Legislative proposal to crack down on non-compliant short-term rentals

In this blog, we will review the details of:

• the proposed draft legislation and what it covers
• the scope of assessments of tax, interest and penalties
• the consequences of the legislative change

Legislative proposal on non-compliant short-term rentals

In its 2023 Fall Economic Statement, the federal government proposed to deny deductions for short-term rentals for taxpayers where there is non-compliance with provincial or municipal laws or regulations related to short-term rentals, starting on January 1, 2024. The federal government is now planning to take action to crack down on short-term rentals, which are keeping homes for Canadians off the market.

This initiative will be accomplished by denying income tax deductions for expenses incurred to earn short-term rental income on residential properties by taxpayers who are not complying with provincial or municipal rules or restrictions.  

The Department of Finance released draft legislation on December 20, 2023, to implement this proposed measure for non-compliant short-term rental expenses incurred on or after January 1, 2024.

Taxing net income:

The Income Tax Act (ITA) supports the concept of deducting expenses incurred to earn income from a business or property which are not specifically restricted by statute. There are various provisions in the ITA which were approved by Parliament that deny or delay the deduction of certain expenses (e.g., personal expenses – denied, or capital expenses – delayed), resulting in a tax base subject to our progressive tax rates.

The deduction of parliamentary-approved expenses incurred to earn income from a business or property is extremely important to properly measure the net income of the activity in question and to ensure the taxpayer’s ability to pay the resulting tax.

Draft legislation:

The December 20, 2023 draft legislation restricting the expenses incurred to earn income from short-term rentals is in proposed section 67.7 of the ITA ,and can be broken down as follows:

• What is a non-compliant short-term rental?
• How is this non-compliant amount calculated? 
• What is the outcome for non-deductibility of short-term rental expenses?

What is a non-compliant short-term rental?

To have a non-compliant short-term rental, the following three conditions must be present: (1) You have a residential property, (2) offered as a short-term rental, (3) that is non-compliant. 

These three conditions are specifically defined in the proposed legislation as follows:

• residential property – all or any part of a house, apartment, condominium unit, cottage, mobile home, trailer, houseboat or other property located in Canada, the use of which is permitted for residential purposes under applicable law
• short-term rental – a residential property that is offered for rent for a period of less than 90 consecutive days
• non-compliant short-term rental – means, at any time, a short-term rental that is located in a province or municipality that, at that time,
• does not permit the operation of a short-term rental at the location of the short-term rental;
• requires registration, a license, or a permit to operate as a short-term rental, if the short-term rental does not comply with all registration, licensing and permit requirements

How is this non-compliant amount calculated?

The amount of expenses to be denied for a given taxation year in respect of a non-compliant short-term rental is based on the formula, A × B ÷ C, where:

• A = the total of all outlays made, or expenses incurred, in the taxation year in respect of the use of a residential property as a short-term rental in the taxation year
• B = the number of days in the taxation year that the residential property was a non-compliant short-term rental
• C = the number of days in the taxation year that the residential property was a short-term rental

Given that the formula is taking a proration of the total short-term rental expenses based on the number of non-compliant days, the deductibility of expenses may be altered in years where a short-term rental becomes or ceases to be compliant. There is a proposed transitional rule for 2024 resulting in deemed full compliance throughout the year if a short-term rental is in a province or municipality that requires registration, a license, or a permit to operate as a short-term rental, and the operator of the short-term rental complies with all such requirements on December 31, 2024.

What is the outcome for non-deductibility of short-term rental expenses?

As a result, any non-compliant amount of a non-compliant short-term rental would be non-deductible for income tax purposes.

For example, an individual taxpayer has a residential property in Canada rented out as a short-term rental property for 366 days in 2024.  This property results in a $20,000 profit after incurring $100,000 in expenses. If the municipality, where the property is located, imposes a ban on short-term rental activities halfway through 2024, then the taxpayer would have a non-compliant amount equal to $50,000 ($100,000 x 183 non-compliant days / 366 days in 2024).

The taxpayer’s $20,000 accounting profit would be increased to $70,000 for tax purposes because of the non-deductibility of the non-compliant amount. Assuming a marginal tax rate of 54%, which is the highest marginal tax rate in Nova Scotia, and currently one of the highest tax rates in Canada, this would result in $37,800 of personal income tax. The effective tax rate for accounting purposes would be 189% ($37,800 / $20,000).

This result of non-deductible expenses can also apply to corporations and trusts.

Reassessments

The proposed legislation, if enacted in its current form, would allow the Canada Revenue Agency (CRA) to assess or reassess the tax, interest and penalties resulting from the non-deductibility of a non-compliant amount for any taxation year at any time, after 2023. In effect, the CRA would not be limited by the normal reassessment period to deny the deduction of a non-compliant amount.

Unintended consequences

There are consequences to every legislative change in the ITA. Those consequences are either intended or unintended. The policy intent behind this proposal is to move short-term residential properties back into the permanent residential supply chain to help ease some of the problems in the current housing market. However, potential unintended consequences of this new measure could include: 

• unequal treatment of taxpayers throughout Canada under the federal ITA based on municipal or provincial policies
• an increase in potential GST/HST self-assessment situations resulting from the need to convert a residential property from a taxable short-term rental property into an exempt residential property
• pushing short-term rental operators into not reporting their rental activities and further adding to the underground economy

Conclusion

With this proposed legislation, short-term rental operators will need to be even more diligent with municipal and provincial compliance.  Short-term rental operators should do their homework and seek professional advice to avoid negative tax consequences.

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Disclaimer

The views and opinions expressed in this article are those of the author and do not necessarily reflect that of CPA Canada.