Deemed Disposition
Where there is a change in use of property (real estate), the owner of the property is deemed to have sold the property, and to have immediately re-purchased it. This occurs whether the change in use is from personal use to income producing, or from income producing to personal use. Both the sale, and re-purchase are done at fair market value.
Income Producing a Personal Use
When a property changes from incoming producing to personal use, the deemed sale may result in a capital gain. A capital gain is calculated by subtracting the “adjusted cost base” of the property from the fair market value at the time the change in use occurred. The adjusted cost base is essentially the purchase price plus various capital improvements.
If there is a partial change of use then the deemed sale will only be for that portion of the property. An example of this would be changing an income producing property into a duplex where the owner lives in the newly created space.
If a capital gain is produced by the change in use, it can be deferred by making an election under subsection 45(3) of the Income Tax Act. Further information on this election may be found here: T4037 Capital Gains.
Personal Use a Income Producing
When a property changes from personal use to income producing, the deemed sale may result in a capital gain. This capital gain can be eliminated by making use of the Principal Residence Exemption (link to article) if applicable.
Canadians should be careful when changing an offshore property from personal use to income producing. If this occurs, and the property is worth more than $100,000 CAD, the Canada Revenue Agency requires a form filled out known as the T1135 foreign income verification statement for each year the property is owned moving forward.
There is a way for the property owner to defer the change in use known as electing under subsection 45(2) of the Income Tax Act. This election deems the change in use to not have occurred. The election can only be made if there is a complete change in use. A partial change in use will not suffice.
Once the election is filed, the property can qualify as the owner’s principal residence for up to 4 taxation years, even if the owner does not live there. The owner must remain a deemed resident of Canada during these years, and cannot designate another property his or her principal residence.
The election should be filed in the year that the change of use occurs. The Canada Revenue may accept a late filed election. For more information please see CRA Information Circular 92-1, Guidelines for Accepting Late, Amended or Revoked Elections.
Example:
Mr. Monroe rented out his principal residence on June 1, 2004 after living in it since 1994. Mr. Monroe moved in with a friend at this time. He filed a subsection 45(2) election for the 2004 taxation year, and sold the property in 2010. No capital cost allowance was claimed while the home was being rented.
As the election was filed, the following would occur:
- The change in use was deemed not to occur.
- There was no deemed sale in 2004.
- When the home was sold in 2010, there would be a capital gain.
- The number of years that qualify for the principal residence exemption would be 11 (1994 to 2004) plus 1 (regularly allowed by PRE formula) plus 4 (because of election being filed), for a total of 16 years.
- As the home was owned for 17 years, the principal residence exemption would shelter 16/17 of the total gain.
If the election was not filed then there would be a deemed sale in 2004 at fair market value with any gain sheltered by the Principal Residence Exemption. Once the property was sold, there would be a capital gain based on the increase in the fair market value since the deemed sale.
Change in Use by Reason of Employment
Subsection 54.1 of the Income Tax Act allows a property to qualify as a principal residence for more than 4 taxation years if the reason for the change in use is related to employment changes. For the requirements please see subsection 54.1 of the Income Tax Act.
Renting out the Basement
If a property owner decides to rent out a portion of their principal residence, there is a change in use for that part of the home. The use is changed from personal use to income producing (rental property). When the owner sells the home, or changes the property back to completely personal use, there may be a capital gain to report.
However, there are times where the above does not result in a change of use. If all of the following conditions are met, the property owner will not be considered to have a change of use:
- The part of the home used for rental purposes is small in relation to the size of the whole property;
- Structural changes are not made to the property to make it more suitable for rental purposes; and
- Capital cost allowance is not claimed on the part you are using for rental purposes.
If all of the above conditions are met, there is no change of use, and a capital gain would not be reported on the eventual sale.
The CRA Rental Income Tax Guide, T4036, and S1-F3-C2: Principal Residence all provide for the change in use rule found above.
CRA Resources:
Changing all your principal residence to a rental or business property: http://www.cra-arc.gc.ca/tx/ndvdls/tpcs/ncm-tx/rtrn/cmpltng/rprtng-ncm/lns101-170/127/rsdnc/chngs/chngngll-eng.html
Guide T4002, Business and Professional Income
T2091(IND)-WS, Principal Residence Worksheet
TI-001, Sale of a residence by an owner builder
Designating a principal residence
Changes in the use of a principal residence
Sale of farm property that includes a principal residence
