Change in Use of Property: Tax Implications

Navigating real estate and tax regulations in Canada can be overwhelming, particularly when you are confronted with unfamiliar situations. For example, what are the tax implications if you decide to rent out your home after moving out, or if you return to a property you previously rented to others? 

It is essential to grasp the concept of a “change in use.” According to the Canada Revenue Agency (CRA), your principal residence is the property where you typically reside. When this property shifts to being a rental, or you move back into a place you previously rented out, it triggers a “change in use.” Many people may not be aware that the CRA treats this scenario as a sale and immediate re-purchase of the property at its current fair market value (FMV), despite no actual sale occurring. This is referred to as a deemed disposition and this scenario can trigger a capital gain or loss based on the difference between the purchase price and the deemed disposition date. If the FMV of your property has increased since you purchased it, you will realize a capital gain. However, the portion of that gain from the time you occupied it as your principal residence is generally exempt from taxes under the principal residence exemption. Only the gain associated with the rental period will be taxable.  If the FMV has decreased, you will incur a capital loss. Unfortunately, capital losses related to principal residences cannot be reported on your tax return.

Strategy to minimize tax implications: Fortunately, the Income Tax Act includes options under subsections 45(2) and 45(3) that allow you to defer capital gains until the property is actually sold. 

Changing Use of your Rental Property to a Principal Residence

To defer the gain on a rental property converted to a principal residence, you must file the election with your tax return for the year the property is sold. This election cannot be made if any capital cost allowance has been claimed against the rental income in any year. This election will allow you to designate the property as your principal residence for up to four years before you actually start living in it as your principal residence.

To make this election, include a letter signed by you with your income tax return for the year in which you sell the property. The letter should describe the property and indicate that you wish to apply subsection 45(3) of the Income Tax Act.

Changing Use of your Principal Residence to a Rental Property

Conversely, if you are deferring the gain on a principal residence converted to a rental property, you need to file the election with your tax return for the year the change occurs. Once filed, you cannot claim any capital cost allowance on the property. If you do claim it in the future, the election will be automatically revoked. While your election is in effect, you can classify the property as your principal residence for up to four years, even if you are not living in it. However, during this time, you must not designate any other property as your principal residence, and you must be a resident or deemed to be a resident of Canada.

You can extend the four-year limit indefinitely if you meet the following conditions in addition to those previously mentioned:

• You are away from your principal residence due to a relocation requested by your employer or your spouse's or common-law partner's employer.

• You and your spouse or common-law partner are not related to the employer.

• You return to your original home while you or your spouse or common-law partner are still employed by the same employer, or before the end of the year following the end of that employment, or if you pass away during your employment.

• Your original home is at least 40 kilometers (measured by the shortest public route) farther from your temporary residence than your, or your spouse's or common-law partner's, new workplace.

  
  

To make this election, attach a letter signed by you to your income tax return in the year in which the change of use occurs. Describe the property and state that you want subsection 45(2) of the Income Tax Act to apply. This letter should be sent before your return’s due date.

Keep in mind that despite these elections extending the principal residence exemption eligibility, only one property can be claimed under the exemption each tax year. Thus, while you might claim the exemption for the year the property was rented, you would lose the exemption on any other properties for that same year. This extension can be particularly advantageous if you rented your home for a renovation or moved away for employment for that time.

By understanding the reporting requirements and strategies, you can handle changes effectively and reduce tax burdens. Accurate reporting and documentation are crucial to avoid issues with the CRA and make the most of real estate tax rules. Consulting a tax professional is advisable for personalized guidance.