Author: Marco Jotic, CPA, CGA
Editors: Peter Weissman FCPA, FCA, TEP and Matthew Cho CPA, CA, TEP
Occasionally, a taxpayer moves from his/her principal home into a new home and rents the old home out, or converts part of the home for a different purpose. Alternatively, he/she may move into one of his/her rental properties and turn it into a principal home. While this may not be an issue if the change is short term and temporary, a permanent change could give rise to a deemed disposition of the property for tax purposes. If not carefully managed, this deemed disposition can create undesirable results for these taxpayers.
Complete change in use
Where a taxpayer owns real property and converts it entirely from personal to income-producing (e.g., rental) purpose or the other way around, the taxpayer is deemed to have disposed of the property at the time of conversion at its fair market value and reacquired it for the same amount.
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 4 year limit may be extended if certain conditions are met.
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.
Partial changes in use
When only a portion of the property undergoes a change in use, the deemed disposition will only apply to that portion of the property. The elections under subsections 45(2) or 45(3) cannot be made as they only apply to a complete change in use. 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.
For principal residences, the CRA considers a partial change in use to occur where there have been significant modifications to the property that are permanent in nature. In addition, the CRA will not apply the deemed disposition rules with respect to a principal residence (and takes the view that the entire property remains a principal residence) where the following conditions are met:
- There have been no structural changes to the property
- CCA has not been claimed on the property; and
- The main use of the property is as a residence and the income producing use is ancillary.
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. If you have situations involving the application of these rules, a Cadesky Tax representative would be happy to assist you.
“Be Aware of Changing a Principal Residence to Investment Property or Vice Versa.”
It is not uncommon for taxpayers to convert their principal residence, wholly or partly, to business or rental use. Unfortunately, adverse tax consequences may arise for the unwary as the change of use may result in a deemed disposition of the property which may trigger a taxable capital gain unless the full amount of such gain qualifies for the principal residence exemption.
The first consideration in determining the tax effects is to review the extent to which the property was converted to income-producing use. In the case of a partial conversion, there will be no deemed disposition of the property, provided all of the following conditions can be satisfied:
- the income-producing use is ancillary to the main use of the property as a residence
- there is no structural change to the property
- no capital cost allowance is claimed on the property
There is a partial conversion where a taxpayer rents one or more rooms or where a taxpayer has an office in his home which is used in connection with his business or employment. These partial conversions would be tax-free.
In situations where a taxpayer has converted his entire principal residence to an income-producing use, there will be a deemed disposition of the property. However, by filing an election under subsection 45(2) of the Income Tax Act, the taxpayer may defer the recognition of the gain. The election remains in effect for up to four taxation years unless rescinded by the taxpayer. An indefinite extension to the four year limitation is available under section 54.1 of the Income Tax Act for certain employees who have converted their residence to income-producing use as a result of a change in their employment location.
When a taxpayer has made a substantial conversion of his residence to income-producing use, and subsequently converts it back to use as his principal residence, there will be a second deemed disposition of the property. This second conversion is more likely to trigger a taxable event if the property has increased in value during the period it was used for income-producing purposes or if capital cost allowance had been claimed during that period of time. The property would not qualify as a principal residence during the period it was used for income-producing purposes.
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The material provided in Tax Tip of the Week is believed to be accurate and reliable as of the date it is written. Tax laws are complex and are subject to frequent change. Professional advice should always be sought before implementing any tax planning arrangements. Neither the Tax Specialist Group nor any member firm can accept any liability for the tax consequences that may result from acting based on the contents hereof.