Tax consequences of changing the “use” of your home
If you own your home and decide to move out in order to rent it, the CRA considers you to have disposed and reacquired the property, with both transactions occurring at fair market value. This “deemed disposition” triggers a capital gain which is calculated by subtracting the adjusted cost base (ACB – usually the original purchase price of the property) from the fair market value (FMV).
This deemed disposition must be reported on your personal tax return and, assuming you have lived in this property since it was purchased, the tax on the capital gain will be eliminated by claiming the principal residence exemption (PRE).
Using the Section 45(2) election to defer and reduce capital gains
Section 45(2) of the Income Tax Act (the Act) allows an election to be made to indefinitely defer the deemed change in use. This would defer the capital gain until the property is ultimately sold. The election also allows the property to qualify as your principal residence for an additional four years. There are a few requirements when using this election:
- You must remain a resident of Canada during the extension
- You can’t designate any other property as a principal residence during the extension
- You must report the net rental income on your personal tax return
- You can’t claim CCA against the rental income of the property
The four-year extension to the principal residence qualification shelters a portion of the capital gain in the year the property is sold. For example, If you purchased a property as your personal residence in 2005, moved out and rented it in 2015, and sold it in 2020 (16 years inclusive):
- Without the Section 45(2) election, there would be a deemed disposition and resulting capital gain in 2015, calculated by subtracting the original ACB from the 2015 FMV. This gain would be sheltered by claiming the PRE. There would then be a second capital gain in 2020 calculated by subtracting the 2015 FMV from the 2020 sale price. The tax related to this capital gain would have to be paid with your 2020 personal tax return.
- With the Section 45(2) election, there would be no deemed disposition in 2015 and the property would be considered your principal residence for all of the years you lived in it, plus the four-year extension, plus one, for a total of 16 years. On your 2020 tax return, the capital gain would be calculated by subtracting the original ACB from the 2020 sale price. You could then claim the PRE for 100% (16/16ths) of the capital gain.
Making the 45(2) election
This election should be made in writing with your personal tax return in the year of the change of use. If it was not made at that time, the CRA may still accept a late-filed election if the requirements above are met and the election remains in effect. It is unlikely that the election would be accepted in a tax year subsequent to the sale of the property.
There is a possibility for the four-year extension to be extended indefinitely if the change-in-use is because of a change in employment, subject to certain conditions. The CRA also offers capital gains deferral for the opposite situation, where a property originally purchased as a rental becomes your personal residence. This situation is covered in Section 45(3) of the Act.
If you are considering changing the use of a property you own, feel free to get in touch to discuss your options and tax situation.
Information from the CRA: https://www.canada.ca/en/revenue-agency/services/tax/individuals/topics/about-your-tax-return/tax-return/completing-a-tax-return/personal-income/line-127-capital-gains/principal-residence-other-real-estate/changes-use/changing-your-principal-residence-a-rental-business-property.html
Written by: Rob Fahie