Converting a Principal Residence into a Rental Property – The Solution!

This is a guest article from Kerry, a soon to be Chartered Accountant, who has tips for those who want to convert a principal residence to a rental property.

From a young age many of us aspire to own a home. Historically, the investment benefits of home ownership have been fairly significant, particularly here in British Columbia. While many of us are content owning the home we live in, others want more of a good thing choosing to buy one or more rental properties. If you are contemplating joining this latter group, you’ll want to ensure you don’t make the “big mistake”. Actually, the “big mistake” could just as easily be called the “common mistake” given the frequency with which it occurs.

A Common Tax Mistake

So what exactly is the “big mistake”? The “big mistake” assumes many forms but a fairly simple example can be used to illustrate the problem.

With help from her bank Miss Take purchased her principal residence a number of years ago. A lot of hard work and countless mortgage payments later Miss Take is now mortgage free. As is often the case, Miss Take finds that the old house isn’t really satisfying her needs anymore and she’s looking to move to a bigger and better home. The old home has increased substantially in value and Miss Take has developed a certain affinity for the place so she has decided to keep the house and rent it out.

Relying on her equity in the old house, back to the bank she heads to take-out another mortgage on the old place to buy her new home. The mortgage interest paid on the old house will go a long way in sheltering from income tax the rent Miss Take receives. It should be smooth sailing ahead, or so she thinks.

Everything seems just fine until Miss Take pays a visit to her accountant to get her personal tax return completed. After reviewing the facts, the accountant has determined that Miss Take has fallen victim to the “big mistake” – what seemed like very logical steps to follow at the time have left Miss Take with taxable rental income but non-deductible mortgage interest – clearly not the most desirable outcome.

What do you mean non-deductible interest? She did borrow against the rental property after all, didn’t she? How can this be?

A Backgrounder

The error in Miss Take’s game plan is her assumption that conversion of her former principal residence to a rental property and placing a mortgage on that same property to buy her new home will result in tax deductible interest. Unfortunately for Miss Take, this is not the case. Although greatly simplifying the issue, provided the amount is reasonable, interest paid is generally deductible for income tax purposes under the following conditions:

  1. The interest was paid or payable in the year in accordance with a legal obligation, and
  2. The borrowed funds were used for the purpose of earning income from a business or property – the term “property” referring to interest income, dividends, rents and royalties but not capital gains.

The first condition rarely causes problems because most loans are properly supported by a written agreement but the same can’t be said for the second condition.

The Canada Revenue Agency has produced an Interpretation Bulletin, IT-533 Interest Deductibility and Related Issues, which provides its interpretations of the deductibility of interest expense under various provisions of the Income Tax Act and the judgments in numerous court decisions involving the deductibility of interest expense.

The Bulletin states that “the test to be applied is the direct use of the borrowed money. In certain circumstances, however, the courts have stated that indirect use will be accepted as an exception to the direct use test.

In determining what borrowed money has been used for, the onus is on the taxpayers to trace or link the borrowed money to a specific eligible use, giving effect to the existing legal relationships.”

Applying this “trace or link” test to Miss Take’s situation it’s clear that the borrowed funds were used to purchase her new principal residence. The fact a rental property was used as collateral for her loan is of no consequence; all that matters is the use made of the borrowed funds. In this case, she clearly used the borrowed funds to purchase her new principal residence and, as we all know, interest paid on debt incurred to purchase a principal residence is not deductible for income tax purposes. The end result for Miss Take will be taxable rental income and non-deductible interest expense – clearly not a very good outcome.

The problem here is the taxpayer has confused the security for the new borrowing with the use of the borrowed funds. In this case, the security for the loan does not matter – it’s the use of the borrowed money that counts.

The Solution

So what could have been done differently here to provide tax deductible interest expense for offset against the rental income received? Consider the approach taken by Rita Ohn who has paid-off her existing home and now wants to buy a new home and commence renting her own home. Knowing the importance of “tracing” in the deductibility of interest, Rita took the following steps, in order, and at fair market value:

  1. On day one, Rita sold her current home (the “old home”) to her parents for fair market value. Rita’s parents paid for the purchase by issuing a promissory note to Rita. Always concerned about property transfer tax and other matters, Rita discussed this series of transactions with her lawyer who ensures all steps are properly documented;
  2. On day two, Rita reacquired the “old home” from her parents by borrowing from the bank on the security of a mortgage. Rita plans to use the “old home” as a rental property;
  3. Rita’s parents use the funds received to repay the promissory note they issued to Rita on day one, and
  4. Rita then uses the funds received from her parents to purchase her new home.

