producing use is ancillary to the main use of the property as the taxpayer’s principal residence.  The term “ancillary” is not defined in the Act; however, the CRA generally interprets ancillary as being subordinate or secondary to a more important or primary purpose.  There is no specific percentage or threshold which may be used in determining whether the particular change in use of a particular property is ancillary to the use of the property as the taxpayer’s principal residence.  This can only be determined by a review of the particular facts and circumstances in each case.

Structural change

The CRA will also look at whether there have been any structural changes to make the property more suitable for rental or business purposes.  Generally speaking, such changes must be of a more permanent nature, such as the installation of a separate entry or kitchen, or an addition or reconfiguration of space by adding, moving or removing walls.  Determining whether there has been a structural change to the property to make it more suitable for rental or business purposes requires a review of all the particular facts and circumstances in each case.  However, the conversion of a portion of a taxpayer’s principal residence into a separate, self-contained domestic establishment (housing unit) to be used for earning rental income will generally result in the application of the change-in-use rules (i.e., the CRA’s administrative policy described above would likely not apply).

We trust these comments will be of assistance to you.

Sincerely,

Michael Cooke, CPA, CA
Manager
Business Income and Capital Transactions Section
Business and Employment Division
Income Tax Rulings Directorate

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