Saving on primary residence converted to rental property

When you start renting out your primary residence, it’s important to be aware of the various tax and interest implications. You can still deduct your mortgage and home equity line of credit interest. Continue reading to find out how.

Let’s Look at an Example:

Jenny owns a home in Toronto worth $1,000,000.  She has a mortgage of $400,000. Jenny wants to move to a larger home in the suburbs and would like to keep and rent out her Toronto home. She obtains a home equity line of credit secured against her Toronto home in the amount of $200,000, which she uses to make a down payment on her new primary residence.

Without consulting her accountant, she deducts the interest paid on the $400,000 mortgage and $200,000 home equity line of credit on her Toronto home.  Upon an audit, the Canada Revenue Agency (CRA) disallows the interest deduction because the mortgage and home equity line of credit were never intended to be used for buying income-generating investments.

You see, according to the CRA’s tracing rule, borrowed money must be directly traced to its initial use in order to determine whether interest paid is tax-deductible.  Jenny’s $400,000 mortgage was initially used for her primary residence and her $200,000 Home Equity Line of Credit was solely used to purchase her new primary residence in the suburbs.  Neither of these uses has anything to do with earning income from real estate, which makes the interest paid on these loans non-deductible for tax purposes.

Making a Mortgage Interest and Home Equity Line of Credit Tax Deductible

Had Jenny consulted with her accountant, she would have followed these 6 steps to make the interest paid on her $400,000 mortgage and $200,000 Home Equity Line of Credit tax deductible:

Jenny sells her Toronto home to her parents for market value, $1,000,000. In exchange for receiving the Toronto home, Jenny’s parents enter into a promissory for $600,000  payable to Jenny and assume her mortgage of $400,000. Jenny agrees to buy back the Toronto home from her parents for $1,000,000 and gets a mortgage for $600,000 from her bank to help finance this purchase. Jenny owes her parents the balance of the purchase price, $400,000.

Jenny’s parents receive $600,000 on closing from her.  Of the $600,000 they receive, $400,000 is used to repay their mortgage of $400,000.  The remaining $200,000 is given to Jenny as partial repayment of the $600,000 promissory note owing to her. The promissory notes between Jenny and her parents are offset and extinguished.

Jenny rents out her Toronto home.  The interest she pays on her new $600,000 mortgage is tax-deductible.  This is because she used the mortgage money to purchase a rental property, being her former Toronto home.  Jenny uses the remaining $200,000 that’s now in her pocket to make a down payment on her new primary residence.

So Here’s the Tip:

When changing the use of your primary residence to a rental property, make sure you plan property to be able to deduct the interest paid on your mortgage for tax purposes. Make sure you also know how to properly prepare a tax return for rental properties.

ABOUT THE AUTHOR

ALLAN MADAN

CPA, CA

Allan Madan is a CPA, CA and the founder of Madan Chartered Accountant Professional Corporation. Allan provides valuable tax planning, accounting and income tax preparation services in the Greater Toronto Area.

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