One topic that consistently captures the attention of property owners and investors is the change in use of property. Whether you’re a homeowner contemplating the transformation of your residence into a rental property, or a real estate investor seeking to optimize your portfolio, understanding the intricacies of altering a property’s use is of the utmost importance. This shift not only carries significant financial implications but also requires careful navigation through the tax rules and regulations, and we are here to help.
Change in Use of Property
Are you looking to change the use of your principal residence or other properties? Or are you curious about income generating properties and how you could change your principal residence into a rental property? There are certainly some tax implications to consider.
Many taxpayers are not aware that each time you change the use of a property that you own from a personal-use property to an income-producing property or vice versa, you are considered to have sold the property for tax purposes. Whenever you make a change in the use of your property it is deemed to be sold at its fair market value and immediately reacquired at the same amount. The fair market value at the date of the change of use becomes the new adjusted cost base of the property.
The resulting capital gain or loss on this deemed disposal of the property must be reported on your tax return in the year the change of use occurs. There will be tax calculated on any capital gain that arises, but there will be no proceeds to pay this tax as the property has not actually been sold. However, here is where Lott & Company comes in – there potentially is relief from this prepayment of tax. Now let’s dive in!
Changing your principal residence to a rental property
There are a few options to consider when changing your principal residence to an income-generating property. As we discuss all options, we will offer insight and guidance in order to help you make the best choice for you.
Any capital gain that results from converting a principal residence to a rental property could be sheltered by using your principal residence exemption (PRE). You must file Form T2091 to make the principal residence designation for the applicable years. If you have not previously designated any of the years in which you owned the current property as your principal residence, then you will be able to shelter all the capital gain from tax using the PRE.
Now, if you have already designated another property as your principal residence for some of the years in which you owned the current property, then you must report the portion of the capital gain that relates to the years for which you did not designate the current property as your principal residence. For example, you may have owned a cottage at the same time as your current home. If the cottage was sold and for the years that it was owned the cottage was designated as your principal residence, then those years are not available for your current home.
There is another option available to you to avoid paying tax on the change of use of your personal-use property. You can make an election using the provisions of subsection 45(2) of the Income Tax Act (ITA) to deem the change of use not to have occurred. This election defers the payment of tax on any capital gain until the property is sold or the election is rescinded. This election will remain in force, even if the property is changed back to personal-use after making this election.
However, if this election is made, you cannot claim capital cost allowance (CCA) on the property. You still need to report the rental income on this property each year.
This election must be filed for the tax year in which the change occurs. If you have not filed the election within the year the change occurred, it can be filed late, but keep in mind there is a late-filing penalty that must be paid before the election can be accepted.
If the property was your home and you file the election under subsection 45(2), then you can also designate the property as your principal residence for up to four additional consecutive years, even if you do not use the property as your principal residence. To make this additional designation, you must be a resident of Canada and cannot designate any other property as your principal residence for those years. However, the four-year limit can be extended if you had to relocate at your employer’s request and certain other conditions are met.
Changing your rental property to a principal residence
Now let’s look at the reverse, you are changing your rental property back to your principal residence. The subsection 45(2) election does not work when a property’s use is changed from income producing to personal. However, subsection 45(3) allows for a similar election to be made to postpone the reporting of the deemed disposition until the property is actually sold if the property becomes your principal residence.
This election can only be made if no CCA has been claimed on the property since 1985. If CCA was claimed prior to 1985, you must include any recapture in your business or rental income in the year of the change of use. In this case, this election only needs to be filed by the due date for your personal tax return in the year in which the property is actually sold.
In addition, the property can be designated as your principal residence for up to four years before you occupy it as your principal residence.
Changing a portion of your principal residence to a rental property or vice versa
The above elections under subsections 45(2) and 45(3) can also be used so that the deemed disposition that would normally arise on a partial disposition does not apply in the year of the change.
If converting a portion of your principal residence to a rental property, CRA will consider that no change in use has occurred if the following conditions all apply:
- Your rental use of the property is relatively small in relation to its use as a principal residence;
- You do not make any structural changes to the property to make it more suitable for rental purposes; and
- You do not deduct any CCA on the part you are using for rental purposes.
If all conditions are met, then the entire property may qualify as your principal residence, even though you are using a portion for rental purposes. If the conditions are not met, then there is a deemed disposition of the portion of the property that is converted to rental use. When the property is actually sold, the selling price must be allocated between the part of the property used as a principal residence and the part used for rental or business purposes. Any capital gain on the rental or business portion must be reported for tax purposes, however, the year in which this gain is reported may be deferred if a subsection 45(2) election is filed in the year the change in use occurs.
Navigating these waters can be tricky, seeking expert assistance is the best way to ensure you make the most out of your property. Please contact Lott & Company if you require advice when planning a change in the use of a property or if you have already begun the process and are looking for advice as you navigate this transition. We can review the options available to help to minimize and/or defer your tax liability.