Principal Issues: 1) Whether a change in use occurs when a taxpayer moves from one unit of a duplex to another unit, which he previously rented, and starts to rent the unit he used to inhabit?
2) Whether a change in use occurs as a result of important renovations made to one unit used for personal purposes, without any corresponding renovations being made to the other unit?
3) In the situation described in 2) whether certain expenses incurred in respect of the whole duplex should, after the renovation, be allocated on the basis of the relative FMV or relative cost of each unit, rather than based on the square meters of each unit?
4) In the situation described in 2), if the taxpayer were to dispose of the duplex, how should the proceeds of disposition be allocated considering the costs incurred for the renovation of one unit and the increase in value attributable to such renovation?
Position: 1) Generally no, if the size of each unit is the same and the proportion of each use (personal and rental) of the duplex remains unchanged.
2) Generally no, unless the renovations are such that the size of the renovated unit is increased.
3) The allocation has to be reasonable considering all the relevant circumstances.
4) None.
Reasons: 1) Wording of paragraphs 45(1)(a) and 45(1)(c), considering that the duplex is one single property.
2) Wording of paragraph 45(1)(c).
3) In accordance with paragraph 18(1)(a), an expense is not deductible except to the extent is was incurred by the taxpayer for the purposes of earning income. The allocation has to be reasonable in the circumstances.
4) The question is based on assumptions which the CRA is unable to verify.
ROUND TABLE ON THE TAXATION OF INDIVIDUALS , FEBRUARY 2, 2017
QUEBEC ORDER OF CPAS
1.4 - Change in use of a duplex
Consider the following hypothetical situation. In 2010, an individual acquires a duplex for $300,000 (being the "building" portion only to simplify the example). The duplex is composed of two units of the same size and having the same characteristics. The individual lives in one of the two units and rents out the other. Thus, half of the acquisition cost, or $150,000, represents the capital cost of the portion of the duplex used to earn rental income, and the other half represents the adjusted cost base of the personal portion of the duplex.
At the beginning of 2016, the individual decides to vacate the previously lived-in unit and to move into the previously-rented unit. As for the unit he had previously lived in, the individual decides to rent it out. Although there is a change in use with respect to each of the two units, taken as a whole, there appears to have been no change in use with respect to the duplex. Indeed, before the owner moved, the duplex (which is a single property according to the current CRA position) was used 50% for the purpose of earning income, and it was still used 50% for the purpose of earning income after the owner’s move. As the percentage is the same, the rules in paragraph 45(1)(c) of the Income Tax Act (the "Act"), respecting a partial change of use, do not appear to apply.
Later in 2016, the individual decides to do significant work on the housing unit he had been living in since the beginning of 2016. This clearly constitutes an expenditure of a capital nature and not just restoring of the unit to its original state. Since the expenditures are not attributable to the rental portion, none of them are capitalized to the rental portion. The amount expended on the purchase of materials for the work done by the individual is $50,000, while the market value of the property increases by $100,000 following the completion of the work, based on an assessment obtained from an independent expert. No additional loan was taken out for the completion of the work. Since the only work carried out on the building is the work done on the part occupied by the individual, it seems reasonable to believe that this increase in value should be attributed in full to the unit occupied by the individual.
Questions to the CRA
(a) When the individual decided to move to another unit at the beginning of 2016, should there be considered to have been a change in use for each unit, which would result in a deemed disposition of 100% of the property in accordance with the rules in subsection 45(1), or should there be a comparison of the duplex's overall percentage utilization for the purpose of earning income before and after the change, in order to determine the percentage change in use?
(b) Does the CRA consider that there is a partial change in use of the duplex as a result of the renovations being completed later in 2016, since the proportion of the market value of the rented unit ($150,000) compared to that of the owner-occupied unit ($250,000) is no longer 50-50, but instead 37.5-62.5? Based on cost, the new proportions would be 43-57 ($150,000 vs. $200,000). However, based on area, the proportions would remain at 50-50.
