The basement

Landlord math was on display here over the weekend. It’s almost as amusing as developer math, used by clever people like Brad Lamb to make you beg to buy one of his condos so you can start making 18% a year.

Face it. With real estate at current levels it’s about impossible in an urban centre bigger than Tatamagouche to buy a house or a condo, rent it and be in positive cash flow. The only way amateur landlords can make themselves feel better is to (a) ignore half their mortgage payments saying ‘the tenant is paying off the loan,’, (b) forget about the opportunity cost of the downpayment, or (c) believe the price of their property will rise forever.

Of course, lots of people have grown rich by acquiring buildings, renting them out for decades and profiting from an historic bull run in real estate. But those days are over. Most amateur landlords are currently in negative cash flow. And Landlord Math is nothing but accounting fiction.

First, you can’t count all the rent you collect as revenue without considering mortgage principal payments (along with interest) as an expense. Second, buying a $600,000 condo to rent out with a $120,000 downpayment and $15,000 in closing costs means you’ve lost the use of $135,000 which could be netting 6% from a balanced portfolio. That’s almost $700 a month. Add it in. And as for capital gains, those days may well be ending. In fact they did years ago in places like Calgary and Edmonton. They barely exist in Montreal. And the tide may be going out in the GTA.

Anyway, be careful. Now that Ontario has ushered in universal rent controls – and rents are already absurdly low compared to the value of properties – it’s almost certain the money you collect each month from a tenant will not cover the amount leaving your bank account. Mortgage payments, condo fees, property taxes, insurance, maintenance and an allowance for vacancies – not to mention the cost of getting a drunken iguana out of a toilet trap – all add up. So with rents capped and everything else uncapped, this is a dodgy investment.

But what about renting out part of your house? Is that a slam dunk – since you already own it, and live there?

Obviously a lot of people think so. Especially in Vancouver, where the average family long ago lost the ability to afford the average home. A poll two years ago found 43% of people with houses rent out their basements or laneway structures (a.k.a. garages). That’s double the rate in Toronto (20%) and vastly above the national average (14%).

Some of these people (impossible to know how many) never claim expenses as deductions from their taxable incomes because they don’t declare the rental income they’re receiving. This, of course, makes them criminals. Tax evasion is a serious deal. So they’d better hope their tenants don’t use that address on their annual tax returns.

The rest of the folks, who legitimately report the rent, add it to their employment incomes and pay tax at the higher marginal rate which results, get to deduct a portion of their residency costs. But I’ll bet many of them have no idea what surprise waits in store down the road when they come to sell. The basis of this is the change which came in last October forcing anyone selling a property to apply for the Principal Residence Exemption, instead of automatically receiving it. So the feds are building a fat database on residential real estate which can then be used to check against all kinds of other things – like your tax records showing rental income, or the pasty guy in the basement who used that address to file HST for his online porn business.

What does this mean if you have a suite?

Well, it’s complicated.

If you rent out your whole house and move to France for four years, no problem. You can still claim the PRE if you sell and make a profit. More than four years, and the exemption is lost.

If you lease a portion of your house, you may lose a hunk of the PRE when you sell – which could be devastating in cities like Toronto and Vancouver where properties have inflated wildly. The CRA says if your home is altered in order to accept a tenant – like adding a new entrance or having a kitchen in the basement – then it fails a simple test which would have preserved your PRE. Any structural change made to accommodate a renter means the leased part of the house is subject to capital gains tax when you dispose of the property. The adjusted cost base (ACB) is determined by the date you started to rent.

So, if you leased a space in 2005 equivalent to 30% of your (then) $500,000 house which you just sold for $1,000,000, you probably have a taxable capital gain of $150,000. The good news is half of that is tax-free. The bad news is the other $75,000 must be included in your taxable income.

Gee. Renters win again.