Laneway homes have become very popular in the lower mainland to supplement the cost of living, or to help look after aging parents or assist adult children. But there has been very little information with respect to the income tax implications of these homes. One of the biggest tax breaks for Canadian residents is the principal residence exemption.
For example, if you bought a home 10 years ago for $500,000, used it as your principal residence and designated it as such for income tax purposes throughout that time, and sell it today for $1.2 million, that $700,000 gain is tax free.
The main distinction for income tax purposes between building and renting a self-contained laneway house – versus renting out a suit in your home – is that the laneway house, and the land it is situated on, will commence to be considered a separate housing unit that is not part of your original principal residence, and unless the laneway house is subsequently occupied by your or your child, it may not be eligible for the principal residence exemption.
It is very important to realize the difference in tax treatment of a basement suite compared to a laneway house. The fact that Canada Revenue Agency (CRA) considers a laneway house as a separate housing unit is the key distinction.
In the year that a laneway house begins to be rented, the owner will realize a disposition for income tax purposes, of the portion of the property used for the laneway house. If the owner is entitled to use the principal residence exemption to shelter gains, there will be no immediate taxes. However, if the owner is not entitled to use the principal residence exemption (i.e. rental property), any gain realized could result in a tax liability for the owner.
When the entire property is eventually sold (or when the owner dies), any gain realized on the laneway house portion will not be eligible for the principal residence exemption.
The owner is required to track all costs associated with building the laneway house, as well as keep records related to the original cost of the property, capital improvements made, the relative value of the land versus the main residence on the date of the deemed disposition and on the date of sale.
While the lure of additional rental income may be appealing, professional tax advice should be sought when contemplating adding to your property.