How to Optimize Savings When Transforming a Primary Home into a Rental Property 

When you decide to rent out your main home, it’s crucial to understand the tax and interest implications that come with it. Even though you’ve transitioned your primary residence into a rental property, you can still claim deductions on your mortgage and home equity line of credit interest. Here’s a deeper dive into the process. 

A Practical Scenario: Consider Jenny, who owns a house in The greater toronto area valued at $1,000,000 with a mortgage of $400,000. She’s looking to relocate to a more spacious house in the suburbs but wishes to retain and lease her The greater toronto area property. To make a down payment on her new home, she secures a home equity line of credit against her The greater toronto area property for $200,000. Without seeking advice from her accountant, Jenny deducts the interest from both her $400,000 mortgage and the $200,000 home equity line of credit. However, during an audit, the Canada Revenue Agency (CRA) rejects her interest deduction. This is because neither loan was intended for income-generating investments. 

According to CRA’s tracing rule, the purpose of borrowed funds must be directly linked to its original use to determine if the interest is tax-deductible. In Jenny’s case, her $400,000 mortgage was initially for her primary residence, and the $200,000 home equity line was solely for her new suburban home. Neither of these purposes relates to real estate income, rendering the interest on these loans non-deductible. 

How to Make Mortgage Interest and Home Equity Line of Credit Tax Deductible: If Jenny had consulted her accountant, she would have taken the following six steps to make her interest payments tax-deductible: 

• Jenny sells her The greater toronto area property to her parents at its market value of $1,000,000. 
• In return, her parents sign a promissory note for $600,000 payable to Jenny and take over her $400,000 mortgage. 
• Jenny then agrees to repurchase the The greater Toronto area property from her parents for $1,000,000, securing a $600,000 mortgage from her bank for this acquisition. 
• On closing, Jenny’s parents receive $600,000 from her. They use $400,000 to settle their mortgage, and the remaining $200,000 is returned to Jenny as a partial repayment of the promissory note. 
• The promissory notes between Jenny and her parents are squared off and nullified. 
• Jenny then rents out her The greater Toronto area property. The interest on her new $600,000 mortgage becomes tax-deductible since the funds were used to buy a rental property (her previous The greater Toronto area home). She uses the spare $200,000 for the down payment on her new primary residence. 

Key Takeaway: If you’re considering converting your primary home into a rental property, it’s essential to strategize effectively to maximize interest deductions on your mortgage for tax purposes. Additionally, familiarize yourself with the nuances of preparing a tax return for rental properties.