Principal Issues: [TaxInterpretations translation] Does the principal residence exemption apply to the entire residence of a taxpayer who used part of it for business purposes and rented another part to his son?
Position: Yes
Reasons: Income Tax Technical News No. 25, "Reasonable Expectation of Profit", paragraphs 30 to 32 of Interpretation Bulletin IT-120R6 and the definition of principal residence in section 54.
January 7, 2004
XXXXXXXXXX Tax Services Office Headquarters
Desk Review Lucie Vermette, CGA
(613) 957-2092
Attention: XXXXXXXXXX
2003-003821Principal residence exemption
This is in response to your email of September 10, 2003 and your fax of October 28, 2003, in which you requested our opinion on the above subject. We have also considered the comments of the taxpayer's representative which we received on June 10, 2003.
FACTS
A taxpayer constructed a housing unit for his son and his son's spouse on the second floor of his personal residence. To do so, he incurred an amount of $XXXXXXXXXX which was capitalized to the cost of the house. He reported the income from the rent paid by his son and claimed XXXXXXXXXX% of the expenses of the house against that income. The taxpayer incurred rental losses of several hundred dollars over the years.
The taxpayer also used part of the basement of his residence for business purposes. He reported income and claimed expenses related to a business of XXXXXXXXXX. He claimed XXXXXXXXXX% of the property taxes and house insurance and XXXXXXXXXX% of the electricity expense. The taxpayer has always reported a profit on this business except in one year when he incurred a loss.
The taxpayer did not claim any depreciation expenses in respect of the residence.
The sale of the house took place in XXXXXXXXXX for $XXXXXXXXXX while the adjusted cost base was $XXXXXXXXXX.
QUESTION
You wish to know whether the taxpayer's entire residence qualifies as a principal residence for the purposes of the principal residence exemption in order to exempt the gain on the sale from tax.
OUR COMMENTS
Paragraph 45(1)(c) of the Income Tax Act (the "Act") provides, inter alia, that a taxpayer who partially converts a principal residence into an income-producing property is deemed to have disposed of the proportion of the property so converted for proceeds equal to its fair market value and to have immediately thereafter reacquired that proportion at a cost equal to that same amount. Any gain from the deemed disposition is usually eliminated by the principal residence exemption. The subsequent disposition of the entire property after the first change in use may result in a taxable capital gain relating to the period during which that proportion of the property was used to earn income.
Paragraph 32 of IT-120R6 states that the deemed disposition rule (described above) is not applied if:
- the income-producing use is ancillary to the main use of the property as a residence;
- there is no structural change to the property; and
- no CCA is claimed on the property.
For the purposes of this letter, we will deal first with the rented portion of the house and then with the portion used for the taxpayer's XXXXXXXXXX business.
Rented Portion
First, in the present situation, the question is whether there has been a partial change of use of the upper floor of the principal residence to an income-producing property such that paragraph 45(1)(c) applies.
Based on the approach described for the concept of "reasonable expectation of profit" in Income Tax Technical News No. 25, we are of the view that the rental activity carried on by the taxpayer has a personal aspect since he rents out a portion of his residence to his son and the rent charged is approximately equivalent to the expenses related to that portion of the house. Where there is a personal aspect to an activity, in order to consider the activity as a source of income, it must be shown that the taxpayer was carrying on the activity in a sufficiently commercial manner to conclude that he converted part of his principal residence for the purpose of using that part to earn income. This may be difficult to demonstrate in this case and, in our view, paragraph 45(1)(c) is not applicable. Paragraphs 30 to 32 of IT-120R6 are therefore not relevant in the circumstances. This portion of the house, rented to the taxpayer's son, can therefore benefit from the principal residence exemption since it is considered to still be an integral part of the taxpayer's principal residence.
Portion used for the business
In light of the above approach set out in Income Tax Technical News No. 25, the activity carried out by the taxpayer in a portion of the basement of his residence does not appear to be a personal endeavour or a hobby. It appears to us to be conducted in a sufficiently commercial manner to consider that the taxpayer is using that part of his residence for the purpose of earning income. Consequently, paragraph 45(1)(c) could apply. There could therefore have been a deemed disposition of that portion of the residence at the time this activity began. However, in reviewing the three conditions that must be satisfied in paragraph 32 of IT-120R6 to avoid the application of this deemed disposition, and based on the information you submitted to us, we have concluded that the taxpayer satisfies all of these conditions. Indeed, the house is used principally as a principal residence (more than 50%) and its use to produce income is only ancillary, there was no structural change for the purposes of XXXXXXXXXX's business and no capital cost allowance was claimed for that portion of the house. Consequently, the taxpayer, in our view, does not lose access to the principal residence exemption for that portion of the house.
Conclusion
According to the information submitted to us, we are of the view that the taxpayer's entire residence is eligible for the principal residence exemption.
Furthermore, as discussed, we confirm that in the context of this technical interpretation we are not expressing an opinion on the proceeds of disposition of the residence which, following an examination of certain documents you sent us relating to the sale, appears to us to be an element that could be the subject of a more in-depth verification.
For your information, unless exempted, a copy of this memorandum will be severed using the Access to Information Act criteria and placed in the Canada Revenue Agency's library. A severed copy will also be distributed to the commercial tax publishers for inclusion in their databases. The severing process will remove all material that is not subject to disclosure, including information that could disclose the identity of the taxpayer. Should your client request a copy of this memorandum, the CRA library version can be provided. Alternatively, the client may request a severed copy using the Privacy Act criteria, which does not remove client identity. Requests for this latter version should be made by you to Ms. Jackie Page at (819) 994-2898. A copy that has been severed in accordance with the Privacy Act will be sent to you for delivery to the client.
Should you require further information on this subject, please do not hesitate to contact us.
Best regards,
Ghislaine Landry, CGA
Manager
Individuals, Business and Partnerships Section
Business and Partnerships Division
Income Tax Rulings Directorate
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