As university students head back to school next month, homeowners may want to
rent out part of their homes to pull in some extra cash. But what if you don't
make enough in rental income to cover your expenses -- will your losses be tax
deductible?
Grant Nixon faced this issue in Tax Court last month. Mr. Nixon moved to
Waterloo, Ont. in 1990 and purchased a bungalow within easy commuting distance
from each of Kitchener-Waterloo's two universities. He renovated the basement to
make it suitable to tenants and leased it to students each year, from 1990 to
2000.
During that period, Mr. Nixon reported cumulative rental losses of just over
$10,000, with annual losses ranging from $800 to $4,000. The losses were
primarily attributable to the fact that the mortgage interest and taxes
allocated to the apartment exceeded the gross rental income received.
The Canada Revenue Agency disallowed Mr. Nixon's rental losses on the basis
that there was "no reasonable expectation that [his] rental operation would
produce a profit in the foreseeable future."
Mr. Nixon testified that he went to great lengths to try to ensure that the
basement was fully rented. He set his monthly rent at a fair market level after
direct consultation with the universities' student housing offices.
Despite these efforts, the rental income he received did not exceed his
expenses. As the judge observed, "it is obvious that until the mortgage interest
is reduced, either by renewing it at a lower rate or paying some principal or
both, the expenses will continue to exceed revenue as they have done for at
least eleven years."
Fortunately for Mr. Nixon, a recent Supreme Court of Canada decision
concluded that a "reasonable expectation of profit alone is no longer an
acceptable basis for denying business losses." In that case, the high court
established a test to determine whether a rental activity could qualify as a
source of income, even though it produced losses on a recurring basis. Part of
the test was whether the rental activity was undertaken "in pursuit of profit"
or whether there was a personal element.
Relying on that test, the Tax Court judge allowed Mr. Nixon's losses,
concluding: "there is no doubt that Mr. Nixon's rental operation was undertaken
with a view only to profit, and that he carried it out in a businesslike
way...Although [Mr. Nixon], by renting the basement, did defray some of his
personal living expenses each year, he also gave up possession of and thereby
lost the use of one-half his residence...and so there is no personal element to
the rental activity."
Mr. Nixon's victory, however, may be short lived. Draft legislation
introduced late last year and scheduled to take effect in 2005, would
specifically disallow losses where there is "no reasonable expectation of
cumulative profit" -- ignoring the potential for a capital gain upon ultimate
sale.
These draft rules have been the subject of much criticism as well as numerous
submissions from the business community, as they would discourage
entrepreneurial activity. It remains to be seen whether the new Liberal minority
government will proceed with the legislation this fall or will pay attention to
the comments it has received and abandon it altogether.