When the dust settles, Rita owns a rental property (the former “old home”) and she also owns a new home. Following the “tracing” principle Rita can clearly show that the money she borrowed was used to purchase a rental property and, therefore, the interest paid should be deductible against the rental income she receives in the calculation of her taxable income.

This example shows that a few simple steps can result in a very different outcome – in Rita’s case, an outcome that provides her with tax deductible interest expense.

Submitted by CA Student:  Kerry works in British Columbia as an articling student with Meyers Norris Penny LLP. He obtained his Bachelors of Business Administration in 2010 and plans to write his Uniform Exam (UFE) this September to obtain his Chartered Accountant designation. He enjoys reading and learning about all aspects of personal and business finance.

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FT is the founder and editor of Million Dollar Journey (est. 2006). Through various financial strategies outlined on this site, he grew his net worth from $200,000 in 2006 to $1,000,000 by 2014. You can read more about him here.
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5 years ago

It looks like BC property transfer taxes are except if transferring between parent and child and the either one has been living in the property for 6 months.

6 years ago

I own a residence in BC. I rent out the basement suite as a mortgage helper and live in the upstairs section as my primary residence. I claim the rental income yearly and use all tax benefits associated with that. I’ve been fortunate to have purchased the home in 2014 and now in 2017 August the home is valued at approximately $215,000 more than the purchased amount. I have substantial equity in this home.
I am thinking of using an existing HELOC I have with this home to use towards purchasing another home.. this time the home is in Cochrane, Alberta. I’d like to move to this new home and declare it my primary residence and transition my BC home into a full rental property (basement suite and the upstairs section that I previously lived in).

What are the tax implications with this situation? Would I be able to use the existing equity in my BC home and HELOC to use as a down payment on a new home and mortgage?

What kinds of things should I be concerned about or what questions should I be asking?

Taxmaster's student
11 years ago

@monopolyforreal : You can be in big trouble … As soon as you started renting your other property for rental income you might have changed the purpose of the house from being a personnal property to a rental property, this could trigger a disposal even thought you havnt actually sold the house. That disposal would probably be tax free since you mentioned it is your primary residence, but do understand that you will loose your capital gain deduction on the future value of that house after that date of the disposition to yourself.

regarding principal residence, it is up to you to decide each year which residence will get to be treated as so, understand that in the fomula every house gets one free year. In practice what we do is that before you sell a house we take the ACB of all your property and than there fair value today and than we see which one as a greater capital gain PER year (not overall), and that residence we will ellect it to be your primary residence. You may have more that one primary residence, but only 1 per year.

I highly suggest speaking with a tax specialist or an accountant (cheaper) with experience in these transaction to avoid any re assement from CRA

Taxmaster's student
11 years ago

@Ollie & Brookeprofessionnal : Regarding the transfer of a property and transferring the GEC as well or ACB, that doesn’t apply to any rental property, you guys are referring to either involuntarily disposition (ex: a fire) or voluntary disposition. In this case we would have a voluntary disposition, therefore in the tax act the rule is you have 12 month to buy a similar good to be used for similar purposes, if so you can transfer your capital gain to the new good, that way pushing back the tax on the capital gain that you would pay until when you sell the newly purchased good. Keep in mind this is not a tax evasion tactic put simply a way to differ your tax later on since the tax men will collect the same amount of money but only later on. This rule only apply to none rental property, it is explicitly mentioned in the law. Here’s a working example where this rule could apply, u own a business, you have a truck that you purchased for 20k and amortized for 15k therefore its value is 5k, but then you sell it for 30k. We agree that gain on capital will be 10k at 50% x your tax rate AND you will recapture some amortization as well for 15k since the tax men let you take 15k as expenses because it thought it would lose value, and that 15k is taxed at 100% not like capital gain, so right now you’re paying a lot of tax, but let’s say in 5 month you now purchase a new truck similar use for 50k, you will have the option to start amortizing this good at 35k instead of 50k (50k-15k the recapture amortization), and the ACB instead of being 50k it will be 40k (50k-10k the capital gain at 100%). This way you DIFFER your taxes and not avoid, because let’s say if you re sold this same truck at 50k its fair value the day you purchased it, your fair value would be 50k, ACB 40k so 10k in capital gain at 50%, and you would again recapture 15k in amortization.

