Many times a property is bought for one use, but the owner may later decide to put it to another use. This is often the case with a house: as the family’s circumstances change, the use of the home may also change. For example, a family home may be rented out during a long-distance work assignment. A partial change might also occur. For example, new homeowners may rent out part of their basement to help cover the mortgage in the early years, and may later reclaim that basement space for personal use.
The general tax rule is that a change in use triggers a deemed disposition, in which case the property owner must report any resulting capital gain or loss on his or her income tax return in the year of the change. Of course, a capital gain on the disposition could be reduced by any available principal residence exemption. A change in use can be complete or partial.
There are exceptions to the general deemed disposition rule. The first exception allows the taxpayer to elect to defer the deemed disposition when changing from a principal residence to another use. This is achieved by preparing a signed letter in which the taxpayer clearly requests the election. The letter is submitted to the Canada Revenue Agency by filing it with the taxpayer’s income tax return for the year in which the change in use has taken place. If the taxpayer uses e-filing, the request must be separately paper filed. The election is not available if there is only a partial change in use.
This election to defer is only available provided the taxpayer does not claim depreciation/capital cost allowance (CCA) during the time the property is used for income-producing purposes. Should the taxpayer decide to claim CCA on the property, it will cause the election to be rescinded on the first day of the year in which the CCA claim is made. Alternatively, should the taxpayer rescind the election in one of the subsequent years, a deemed disposition of the property on the first day of that subsequent year and immediate tax consequences would occur.
During the time that the election remains in effect, the property will continue to qualify as the taxpayer’s principal residence for up to four years, even if the taxpayer or his or her family does not reside in the home. However, the taxpayer must continue to be a resident of Canada for tax purposes.
Rather than file the election to defer the gain resulting from the deemed disposition, the taxpayer could choose to report the gain and offset it by claiming any available principal residence exemption.
Consider the following example:
- Home bought in 2001 for $500,000 and used as a principal residence
- Change in use in 2005 to a rental property when the home was worth $600,000.A letter was filed with the 2005 tax return requesting a deferral of the deemed disposition.
- Home sold in 2014 when the home was worth $800,000.
The homeowners could recognize the deemed disposition in 2005 and report the resulting capital gain of $100,000 on their tax returns. They could claim the principal residence exemption and offset the income tax consequences of recognizing the capital gain.
The homeowners could elect to defer the gain in 2005 and wait until the year of disposition to report any resulting gain. In 2014 they would report a capital gain of $300,000. The principal residence exemption could be applied to the years 2001 to 2009 for a total of nine years out of 14 years of ownership. The formula produces a principal residence exemption of approximately $214,300, derived as 101 ÷ 142 x $300,000. The couple would have a net income inclusion of $42,850 ($300,000 capital gain less $214,300 principal residence exemption x the capital gains inclusion rate of 50%). Notes: (1) 9+1 years of principal residence designation; (2) 14 years of ownership.
The second exception to the deemed disposition rule is when there is a change from a rental property to a principal residence. The taxpayer can elect to defer the gain, but only if no capital cost allowance has been claimed on the property that is being changed over from a rental to personal use property.
It should be noted that these deemed disposition rules can change the adjusted cost base of the property. This could have a big impact if the property is offshore, because the new adjusted cost base may exceed the $100,000 foreign property reporting threshold for the taxpayer.
As life changes, one’s plans can change too. It is important to recognize what reporting has to be done from an income tax perspective, and equally important to know what options may be available.
E.O. & E.
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Contributors to this edition:
James W. Kraft, cpa, ca, mtax, tep, cfp, clu, ch.f.c.
Deborah Kraft, mtax, tep, cfp, clu, ch.f.c.