A hot housing market and a change in use equals tax with no cash. But there is a solution.
Most Canadians know that selling their home normally will not result in income tax thanks to the principal residence exemption (PRE). Unfortunately, people tend to extend this "knowledge" into a feeling that they need never worry about tax when dealing with their principal residence.
A situation that is often overlooked by residential property owners, but can result in an unexpected tax burden, is the change in use of a residential property. Under subsection 45(1) of the Income Tax Act (ITA), there is a deemed disposition and reacquisition at fair market value when an individual changes the use of a property from personal use to income-earning use, or vice versa. The primary concern in such a situation is that, without an actual third-party sale, there are no proceeds to fund the resulting tax.
Several strategies are available to help mitigate this potential situation. Before discussing those strategies, however, it would be helpful first to review the principal residence exemption concept. This will not be a complete discussion of the concept, but it will provide a backdrop for understanding the "change in use" rules presented below.
Principal residence exemption
The principal residence exemption (PRE) can reduce or eliminate the capital gain on a taxpayer’s principal residence. To qualify for the PRE, the taxpayer must own the property (including joint ownership and beneficial ownership in common law jurisdictions). The residence also must be ordinarily inhabited (at some point in the year) by the taxpayer, the taxpayer’s spouse or the taxpayer’s child. A taxpayer may only designate one property as their principal residence for any particular tax year. In addition, only one property per family unit 1 may be designated as a principal residence (since 1981).
In simple terms, any gain on the disposal of a principal residence is exempted from tax in respect of the years for which it qualified as (and was designated as) the principal residence of the taxpayer. If the property was owned for more years than the property was designated, a pro-rated portion of the gain will be subject to tax. However, there is a "plus one" rule that can allow an exemption for one year more than ownership to ensure that the PRE is available in the year in which an individual moves to a new principal residence resulting in two principal residences in a single year.
Beginning in 2016, even if the entire gain on the disposal of a property is exempted by the PRE, the disposition of the property, and the designation of it as a principal residence, must be reported to the Canada Revenue Agency (CRA) in the year of disposition.
Change in use (from a principal residence to another use)
When a homeowner moves out of their home without selling it, and opts to rent the home or use it for business purposes, the "change in use" can have significant unfavorable tax consequences. Essentially, the taxpayer is deemed, for tax purposes, to have sold the property at the time of the change in use. The deemed selling price is the fair value of the property at the time of the change in use. This deemed disposition might not be an issue if the PRE can be used to shelter the entire gain from tax. However, that might not always be the case. If the taxpayer owns a second property (such as a cottage) that they have already designated for their PRE (or intend to designate in the future), a portion of the gain may be taxable.
There is a possible saving grace: little-known subsection 45(2) of the ITA addresses this situation. In essence, it provides an election that defers the gain on the property until the year of actual disposition (unless the taxpayer rescinds the election or claims capital cost allowance on the property).2
The election must be filed with the CRA in the taxpayer’s tax return for the year in which the change in use occurred. In certain circumstances, it may be filed late (subject to the Minister’s discretion). This election has an additional benefit: while the property is subject to the election, it will continue to qualify as a principal residence for up to four years even though it technically does not meet the criteria. This additional benefit can result in significant tax savings on the eventual disposition of the property.
Change in use (conversion to a principal residence)
Sometimes, the change in use goes the other way: an individual decides to move into a property that they previously treated as a rental property, making it their principal residence. In this circumstance, there is also a deemed disposition; the taxpayer is deemed to have sold and immediately reacquired the property at the time of the change in use. Consequently, any accrued gain would immediately be subject to tax without the benefit of the PRE (since it was a rental property).
Subsection 45(3) can help in this situation as it provides an election that defers the gain on the property until the year of actual disposition (unless the taxpayer rescinds the election or claims capital cost allowance on the property). The filing due date for this election is the filing due date for the tax return of the year the actual disposition of the property occurred.
Like the subsection 45(2) election, this election can also extend the PRE. It allows the taxpayer to "look back" up to four years when designating the property as a principal residence. Further, as with the subsection 45(2) election, this election is permitted only if capital cost allowance has never been claimed on the property.
Conclusion
The tax consequences related to a change in use of a residential property are too often ignored and, in today’s hot housing market, can result in an unexpected tax burden. Many factors and strategies can come into play. The subsection 45(2) and 45(3) elections are just two aspects of principal residence tax planning that should be considered. Our professional staff at Baker Tilly can help you through this process.
- Income Tax Folio S1-F3-C2, Paragraph 2.13 - Family unit includes, in addition to the taxpayer, the following persons (if any):
- the taxpayer’s spouse or common-law partner throughout the year, unless the spouse or common-law partner was throughout the year living apart from, and was separated under a judicial separation or written separation agreement from, the taxpayer;
- the taxpayer’s children, except those who were married, in a common-law partnership or 18 years of age or older during the year; and
- where the taxpayer was not married, in a common-law partnership or 18 years of age or older during the year:
- the taxpayer’s mother and father; and
- the taxpayer’s brothers and sisters who were not married, in a common-law partnership or 18 years of age or older during the year.
- Income Tax Folio S1-F3-C2, Paragraph 2.48 - If CCA is claimed on the property, the election is considered to be rescinded on the first day of the year in which that claim is made.
Meet the Author
Eric Gagnon
Information is current to June 7, 2021. The information contained in this release is of a general nature and is not intended to address the circumstances of any particular individual or entity. Although we endeavour to provide accurate and timely information, there can be no guarantee that such information is accurate as of the date it is received or that it will continue to be accurate in the future. No one should act upon such information without appropriate professional advice after a thorough examination of the particular situation.