Principal Issues: [TaxInterpretations translation] (1) What are the CRA's criteria for determining the FMV of rent?
(2) Can rental losses realized while the property is rented to related persons be deducted?
(3) What will be the tax treatment of any rental income earned while the property is rented to both co-owners? What about rental income earned when the property is rented to unrelated persons?
(4) In view of the co-ownership agreement, can all rental losses be deducted and must all rental income be taxed?
Position: Source of income, general comments, question of fact
Reasons: Income Tax Act
XXXXXXXXXX 2009-032716 Anne Dagenais April 12, 2010
Dear Madam,
Subject: Rental income
This is further to your letter of May 25, 2009, in which you made various requests for information regarding rental income.
Unless otherwise indicated, all legislative references herein are to the provisions of the Income Tax Act (the "Act").
More specifically, a taxpayer acquired a property jointly with her stepfather and mother, who appeared on the notarized contract for mortgage financing purposes. Immediately following the acquisition of the property, the three co-owners signed an agreement to modify their undivided share in the property. Following this agreement, the taxpayer's undivided share changed to 98%, and to 1% for each of the other co-owners.
Since acquiring the property, the taxpayer has been renting the property to both co-owners and generating a rental loss. You wish to obtain answers to the following questions:
(1) What are the Canada Revenue Agency's ("CRA") criteria for determining a fair market value ("FMV") rent?
(2) Can the taxpayer deduct rental losses realized while the property is leased to related persons?
(3) What will be the tax treatment of any rental income earned while the property is rented to both co-owners? What about rental income earned when the property is rented to unrelated persons?
(4) In light of the co-ownership agreement, you wish to know whether the taxpayer could deduct all of the rental losses and whether the taxpayer should be taxed on all of the rental income.
Our Comments
It appears to us that the situation described in your letter and summarized above could constitute an actual situation involving taxpayers. As explained in Information Circular 70-6R5, it is not the practice of this Directorate to provide comments on proposed transactions involving specific taxpayers otherwise than in the form of an advance income tax ruling. If your situation involved specific taxpayers and one or more transactions, you should submit all relevant facts and documentation to the appropriate Tax Services Office (“TSO”) for its opinion. However, we can offer the following general comments that may be helpful.
Rental income
The tax treatment of rental losses and rental income relates to the existence of a source of income.
For particular activities to be a source of income, a two-stage analysis is required:
(1) Is the activity of the taxpayer undertaken in pursuit of profit, or is it a personal endeavour?
(2) If it is not a personal endeavour, is the source of the income a business or property?
Where the nature of a taxpayer's activities has aspects indicating that they could be considered a hobby or other personal activity, such activities will not be considered a source of income unless they are carried on in a sufficiently commercial manner. For an activity to qualify as commercial in nature, the taxpayer must have a subjective intention to make a profit and there must be evidence of serious business conduct supporting that intention. You will recognize that the determination of the existence of a source of income is a question of fact that can only be resolved in light of all relevant circumstances.
Guide T4036, Rental Income 2009, states that if a taxpayer rents property to a family member for less than the rent that would be charged to another tenant, resulting in a rental loss, the taxpayer cannot deduct that loss.
Furthermore, if rental expenses are always higher than rental income, rental losses may not be deductible because the rental activities would not be considered a source of income. However, if the rent is the same as what you would charge another tenant, you can claim a rental loss if you reasonably expect to make a profit.
Counter-letter
In Quebec law, as a general rule, the owner of a property is the person in whose name the property is registered. In this case, the property was registered in the name of the taxpayer and her parents, each of whom held 33.33% of the property. On the face of it, if there is a source of income, the taxpayer will have to include in the calculation of her rental income the income derived from renting her interest in the house. Thereafter, the taxpayer will only be able to deduct expenses relating to the rented space. This involves allocating the expenses incurred for the entire building between expenses for the rented portion and expenses for the personal portion of the building.
Furthermore, it is important to note that if, in reality, expenses represent a sharing of costs, it will not be possible to deduct rental losses in this regard. For the parents who are co-owners, they will not be able to deduct the expenses related to their undivided share, i.e. 66.66%, during the time they live in the immovable.
However, it is possible that the parties may attempt to modify the apparent contract - the notarial deed - between themselves by means of a counter-letter. According to Article 1451 of the Civil Code of Québec, simulation exists where the parties agree to express their true intent, not in an apparent contract, but in a secret contract, also called a counter letter. Between the parties, a counter letter prevails over an apparent contract. It is necessary to clarify that a counter letter may take the form of either a written or an oral contract.
With respect to the issue of the enforceability of a counter letter against a taxing authority, the Federal Court of Appeal held that, in its role as assessor, the taxing authority (in this case, the CRA) must satisfy itself of the true legal relationship between the parties and assess accordingly. Thus, before deciding whether to agree to be bound by a counter-letter, the CRA should consider all the facts, including whether the party wishing to transfer its interest has acted as a beneficial co-owner or whether the transferee should be considered to be the sole owner since the original acquisition date.
In this case, if a counter letter exists between the taxpayer and her parents, the CRA will have to determine whether she agreed to be bound by that counter letter. This determination is a factual one that will engage a determination, among other things, as to whether the taxpayer has acted as the sole owner of the property since the date of original acquisition.
If the CRA agrees to be bound by this counter letter and there is a source of income, the taxpayer will have to include the income from the rental of her interest in the house. In effect, the taxpayer would be deemed to have rented her 98% undivided interest. Thereafter, the taxpayer will only be able to deduct the expenses relating to the rented space.
These comments do not constitute an advance income tax ruling and are not binding on the CRA in respect of any particular factual situation.
We hope that the above comments will be of assistance.
Best regards
François Bordeleau, Advocate
Manager
Business and Partnerships Section
Income Tax Rulings Directorate.