When selling a property, it is generally known that capital gains tax needs to be calculated based on the property’s use, and the corresponding tax must be paid. If the property is a principal residence, the Principal Residence Exemption (PRE) can be used to exempt some or all of the capital gains tax. However, many people are unaware of the provisions of Section 45(1) of the Income Tax Act, which states that when there is a change in the use of a property, it is deemed to be disposed of at fair market value. A change in use refers to converting a property used for personal purposes into one used for income-generating purposes, or vice versa. In simple terms, this means that if you previously owned a principal residence or a vacation home that you used solely for personal enjoyment (e.g., living or vacationing), and then decided to use that property to generate income, whether through long-term rental or running a Airbnb, the property is deemed to have been sold at its fair market value at the time of the change in use. The same rule applies if you convert a rental property into one for personal use. The Income Tax Act also provides two sister provisions, Sections 45(2) and 45(3), which allow taxpayers to make elections that, if used correctly, can effectively avoid capital gains tax.
When a property changes its use, taxpayers have two options. The first option is to report the deemed disposition of the property at fair market value on their tax return for that year. The second option is to file the appropriate election under Sections 45(2) or 45(3) of the Income Tax Act. These two options are mutually exclusive; you must choose one or the other. Ignoring this could result in severe tax consequences or penalties. This article primarily focuses on the tax treatment when a principal residence is converted into a rental property.
If you decide to convert your principal residence into a rental property, the first option is to report the deemed disposition of the property at its fair market value at the time of the change in use on your tax return. To avoid the tax consequences of the change in use, you may be able to designate the property as your principal residence, thereby utilizing the Principal Residence Exemption to avoid capital gains tax, provided certain conditions are met. As a result, the gain in the property’s value from the time of purchase to the time of the change in use would be tax-exempt. On the day of the change in use, your principal residence becomes a rental property, and the cost of the rental property is the fair market value at the time of the change in use. You should contact a real estate agent or property appraiser to determine the property’s fair market value at the date of the change in use and report this on your tax return.
The second option is to submit a tax election under Section 45(2) of the Tax Act, known as the 45(2) election. This will be considered as if the change in use has not occurred. This election is particularly useful because it has two effects: First, if you file the Section 45(2) election, you will not be deemed to have disposed of your property on the date of the change in use. Second, if you file the Section 45(2) election, you may continue to designate the property as your principal residence for up to an additional four years while it is being used as a rental property. In markets like Toronto and Vancouver, where property prices have been rising significantly year after year, avoiding an additional four years of capital gains could be very valuable to property owners. Below is an example illustrating how this option can be used to completely avoid capital gains tax when a property undergoes a change in use during the ownership period.
In 2011, Peter purchased a property in Toronto for CAD 500,000 as his principal residence. In early 2017, Peter decided to pursue a career in Vancouver and began renting out his property. The property’s fair market value was CAD 1,000,000 at the time it was rented out. Under tax law, this is deemed to be a sale of the principal residence for CAD 1,000,000, and the purchase of a rental property for CAD 1,000,000.
In 2022, Peter’s career in Vancouver was thriving, and he decided to settle in Vancouver permanently, so he listed his Toronto property for sale. The property eventually sold for CAD 1,500,000.
If Peter chose the first option, he would need to report the deemed disposition of his principal residence at CAD 1,000,000 on his 2017 tax return, with a capital gain of CAD 500,000. Since the property was his principal residence for the previous seven years, he could use the Principal Residence Exemption to avoid capital gains tax on the CAD 500,000 gain. When Peter actually sold the property in 2022, he would need to report the sale of the rental property for CAD 1,500,000 on his 2022 tax return, with the rental property’s cost being the fair market value of CAD 1,000,000 at the time of the change in use in 2017. Peter would need to report a capital gain of CAD 500,000 on his 2022 tax return, of which CAD 250,000 would be included in his taxable income for the year.
If Peter chose the second option, since the property was converted into a rental property in 2017, he could file a Section 45(2) election with the CRA by April 30, 2018. As a result, the deemed disposition at the time of the change in use would not be recognized, and Peter could continue to designate the property as his principal residence for up to four additional years. When Peter finally sold the property in 2022, he would need to report the sale of his principal residence for CAD 1,500,000 on his 2022 tax return, with the property’s cost being CAD 500,000. Over the 12 years of ownership, the property appreciated by CAD 1,000,000. Since Peter filed the Section 45(2) election in 2018, the property could continue to be designated as his principal residence for the four years from 2018 to 2021. The property was his principal residence for a total of 11 years out of the 12 years of ownership (7 years of actual use plus 4 years of deemed use under the Section 45(2) election). The exempt capital gain can be calculated using the following formula:
(Designated years as PR + 1) / Years of ownership x Capital gain on sale
(11 + 1) / 12 x CAD 1,000,000 = CAD 1,000,000
Therefore, the entire CAD 1,000,000 capital gain would be exempt from tax using the Principal Residence Exemption.
The Section 45(2) election must meet the following conditions:
- You must report the rental income during the rental period.
- You cannot claim depreciation on the property.
- The Section 45(2) election must be filed by the tax filing deadline, typically April 30. The penalty for late filing the Section 45(2) election is CAD 100 per month, up to a maximum of CAD 8,000.
Generally, after the property is converted into a rental property, the Section 45(2) election only allows you to designate the property as your principal residence for a maximum of four additional years. In some special circumstances, such as when you have to live in another city for an extended period due to work or business reasons and have to rent out your property for a long time, you can apply to the CRA to extend the designation period.
Using the Section 45(2) election can effectively avoid a substantial amount of capital gains tax. However, it is not always the optimal option under all circumstances, especially for owners of multiple properties. A more detailed analysis should be conducted considering each individual’s specific situation, the trends in the real estate market, and other factors. Real estate investment tax planning is a complex and intricate issue, often involving significant amounts of money. Therefore, consulting an experienced accountant is a wise decision.
For information on what types of properties qualify as a principal residence, you can refer to an earlier article: Principal Residence Series (Part 1) –Principal Residence and Principal Residence Exemption.