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tax matters

Maybe you've heard of the condition. I'm talking about "Empty Nest Syndrome." My wife Carolyn has a pretty bad case of it. "Our little boy isn't a little boy anymore; he's off to school on his own now. He doesn't need me anymore," she said sadly. When she says "he's off to school on his own now," she means that she no longer drives him to school in the morning. He take the school bus with the other kids. "Carolyn, relax. He'll be home at 3 o'clock today."

I'll never suffer the syndrome like some others do. One woman e-mailed me this week and said she's dealing with the issue by renting part of her home to students this fall. Renting out part of your principal residence is a great way to earn some extra income and enjoy the company of others all at the same time. Let's look at what this means from a tax point of view.

1. Partial use to earn income

The taxman has no problem if you want to use your home partly to earn income, and partly as a residence. You can still call the entire property your principal residence if you play your cards right. This is important if you hope to sell the property on a tax-free basis later. As long as you meet the following three tests you'll be able to continue designating the entire property as your principal residence:

1: the partial use of the residence for income-producing purposes is ancillary to the main use as a residence (i.e. beware of renting out more than half of the property);

2: there is no structural change to the property, and

3: capital cost allowance (CCA) – that is, depreciation for tax purposes – has not been claimed on the property.

If you fail to meet these tests, CRA may consider all or part of your property ineligible for the principal residence exemption and you could pay some tax on a sale of the home later.

2. Change in use

If you're considered to have changed the use of your property (or part thereof) from a personal-use property to an income-producing property, or the other way around, you're deemed to have sold the property, and to have reacquired it, at fair market value at the time of the change in use. So, if the property has appreciated in value, there could be some tax to pay on the change in use. A change in use can also take place when a property is simply used more (or less) for income-producing purposes than in the past. If you're converting your principal residence fully or partially to an income-producing property, the deemed disposition from the change in use could result in a capital gain, which may be eliminated or reduced by use of your principal residence exemption. In addition, it's possible to file a special "no change in use" election with the CRA in which case a change in use will be deemed not to have occurred – but the rules are complex, so visit a tax pro to talk about it.

3. Reporting income

If you earn rental income, you're generally required to report it on your tax return. You should use Form T776 for this purpose and file it with your tax return. If you're renting all or part of your home at a rate less than fair market value (perhaps to a family member, for example) and you expect to incur a loss on the rental activity, then you aren't required to report rents and you're not entitled to claim deductions. CRA views this as more of a cost-sharing arrangement, and the taxman doesn't want you claiming losses year after year from this activity (losses, after all, can be applied against other income and will save tax).

4. Deducting expenses

Renting out part of your home is going to entitle you to deductions for costs you're paying for anyway. Deductions can include: A portion of mortgage interest, property taxes, insurance, repairs and maintenance, landscaping, utilities, CCA (depreciation) on fixed assets like furniture, computers, your car, or even your home itself (but this is not generally recommended in most cases since claiming CCA on your residence can jeopardize the principal residence exemption, as I noted above), advertising costs, office expenses, professional fees, management fees, salaries or wages, travel costs, and car expenses, to name the most common deductions. Sorry, but you can't deduct land transfer taxes, mortgage principal, penalties, personal expenses or the cost of your own labour.

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