In its simplistic form, a rental property allows you to leverage a relatively small amount of money to own a high-valued asset. Better still, payments made against the mortgage are made by someone else—your tenant! And, then there are the tax deductions…
Once you’ve set your mind to real estate investments, the next question is how to do it. Here are the pros and cons of converting a portion of your house into a rental suite:
A rental suite inside your home
This is the easiest way to add real estate to your investment portfolio. This option is particularly helpful in property markets where housing prices are quite prohibitive.
The idea is to take an unused, or under-used, area of your home and to create income-generating space.
But this “easy” option does come with difficult steps and decisions.
Consider the Costs
For instance, you may need to install expensive amenities, such as a bathroom or kitchen which could cost at least $20,000. (If doing so would alter the structure of your house, you’ll need to follow local zoning bylaws and building codes.) Keep in mind that you can use this expense to help reduce the taxable income generated from renting.
In simple terms, if you earn $1,000 in rental income, you can claim $1,000 in reno expenses, bringing your taxable earnings to $0. But there’s a catch. The Canada Revenue Agency considers renovations that increase the value or extend the life of a property as a capital expense (versus a current expense, which is more of an ongoing costs, such as cost to clean the gutters or paint the house or deck). Each year, you can only deduct a specified portion of a capital expense — usually between 10% to 20% of the overall annually depreciating cost — and this deduction can help reduce taxable income.
How does that work? Say you paid $24,000 to create a separate suite in your basement that now includes a kitchen and bathroom. If you qualify for 20% capital expense deduction, in the first year, you could deduct $4,800 from any income generated from the rental suite. The next year, you could deduct another $3,840 (another 20%); in the third year you could deduct $3,072, and so on until the cost of that expense depreciates to $0.
To maximize this deduction, make sure you can earn at least the annual deduction limit, if not more. (Remember, also, that appliances, furniture and even cutlery are also a capital expense. Different rates apply to each expense.)
To really maximize your deductions, consider all the expenses. For instance, if you share Internet, hardline phones, the same wiring and plumbing, you could deduct a portion of these expenses as tax deductions against your rental income. (This also includes the interest you pay on your mortgage). Review CRA policies for home-based business deductions.
Living With a Stranger
Although you might be renting out just one room and only through short-term rentals, you are still inviting strangers into your home. To retain some privacy and autonomy in your home, try to create separate living spaces that consider such factors as:
- How and where a potential tenant will enter the suite.
- Low cost privacy features such as large potted plants or garden trellises.
- Tenant parking for a car or bike.
- Where the tenant receives packages and mail.
- Shared internet plan? (Cheaper but riskier.)
Got a mouse or ant problem? With a rental suite, you’ll hear about it ASAP. Address these problems before they become bigger and costlier.
Banks Love Your Cash Flow
Mortgage lenders love low debt to income ratios — so the more documented income that comes in, the better chance of getting the most competitive mortgage or loan interest rate. For real estate investors with an in-home suite, this means that the rent paid by long-term tenants with a lease will be added to the income-side of your balance sheet.
However, don’t expect lenders to treat income generated by short-term rentals the same way. According to Ron Butler, president of Toronto-based Butler Mortgage, no lender in Canada will take rental income generated through short-term rentals as part of their debt ratio calculations. This shouldn’t deter you from creating a short-term rental suite, rather it should be a forewarning that the cash generated should either be used to pay off debt or increase personal assets,thereby establishing better debt ratios.
To protect yourself, become familiar with local laws. Understand how to interview a tenant, how to handle damage deposits (and requests for pets) and what you can and cannot refuse your tenant. The best place to start getting educated is through your provincial Landlord and Tenant Board.