Change in Use of a Residence

Income Tax Act s. 45(1), 45(2), 45(3), 13(7)

When there is a change in use of real estate, either from income-producing to personal-use (e.g., principal residence or cottage/second home), or from personal-use to income-producing, there is a deemed disposition. The owner is deemed to have disposed of the property (land and building), and to have immediately reacquired it, with both transactions done at fair market value.

The result is not troublesome if any accrued gain on the property is fully sheltered by the principal residence exemption but in cases where a full exemption is not available or the exemption is not an option (e.g., the change is from rental to personal), the resulting capital gain and/or recapture will give rise to unexpected tax liabilities.

Thankfully, there are two elections available to taxpayers to avoid this change in use deemed disposition. The first election, under subsection 45(2) of the Income Tax Act (the “Act”), overrides the deemed disposition when the change is from personal to income-producing use unless the taxpayer rescinds the election in a later year or claims capital cost allowance (“CCA”) on the property. This election allows the gain upon conversion to be deferred until an actual disposition. An additional benefit is that the property may be eligible for the principal residence exemption for up to 4 years after the year the election was made.

This election should be filed with the taxpayer’s income tax return for the year that includes the change in use. The Canada Revenue Agency (the “CRA”) may accept a late election if CCA is not claimed at any time.

When the change is from income-producing to personal use, the second election, under subsection 45(3) of the Act, can be used to prevent the application of the change in use rules. Unlike the first election, this election is filed with the tax return for the year when the property is actually disposed of (or within 90 days after a formal demand is issued by the Minister). However, this election is not available if CCA has been claimed at any time prior to the conversion. This election also allows the property to be eligible for the principal residence exemption for up to 4 years prior to the change. The CRA may also allow late filing if it meets the criteria for taxpayer relief.

Key takeaways

If you are renting out the entire home and you take CCA on the property you will not be eligible for the 45(2) and 45(3) elections, and thus you will have two consequences:

• The property will change from Principal residence to income-generating immediately when you start taking CCA. There will be a deemed disposition and potential Capital Gains.

• You will not be eligible for the additional 4 years you can use for the principal residence exemption while you are renting the property and not ordinarily inhabiting it.

Therefore, if you are considering using the home as a principal residence for some of the years, don’t claim CCA. We advise those just renting out just one property and planning to re-occupy to not claim CCA. Those in the business of renting properties should claim CCA because they likely are not going to use these properties as their principal residence anyways.

For partial change in use where no structural changes are made to the home (i.e. renting out a basement) Do not take a CCA deduction, or else deemed disposition will take place, the basement will become income-generating, and that portion of the home (i.e. basement) will not be eligible for the principal residence exemption in the future when you sell the home. For partial change in use where structural changes are made (i.e. significant partial change in use) claim CCA because there will be a deemed disposition and change in use to income-generating regardless of CCA.

Therefore, a thorough analysis should be conducted for situations when a taxpayer contemplates changing a single use property into multiple uses or vice versa, in order to fully appreciate and plan for any tax consequences arising from the change.

The change in use rules are often considered after the fact. Even though some relief is available to defer the resulting tax, there are conditions attached to them that may not be reversible. As a result, taxpayers should consider the impact of these rules when they are considering changing or expanding the use of a property, particularly with respect to their principal residences.

The information provided on this page is intended to provide general information.