Feds slap punitive tax measure on non-compliant short-term rentals

With many Canadians facing the consequences of a serious housing shortage crisis, the federal government has proposed tax legislation to crack down on short-term rentals of residential housing property that are non-compliant with provincial or municipal laws or regulations.

Under this proposed legislation, introduced in the government’s 2023 Fall Economic Statement and effective since January 1, 2024, non-compliant taxpayers are denied the opportunity to deduct expenses incurred to earn short-term rental income. These non-compliant properties offered for rental periods of less than 90 consecutive days would be exposed to this denial of expenses. Residential property could include all or any part of a house, apartment, condominium unit, cottage, mobile home, trailer, houseboat or other property located in Canada.

“The financial disincentives associated with this legislation are steep,” says John Oakey, CPA, vice-president of taxation for CPA Canada.

For example, say an individual taxpayer with a residential property in Canada rented an Airbnb to various occupants throughout the year and incurred short-term gross rent and expenses of $91,250, resulting in zero profit, says CPA Caitlin Butler, a tax specialist and member of the editorial board of Video Tax News.

Under this new measure, that individual taxpayer would add $91,250 to their taxable income for the year, and be denied the opportunity to deduct expenses incurred. For an individual in Ontario subject to the highest marginal tax rate of 53.53 per cent, that would mean additional tax of $48,846 on an activity that generated zero profit.

“The impact of the proposed denial of expenses related to non-compliant short-term rentals on the effective tax rate of rental income is largely impacted by two factors—the marginal tax rate applicable on the rental income of the impacted individual, and the profitability of the short-term rental,” explains Butler.

“The largest impact will be felt by property owners in the top marginal brackets, with a rental property with no profit. Due to the significant increase in operating costs and mortgage rates, it is not unusual for short-term rentals to not be profitable. This is the reality for many property owners,” she adds.

The denied expenses are to be prorated for the number of days in the year the property used for short-term rentals is non-compliant.

Oakey illustrates the huge punitive impact this measure can have on profit with an example of a taxpayer with a residential property that is rented out on a short-term basis for 366 days in 2024, but halfway through the year, the local municipality imposes a ban on short-term rental activities.

The rental property in this example incurred $100,000 in expenses to earn a $20,000 taxable profit. However, because half those expenses, $50,000, were incurred when the short-term rentals were non-compliant, $50,000 of the total expenses would be non-deductible increasing the taxable profit to $70,000.

Assuming the taxpayer is subject to the highest marginal tax rate of 54 per cent in Nova Scotia, they would pay tax of $37,800 on that $70,000 amount. But since the real profit was only $20,000, the effective tax rate for accounting purposes [$37,800 on $20,000] would be an enormous 189 per cent, he says.

This proposed legislation, which also impacts corporations and trusts, would allow Canada Revenue Agency (CRA) to assess or reassess tax, interest and penalties related to the non-deductibility of a non-compliant account for any taxation year after 2023, without restriction. CRA would not be constrained by the normal reassessment periods.

A proposed transitional rule is in place for 2024 only, for short-term rentals that take place in a province or municipality that requires a registration, licence, or permit to operate as such. So long as the operator of that short-term rental property complies with the necessary requirements on December 31, 2024, they will be deemed to have been in full compliance throughout the entire year.

“This will allow some time for property owners to become aware of any local requirements with which they may not be compliant,” says Hugh Neilson, FCPA, a director of taxation services and independent contractor with Kingston Ross Pasnak LLP, and also an independent contractor with Video Tax News.

There are concerns this new law could lead to unintended consequences. For example, municipal and provincial policies across Canada may differ, resulting in potentially unequal treatment for taxpayers, says Oakey.

Neilson, who also serves as chair of CPA Canada’s Small Medium Practitioner Tax Committee, notes that because this proposal would deny all deductions for short-term rental expenses in the event of non-compliance, the costs could vary markedly between taxpayers.

For example, Neilson explains, this proposed tax measure will have a greater impact on mortgaged short-term rental properties. The operating cost of a mortgaged property is higher due to the interest rate on the mortgage resulting in less accounting profit. Even though the accounting profit is less for the mortgaged property, the denial of all rental expenses for both properties results in the same overall tax burden. Therefore, the mortgaged property has a higher cost associated with this tax measure.

Taxpayers subject to lower tax rates will also bear lower costs, says Neilson. “For example, an individual resident in Ontario, and taxed at the highest personal tax rate of 53.53 per cent, will bear a much more significant cost than a taxpayer who holds the same property through a corporation paying 26.5 per cent tax—the rate for a public corporation in Ontario. A private corporation earning active business income from short-term rents could pay as little as 12.2 per cent,” he explains.

Neilson also notes that a non-resident of Canada earning rental income from Canadian real estate is, by default, taxed at 25 per cent of gross rental revenue. Although a non-resident can elect to be taxed at the normal Canadian rates on their net income, deducting expenses, in many cases the Canadian tax cost offsets the taxes otherwise payable in the foreign country.

“As a result, non-residents may have a competitive advantage earning such income,” he says.

This proposed legislation could also result in an increase in possible GST/HST self-assessment situations if a residential property needs to be converted from a taxable short-term rental property to an exempt residential property, says Oakey.

Another potential unwanted consequence is that this might cause a spike in underground economy activity if short-term rental operators decide not to report their rental activities, he adds.

“I question,” says Neilson, “whether it would be more effective to legislate the ability to share information on short-term rental activities with the provinces and municipalities where they are located, to facilitate identification of property owners engaging in short-term rental activities not permitted by their local rules.

“The income tax system is a very blunt instrument, and, in my opinion, very poorly suited for purposes such as this,” he adds.

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Read our tax blog for everything you need to know about non-compliant short-term rentals. And see why the new trust reporting rules may impact unsuspecting Canadians.

Photo caption: The largest impact of the proposed legislation will be felt by property owners in the top marginal brackets, with a rental property with no profit