Many Canadians are aware of the principal residence exemption (PRE), which shelters income tax on the capital gain when a property is sold or deemed sold. Each family unit (generally, a Canadian taxpayer, along with a spouse or common law partner and any unmarried children under age 18) can designate one property as its principal residence for each tax year owned, provided the property is ordinarily inhabited by the taxpayer (or spouse/partner or former spouse/partner or child). Key is that the home is for personal use, and generally not to earn income.
Not well understood are the income tax implications when a property is either partially or fully converted from a principal residence into an income-producing property (or vice versa).
For example, many younger Canadians entering a rising real estate market may decide to rent a portion of their homes (e.g., the basement) to help cover higher housing costs. Alternatively, Canadians with residential rental properties may choose to personally occupy the properties, instead of buying in a hot real estate market.
These examples have implications when claiming the valuable PRE that Canadians covet.
The general tax rule is that when a taxpayer converts the use of a property, partially or fully, they’re deemed to have disposed of and immediately to have reacquired the property at fair market value (which establishes the new adjusted cost base). When a property changes use from principal residence to income-producing, the PRE should shelter the entire capital gain provided the property is designated the taxpayer’s principal residence for each tax year owned. The concern is that when the converted income property is sold in future, a higher taxable capital gain may result.
Here are examples showing how to lessen the tax impact when a change in use occurs.
Partial use for income
In 2017, David purchases a home in Niagara Falls. In 2018 he decides to convert the basement into a rental unit. Under the tax rules, a change in use occurs when David rents the basement to the tenant, resulting in a deemed disposition and possible future taxable capital gain on the converted portion of the home.
The good news is David can still claim the PRE on the entire property—to shelter income taxes and defer reporting the deemed disposition—if three tests are met:
- The home’s income-producing portion is small relative to its personal use portion as a principal residence.
- No structural change to the property occurred for the conversion.
- Capital cost allowance (CCA) hasn’t been claimed on the property.
If David doesn’t meet all three conditions, he can’t designate the entire home as his principal residence. This means he’ll likely have some tax to pay at the time of sale if the property has appreciated in value. When a sale occurs, he must allocate sale proceeds (as well as cost amounts) between the home’s principal residence portion and its income-producing portion, generally based on square feet.
Full use for income
Alyssa lives at home in Truro, N.S., with her parents. In 2016 she receives a job offer in Halifax and purchases a home there for $400,000. In 2018 she is laid off, moves back in with her parents and decides to rent her Halifax home, now valued at $450,000. She anticipates the Halifax real estate market will continue to appreciate and expects her home to be worth $550,000 in five years.
Since Alyssa converted her principal residence into an income property, she’s subject to the change in use rules and is deemed to have disposed of her Halifax home at fair market value ($450,000). While this deemed disposition could result in a capital gain, it may be eliminated or reduced using the PRE. The good news is that Alyssa can file a special election under subsection 45(2) of the Income Tax Act, which effectively deems the change in use not to have occurred and defers reporting the deemed disposition until the property is actually disposed.
Alyssa files this election by attaching a signed letter to her tax return for the year in which the change in use occurs, and the election is in effect into the future (unless she rescinds the letter). For the election to remain in force, Alyssa can’t claim CCA on the Halifax property and must report all rental income on her tax return.
The best part about this election is that Alyssa can continue to designate the Halifax property as her principal residence for an additional four tax years while the property is used for income. This opportunity is available as long as she’s a Canadian resident or deemed resident for taxation purposes, and no other property is designated as the principal residence throughout that four-year period.
Alyssa’s two potential scenarios are as follows:
- No election filed: The PRE shelters the tax on the capital gain of $50,000 ($450,000 − $400,000). If she sells the property in five years for her anticipated $550,000 price, she pays tax on 50% of the increase in value of $100,000 ($550,000 − $450,000).
- Subsection 45(2) election filed: By filing the election, the change in use is deemed not to have occurred. Instead, the disposition can be deferred until the property is sold. Assuming she sells the Halifax property in five years for $550,000, the PRE can be used to shelter the entire $150,000 capital gain because of the four additional years she could designate the property by filing the election (as well as the “one-plus” provided by the PRE formula).
It’s important to note that a similar election (subsection 45(3)) is available to defer reporting any capital gain when an income-producing property is fully converted into a principal residence. In this case, the property may be designated as the principal residence for a period up to four years preceding the change in use, to replace the ordinarily inhabited rule. Similar to the subsection 45(2) election, CCA can’t be claimed to qualify for this election. Finally, the election doesn’t have to be filed until the tax filing deadline for the year in which the property is sold (not at the time the change in use occurs).