(c) As a result of the work, the relative proportions between income-earning use and personal use based on the fair market value (or capitalized cost) of each unit are different from the initial 50-50 breakdown (based on areas). Should the individual then change the proportion of certain deductible expenses (such as property taxes that are based on the value of the property) in computing rental income as a result of this change? A new allocation could thus be justifiable for certain expenses (property taxes), but not for others (interest on loans, maintenance expenses for the whole building).
(d) If the duplex is disposed of, does the CRA accept that the building's increase in value is only attributable to the owner-occupied part as a result of the renovation work? Thus, rather than allocatingt the proceeds of disposition on a 50-50 basis as for the cost at the time of purchase, the rental unit should be considered to have a market value of $150,000 and the personal unit a value of $250,000, as a result of renovations done only on the personal unit. The CRA came to this view in technical interpretation 2000-0047535 with respect to a similar situation. Revenu Québec also came to such a conclusion in its response to question 6 of the APFF 2007 Provincial Roundtable.
CRA response to question 1.4(a)
The CRA is of the view that an immovable is normally considered to be a single and sole property unless it is legally subdivided into two or more separate properties. However, paragraph 45(1)(a) applies only in the case of a complete change of use, that is to say, where a taxpayer has acquired property for some other purpose and at a subsequent time begins to use it for the purpose of earning income, or vice versa. In the situation under consideration, paragraph 45(1)(a) therefore does not apply.
Paragraph 45(1)(c) governs situations where, at any time after a taxpayer has acquired property, there has been a change in the relation between the use regularly made by the taxpayer of the property for gaining or producing income and the use regularly made of the property for other purposes.
In the situation under consideration, although each of the units in the building had undergone a change of use at the beginning of 2016 when the individual left the unit he then lived in and settled in the unit that had been previously rented, the relation between the use regularly made by the taxpayer of the property for gaining or producing income and the use regularly made of the property for other purposes had not changed at that time. Therefore, there was no change in use of the property for the purposes of paragraph 45(1)(c) at the beginning of 2016 by reason of the move of the individual.
CRA response to question 1.4(b)
As noted above, paragraph 45(1)(c) governs situations where, at any time after a taxpayer has acquired property, there has been a change in the relation between the use regularly made by the taxpayer of the property for gaining or producing income and the use regularly made of the property for other purposes.
Generally, the CRA is of the view that renovations by a taxpayer to only one of the two units in a situation such as that described would not in itself have the effect of changing the relation between the use regularly made by the taxpayer of the property for gaining or producing income and the use regularly made of the property for other purposes. Our comments would be different if the renovation had the effect of changing the relative area of each unit.
CRA response to question 1.4(c)
Pursuant to paragraph 18(1)(a), an outlay or expense is not deductible in computing the income of a taxpayer from a business or property, except to the extent that it was made or incurred by the taxpayer for the purpose of gaining or producing income from the business or property. Where an expense is incurred in respect of all of a property of which only a part is used for the purpose of gaining or producing income, the expense will be apportioned between the two parts of the property so that only the part of the expense that can reasonably be considered to have been incurred in order to gain or produce income may be deducted. Where a taxpayer rents out part of the property in which the taxpayer lives then,as set out in Guide T4036, Rental Income, the taxpayer may use the leased area or the number of rooms leased in the building to apportion the taxpayer's expenses, provided the allocation is reasonable. It is for each taxpayer to make such an allocation in a reasonable manner in the light of all the circumstances applicable to the taxpayer’s situation.
CRA response to question 1.4(d)
The issue raised is based on the assumption that the increase in value of the duplex between the time it was acquired and the time of the appraisal subsequent to the renovation is entirely attributable to the renovation . It also assumes that the increase in value resulting from the renovation would always be reflected in the fair market value of the duplex at the time of disposition. The CRA is unable to verify these assumptions. Therefore, with the exception of the comments set out above in response to questions 1.4(b) and (c), the CRA cannot comment on the tax consequences of the situation described.
Mélanie Beaulieu
(613) 670-8905
February 2, 2017
2016-067483