Vacation home write-offs can be risky

National Post

2005-04-23



You've taken the plunge and purchased a vacation property, and to help offset
ownership costs, you are going to rent it out when you are not using it.

Generally, revenue from such endeavors, less expenses associated with the
property, is fully taxable at the owner's marginal rate. Matters become more
complicated if costs such as property taxes, heating, utilities and mortgage
interest exceed rental income, creating a loss. It is unclear whether that loss
is tax deductible against other sources of income.

Draft legislation introduced in October, 2003, limits the deductibility of
losses where there is no "reasonable expectation of cumulative profit." The
legislation clarifies that profit does not include a capital gain (as in the
sale of a vacation property that has appreciated in value).

The legislation was introduced in response to several Supreme Court of Canada
decisions relating to taxpayers successfully deducting interest expense -- to
the chagrin of Canada Revenue Agency.

Under current rules, interest and other expenses are deductible in computing
income from a business or rental property, as long as the expenses are incurred
"for the purpose of earning income." CRA now says, "the meaning of this phrase
has become unclear" and could "lead to inappropriate results."

Of concern was the case of Brian Stewart who purchased four condominiums in
1986 from which he earned rental income. All four were highly leveraged, with
Mr. Stewart paying only $1,000 cash for each. Projections indicated the
properties would generate losses for 10 years. For 1990 through 1992, Mr.
Stewart claimed losses of more than $58,000, which he used to offset other
income. These losses primarily were the result of interest payments. The CRA
disallowed the losses on the basis Mr. Stewart had no reasonable expectation of
profit (REOP) and therefore no business was being carried on. Canada's highest
court disagreed, striking down the REOP test and finding the losses fully
deductible.

Under the proposed legislation, to deduct rental losses against other sources
of income, it must be reasonable, based on the circumstances, to expect to earn
a profit from a rental property. Even if the property produces sufficient rental
revenue to offset directly related expenses, if the mortgage on the property is
so big the interest expense means you may never realize a profit, then you would
not have a REOP.

If you expect your gain on eventual sale will more than make up for
cumulative losses, you may be able to deduct these losses, provided you are
prepared to forgo capital gains, which only taxes half the profit on sale.

Although technically effective in 2005, the legislation is still a draft. In
this year's budget, the federal government said it would respond to concerns
about the draft and develop a "more modest legislative initiative."

Stay tuned.