Can Deducting Home Office Expense Affect Principal Residence Exemption?

I was at the Archangel Summit this past Saturday. For those of you who don’t know about Archangel Summit, it is an event everyone should go to. ?

It’s the 2nd year I participated in this event. Last year was great, but this year was even better.

Akon was there performing all his classics. ? All the ladies were invited to sing and dance along with him.

Here’s the 3 common things I learned from these amazing speakers. (I apologize if this is not complete or if it is misinterpreted in any way. Notes here are something I took away. For those of you who attended, feel fee to share more in the comments section so others can learn from you as well.)

1. Health (fitness and energy level)
   • Key to any kind of success is your health.
   • Take care of your own body and you can then take care of others. It’s the same as the emergency instruction you get before the flight takes off, you must put the mask on yourself before helping others, including your kids.
   • You are what you eat. Sugar and wheat don’t give you the fuel you need. It’s fat and nutrient supplements that give you the energy you need.
   • Shredded mind = shredded body
2. Mindset/being present
   • Meditation calms you down. Everyone needs the quiet time.
   • Connecting with others is not done using a cell phone. Texting won’t build relationships.
   • Fastest way to build relationships is to ask for help. (Simon Sinek)
   • You don’t get to call yourself present, you earn it. (Simon Sinek)
   • Growth is about deconstruction, not to do more and grow more. (Dr. Shefali Tsabary)
3. Finding your why (Simon Sinek)
   • Your why is your origin story, it never changes.
   • Your why should be to serve others, not service to yourself.
   • Leadership is not about experience. It is about waking up everyday and thinking about “how do I make the person on the right be the best he/she can be.”
   • Always remind yourself “you’re here to give”.
4. Goal setting
   • Set aggressive goals, 6 months, 1 year, 10 years, 20 years in all aspects of your life. Read them before bed every night and read them first thing in the morning. (Damond John)
5. Others
   • Everyone is just as f#cked up as you are. (Damond John)
   • Schedule your life. It sounds cold but that’s the only way things get done. (Damond John)
   • Unique proposition of your business: you should be able to describe it in 2 to 5 words (Damond John)
   • Optimism is a choice. (Simon Sinek)
   • Introverts wake up to have five coins in the morning. They give away a coin in every interaction with others. They’re exhausted at the end of the night. Extroverts wake up with no coins. They gain a coin every time they interact with others. They get more energetic as they interact with more people. (Simon Sinek)
   • Do not marry someone for love. Marry someone that allows you to grow. (Dr. Shefali)

The biggest takeaway I got from the event is that we all serve a purpose, a purpose bigger than ourselves. We are here, on this earth, to serve others. And this is how you get fulfilment in your life.

I hope this gives you a bit of inspiration on this Thursday morning.

Now onto this week’s topic.

Many real estate investors, small business owners and employees who work from home came to me to express concerns about deducting home office expenses, worrying that after deducting the expenses they would lose the principal residence exemption.

To qualify to claim home office expense, there are a bunch of criteria that you need to meet, you can refer to my previous blog post as reference.

To qualify to claim principal residence on your own home, first and foremost, you have to “ordinarily inhabit” in the property.

You also need to comply with the following list of criteria from CRA’s website:

1. The income producing use is ancillary to the main use of the property as a residence;
2. There is no structural change to the property; and
3. No CCA is claimed on the property.

Of course, there’s no definition to what “ancillary” means in the Income Tax Act. My interpretation of the term means that more than 50% of the residence is used as residence.

This means that home office expense must be less than 50%. Other factors may affect the decision as well but floor space of 50% or less is a good start. 

Now, for those real estate investors there that also rent out their basements as an extra stream of income, be very cautious. The combination of your home office and rental portion cannot exceed 50% to preserve the principal residence exemption.

If you have a bungalow, rent out the basement and use one room in the main floor as your home office, the income producing use, including basement and the one room, are now the main use. Not the residence.

Be very careful when you use your home for both business purpose and rental purpose.

Secondly, you cannot structurally alter your property to accommodate the home office. For example, if you open up a basement entrance, which did not exist originally, to access your home office, this structural change can affect the claim of the entire house as your principal residence.

Last but not least, do not ever claim capital cost allowance on your principal residence. Once you start claiming CCA on your principal residence, the exemption is gone and you will have to pay tax when you sell the property.

Now, if you are in violation of any of the three conditions, how much tax will you pay?

Let’s say you structurally alter the building to allow separate access to your home office, and the home office space is truly 25% of the entire living space, you will be liable to pay tax for 25% of the gain.

If you purchase the property for $500K and sell it for $800K and you have used the 25% space all these years, the capital gain that is subject to tax is:

($800K – $500K) x 25% = $75K capital gain

50% of capital gain is subject to tax and hence taxable capital gain = $75K x 50% = $37,500.

If you use your home for both rental purpose & home office as well, the combine use is 60% in relation to the total size of the home, you will be paying tax on 60% of the gain.

Using the same numbers as in the first example, the capital gain that is subject to tax is:

($800K – $500K) x 65% = $195K capital gain

Taxable capital gain = $195K x 50% = $97.5K added to your personal income

Hopefully this shreds some light on how you can deduct home office expenses while preserving your principal residence exemption.

Until next time, happy Canadian Real Estate Investing.

Cherry Chan, CPA, CA

Your Real Estate Accountant