Is it tax-inefficient to receive and pay rent?

Question

Suppose I own a home and live in it. Then I realize I want to move to another part of town that is closer to work. But this is temporary because I don't know what my job will be in 5 years.

So I rent out my home, and pay rent to live in a different home. Let's say that the rental income exactly equals the rent I pay to live elsewhere. In an ideal world, there would be no other financial implications.

But if I understand correctly, I would need to report my rental income and pay taxes on it, while my rents paid is not tax-deductible, so I end up worse off. However, if I sold my home and bought another one outright, I would incur realtor fees (easily 5%), land transfer taxes, municipal transaction taxes, etc.

Is my interpretation correct? What is the most financially efficient way to change one's residence?

I am most interested in an answer for Ontario, Canada. But some perspective on other jurisdictions (e.g. USA) is okay.

Answer 1

I would say that, yes, it is tax-inefficient to rent and receive rent. Living in your own home is equivalent to renting to yourself (i.e. paying an amount of rent and receiving the same amount of rent), except you don't get taxed on the rental income as you would if you actually rented out to someone.

This is the concept of "imputed income" -- you save taxes when you provide a service to yourself (in this case, allowing yourself to live in your home) than when one person provides a service to another, because the government taxes a transaction between people, but does not tax the equivalent "transaction" of a person with themself.

Consider the example of two people who rent their houses to each other, with the same rent in both cases. They would both have no net gain or loss, which is the same as if they lived in their own houses. But tax-wise they would both be worse off than if they lived in their own houses, because they would both have to pay income tax on the rental income, which they wouldn't have to pay if they lived in their own houses.

You are right that, if the government allowed you to deduct rent you pay to live somewhere else as an expense deducted against your rental income, then it would no longer be tax-inefficient. However, as far as I know, neither the US nor Canada allows you to deduct rent you pay to live somewhere else as a rental expense.

Answer 2

If you move, you are correct that you would be "worse off" (financially) than you are now, but the things you are comparing are actually independent from each other. Consider these hypotheticals:

1. You currently live in your parents house and pay no rent. If you choose to rent an apartment on your own, you would be "worse off".
2. You currently live in a paid off home with total monthly expenses of $1000/month. You rent out the home for $2000/month (profit $1000/month and say after taxes you keep $650/month), and go rent a house. If the house you rent is less than $1650/month, you are "better off" and if it is more than $1650/month you are "worse off".

The idea here is that you are trying to compare (the large advantage of) living in a paid off home to renting another apartment, and these two things shouldn't be compared in that way, because, of course you're better off living in a paid off home, just like you would better off living with a friend or relative and paying no rent.

It may help to reverse the thought experiment: Suppose you are renting an apartment, and you suddenly acquire a paid off home (perhaps through inheritance). You may choose to rent out the home, presumably make a profit, pay some taxes, and be "better off" than when you didn't have the home. Or if the location is convenient, you could move into that home and be "even better off" since you'd likely save more in rent than you profit from renting out the house. So to answer your specific question of

What is the most financially efficient way to change one's residence?

the answer may simply be:

To move into a friend or relative's house, or one that you already own outright.

The fact that your home is paid off is making it seem like you're worse off if you move, but it probably wouldn't feel that way if you still had a mortgage.

Old answer due to different wording of the question about deducting "rental expenses":

In Canada, like in the US, you can deduct rental property expenses. This doesn't apply to you, but note that if you were to have a mortgage, you can only deduct the interest you pay, not the principal, so it could be the case that your cash flow is negative but you still profit overall when you add in the equity you're gaining each month.

One significant difference between the US and Canada tax law is that in the US rental property depreciation is mandatory, whereas in Canada the equivalent concept, called Capital Cost Allowance (CCA), is optional. In your stated scenario where the expenses equal the income, I'm guessing you'd be better off not taking CCA because it would cause a loss, and it may be better to save the deduction for when you have a gain or when you sell the property.

Answer 3

Something else to consider, because you are in Canada, based on the tax implications of selling a 'principal residence' [ie: the home you actually live in]:

Any gain on selling a principal residence is completely tax free.

For every tax year, only one property can be your 'principal residence'. In some cases, you may have the ability to choose which is which [the common example is that if you own a cabin and live there for a few weeks a year, you can probably claim that as your principal residence, instead of your 'city' home - probably can't legitimately claim this if you rent it out to others 50 weeks out of the year though].

If you plan on selling home A, then living in home A in the meantime will allow you to sell it without paying tax on the gain. If you plan on selling home B, then living in home B in the meantime will allow you to sell it without without paying tax on that gain.

Given the crazy property market in some Canadian cities over the past 5-10 years, the tax on the gain of the home [which, if taxed at all as an investment property, would probably be only half taxable as a capital gain] would probably the tax on the rental income in the meantime. Depending on the market, rental properties are often operated at barely a profit at all [after considering the depreciation you get to claim], so you may find the tax on rental income to be minimal.