I hope that answers in detail your concert to regards of how this rule is applied to Canada (and also that no one else as answered that question).

Regarding the rest of the article, to me what was explained in theories is sound, but do understand that CRA won’t like this sort of transaction, therefore you must make sure to cover all loose ends, I am saying always operating at fair market value, CRA as a form that you can fill out attesting that you believe that you are doing operations at fair value, but in the case where CRA proves you wrong you will take suggested estimate over your own, that way you don’t get a penalty on the difference of estimates. Involves separates bank accounts, and clear transaction, CRA will follow the money, so make sure we have different money going in all directions.

As a reminder, a principal residence, your are allowed to declare one house your principal one every year (you can switch), a rental property cannot be considered a principal residence and when it is sold, it will be subject to tax on 50% of the capital gain if any.

11 years ago

Hmm…Please advise anything I can do to fix this if I have already fallen into this BIG common mistake? Thanks a lot.

12 years ago

It looks like a while since a discussion has happened on here. Can anyone advise me on what to do in this case. I have a house in Victoria with no mortgage (it was my primary residence) and I’m renting it hoping prices will eventually pick back up. I have also bought a house in Vancouver. If I decide to sell the house in Victoria in a year or two do I need to pay capital gains tax because I have another primary residence in Vancouver or is it exempt because of the four year rule?

13 years ago

I have a condo and am looking to convert it into a rental using this system. Most of these examples I read are from people who have already paid off their mortgage, but the difference for me is that I still have a mortgage. I know this gives me other options as I could write off the interest on the current mortgage starting at the time of change in use, but I would like to pull the equity out to purchase a new place and also have this interest be deductible. Could someone help me envision what needs to happen with the current mortgage to make this system work?

Small Capitalist
13 years ago

Great post with lots of ideas!! We live in Regina, Saskatachewan and rental market is great here – thanks to Saskatchewan Booming Economy.

Recently we have been thinking about moving to outskirts of the city and live in an acerage. We were not sure if we should rent our existing principal residence or sell it. I will check with my accountant and see what he thinks about this strategy.

13 years ago

@Scott P…

Thanks for the advice… the appraisal sounds like a good move. I never would have thought to do that. Your example makes sense to me and also makes me feel better about the situation. I’m not looking to evade taxes! I just don’t want to pay more than I have to… (obviously).

We are not in BC… we are in Nova Scotia…but my significant has never owned a property before.

Once again, thanks for the response. :)

Scott Peckford
13 years ago


It is a little unclear from your post, but if I understand you correctly. Here is how I would answer. If you sell a principle residence you do not have to pay any capital gains.

My accountant suggested we get an appraisal on the property when we moved out. That way we have an idea of what it was worth when we converted it to a rental property.

Here is an example to help you

If you buy a property for $100k and live in it for 2 years and it is worth $120k when you turn it into a rental you should not have to pay capital gains on the $20k increase. (Since you were living in it during the increase) If the property continues to increase in value and you sell it 2 years later for $130k it is my understanding you could be liable for the $10k gain from $120k to $130k because it was a rental property. That is why my accountant suggests you get an appraisal.

I have heard of claiming a rental as a principle residence and since i am not an accountant I am not going to comment. It is my opinion you should check with your accountant on this. Don’t trust, ‘Armchair quarterbacks’ in forums, including me. Since ultimately it is your money and your tax bill. :)

However, I still think the appraisal is a good idea to avoid any disputes with CRA in the future.

There is one other thing and maybe this applies to you. If you are in BC and your significant other has never owned a property before then there are some strategies you could use when you buy the next place to avoid/reduce your property transfer tax.

Let me know if you are in BC and if your significant other will be a first time buyer and I’ll give you a couple ideas.