Please note that the following document, although believed to be correct at the time of issue, may not represent the current position of the CRA.
Prenez note que ce document, bien qu'exact au moment émis, peut ne pas représenter la position actuelle de l'ARC.
Principal Issues: 1. Is interest expense incurred to acquire the upper unit of a duplex for rental purposes deductible for tax purposes when taxpayer resides in the lower unit of the duplex? 2. Would paragraph 13(7)(e) of the Act adjust the capital cost of the depreciable property if it is purchased from a sibling? 3. Would the sale of the upper unit in the duplex qualify for the principal residence exemption?
Position: 1. Yes. 2. Yes. 3. Maybe.
Reasons: 1. Interest is generally deductible on funds borrowed to purchase a rental property. 2. Siblings, as related individuals connected by blood, are deemed not to deal with each other at arm's length. If a depreciable property is transferred in a non-arm's length transaction, par 13(7)(e) would apply. 3. The capital gain on the sale of the interest in the duplex (as represented by the upper unit of the duplex) would qualify for the principal residence exemption, if the housing unit met the definition of a principal residence under sec 54 of the Act.
XXXXXXXXXX Sam Kim
April 22, 2010
Re: Principal Residence
We are replying to your correspondence of January12, 2010, concerning the acquisition of a rental property.
As we understand it, you have the following situation:
1. Two sisters, XXXXXXXXXX purchased a duplex as tenants in common. XXXXXXXXXX ordinarily inhabited and used the upper unit (the "Upper Unit") as her principal residence and XXXXXXXXXX likewise occupied the lower unit as her principal residence.
2. Some time later when the value of the duplex had increased, XXXXXXXXXX purchased at fair market value XXXXXXXXXX 's interest in the duplex so that the Upper Unit could be, and in fact was, used as a rental property. We presume that the Upper Unit was rented for fair market rent and is never ordinarily inhabited and used by XXXXXXXXXX as her principal residence.
3. XXXXXXXXXX financed the purchase of the Upper Unit with funds borrowed at interest. All of the funds borrowed were used to purchase XXXXXXXXXX 's property interest in the duplex.
You have requested our comments with respect to the following questions:
1. Would XXXXXXXXXX 's gain on the sale of her property interest in the duplex qualify for the principal residence exemption under paragraph 40(2)(b) of the Income Tax Act (the "Act")?
2. Would paragraph 13(7)(e) of the Act apply to adjust XXXXXXXXXX 's capital cost of the property interest acquired from XXXXXXXXXX ?
3. Would the amount of interest expense incurred on the loan to finance the purchase of the property interest from XXXXXXXXXX be deductible by XXXXXXXXXX in computing her rental income from the Upper Unit?
4. Would XXXXXXXXXX 's gain on the sale of the Upper Unit in the future qualify for the principal residence exemption under paragraph 40(2)(b)?
Written confirmation of the tax implications inherent in particular transactions is given by this Directorate only where the transactions are proposed and are the subject matter of an advance income tax ruling request submitted in the manner set out in Information Circular 70-6R5, Advance Income Tax Rulings, dated May 17, 2002. Where the particular transactions are completed, the inquiry should be addressed to the relevant Tax Services Office (the "TSO"). We are, however, prepared to offer the following general comments, which may be of assistance.
Interpretation Bulletin IT-120R6 - Principal Residence, discusses the requirements for claiming the principal residence exemption, which can eliminate or reduce for income tax purposes a capital gain on the disposition of a taxpayer's principal residence.
Where two individuals own a duplex as tenants in common and each ordinarily inhabits one unit in the duplex, it is our opinion that their respective apartment unit in the duplex is a housing unit for the purpose of the definition of principal residence in section 54 of the Act. This is also indicated in paragraph 3 in IT-120R6.
Therefore, XXXXXXXXXX may be able to designate the Upper Unit as her principal residence, provided all the conditions of the definition of principal residence in section 54 of the Act as discussed in IT-120R6 are met. If XXXXXXXXXX is able to designate the Upper Unit as her principal residence, she may use the exemption under paragraph 40(2)(b) of the Act to reduce or eliminate the capital gain on the disposition of her property interest in the duplex.
Paragraph 20(1)(a) of the Act permits a deduction called the capital cost allowance ("CCA") in respect of the capital cost of depreciable property acquired by a taxpayer to earn income from business or property (e.g., rental income). Subject to certain exceptions, generally an individual may not create or increase a rental loss as a result of deducting CCA. The computation of rental income is discussed in the CRA guide T4036 - Rental Income.
XXXXXXXXXX 's cost of XXXXXXXXXX 's property interest should be allocated between the land portion that is non-depreciable and the cost of depreciable properties such as building and appliances. Paragraph 13(7)(e) would apply to compute the capital cost of depreciable property acquired by XXXXXXXXXX from XXXXXXXXXX .
In general terms, paragraph 13(7)(e) provides that, where a transferor does not deal at arm's length with a taxpayer, the taxpayer's capital cost of depreciable property is equal to the total of the transferor's capital cost or cost, as the case may be, of the capital property and 1/2 of the amount by which the transferor's proceeds of disposition of that property exceed the capital cost or cost to the transferor immediately before the transfer of the property. In this respect, we would note that individuals that are related by blood such as siblings are deemed not to deal at arm's length with each other. More information regarding this can be found in Interpretation Bulletin IT-419R2 - Meaning of Arm's Length.
Interest is generally deductible on funds borrowed to purchase a rental property. Interpretation Bulletin IT-533 - Interest Deductibility and Related Issues, discusses the criteria that must be met for interest deductibility. Paragraph 20(1)(c) of the Act generally permits the deduction of an amount paid in the year, or payable in respect of the year, pursuant to a legal obligation to pay interest on borrowed money used for the purpose of earning income from a business or property to the extent that it is reasonable.
To the extent that XXXXXXXXXX used the borrowed funds to acquire the Upper Unit for the purpose of earning rental income in a bona fide rental operation, XXXXXXXXXX may deduct the interest costs incurred in respect to the borrowed funds.
When XXXXXXXXXX disposes of the rental unit (i.e., the Upper Unit), the gain on the disposition would not qualify for the principal residence exemption under paragraph 40(2)(b) of the Act since, based on the given facts, the Upper Unit is not XXXXXXXXXX 's principal residence as it was used to earn rental income and was not ordinarily inhabited and used as her principal residence.
We trust that these comments will be of assistance.
Business and Partnerships Division
Income Tax Rulings Directorate
Legislative Policy & Regulatory Affairs Branch
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