Change of Use: What Happens When a Home Becomes a Rental, or the Reverse

Moving into a property you used to rent, or renting out a property you used to live in, is a tax event even though no money changes hands and nothing is sold. The Income Tax Act treats a change in the use of a property as a deemed disposition at fair market value, followed by a reacquisition at that same value.

Most people find this out afterwards, when a return is being prepared for the year they finally sold, and the question of what the property was worth in a year nobody documented becomes unanswerable.

What the deemed disposition actually does

Two things happen at the moment the use changes.

A gain or loss is realised. The difference between fair market value at that date and your adjusted cost base is a capital gain, taxable in that year, unless it is sheltered.

The cost base resets to that fair market value. Everything from that point forward is measured against the new figure.

For a home converted to a rental, the gain up to the conversion date is usually sheltered by the principal residence exemption for the years the property qualified, so the immediate tax is often nil. The point of the exercise is not tax today: it is establishing the line between the exempt period and the taxable period, which will decide the tax when you eventually sell.

That means the fair market value on the date of the change is the single most important number in the file. Get an appraisal. A realtor’s opinion letter at the time is better than nothing; a reconstruction eight years later from stale listing data is what you are trying to avoid.

The two elections

The Act provides elections that defer the deemed disposition. They run in opposite directions and they are not interchangeable.

The 45(2) election is the one most people need. You move out, you rent the house, and you elect to be treated as though the use never changed. While the election is in force you may designate the property as your principal residence for up to four years even though you do not live in it, provided you do not designate another property for those years and you claim no capital cost allowance.

The 45(3) election works the other way. A rental property becomes your home, and the election pushes the deemed disposition out to the eventual sale, letting you designate up to four preceding years. It is unavailable if capital cost allowance was claimed on the property, which is why the CCA decision made years earlier keeps deciding outcomes long afterwards.

The four-year rule has an exception worth knowing

Section 54.1 removes the four-year cap on a 45(2) election where you are away because your employer, or your spouse’s or common-law partner’s employer, relocated the place of employment. The conditions are specific:

• The employer is not related to you or your spouse or common-law partner
• The new home is at least 40 kilometres closer to the new place of employment than the old home is
• You resume ordinarily inhabiting the original home while still employed by that employer, or by the end of the tax year following the year that employment ends, or you die during that employment

This is the provision that saves posted public servants, military members and transferred executives, and it is routinely missed. If a move was employer-driven, check it before assuming four years is the limit.

The CCA question decides everything downstream

Claiming capital cost allowance on a converted home looks attractive: it shelters rental income now. It also:

• Makes the 45(2) election unavailable, or invalid if the election was made
• Makes the 45(3) election unavailable on the reverse conversion
• Triggers recapture on sale, fully taxable as income, not half-taxable as a gain
• Can permanently damage the principal residence position on the rented portion

The deduction is a deferral. The consequences are structural. Almost every time I model it over the life of a property, claiming CCA on a residence that will later be sold, or moved back into, loses. How CCA itself works is set out in capital cost allowance explained, and the CRA covers the conversion mechanics in changing from personal to rental use.

Partial changes of use

Renting the basement, or running a business from part of the house, is a partial change of use, and technically it triggers a deemed disposition of the portion converted.

In practice the CRA does not apply that treatment where the income-producing use is ancillary to the main use as a residence, there is no structural change to the property, and no capital cost allowance is claimed on the rented portion. All three conditions have to hold. The position is discussed in Folio S1-F3-C2.

Building a separate entrance, a second kitchen and a legal secondary suite is a structural change. A tenant in a bedroom is not. The middle ground is genuinely grey and depends on the facts, so if a renovation is planned, get the analysis done before the walls move rather than after.

Working out which situation you are in

Has the way the property is used changed?
  |
  +-- Whole property, home to rental
  |     |
  |     Do you want to keep designating it as a principal residence?
  |       |
  |       +-- Yes .... File the 45(2) election with that year's return.
  |       |            Claim NO capital cost allowance.
  |       |            Check section 54.1 if the move was employer-driven
  |       |
  |       +-- No ..... Report the deemed disposition. Get the fair market
  |                    value appraised and keep it forever
  |
  +-- Whole property, rental to home
  |     |
  |     Was CCA ever claimed on it?
  |       |
  |       +-- Yes .... No 45(3) election. Report the deemed disposition
  |       |            and the recapture
  |       |
  |       +-- No ..... Consider the 45(3) election, filed with the return
  |                    for the year you eventually sell
  |
  +-- Part of the property only
        |
        Structural change, or CCA claimed, or use is more than ancillary?
          |
          +-- Yes .... Deemed disposition of that portion
          |
          +-- No ..... Generally no deemed disposition. Document why

What to do the week the use changes

1. Get a written valuation dated within the month of the change
2. Decide on the election before the filing deadline for that year. A 45(2) election filed with the correct return is routine, and a late one is not something to plan around
3. Do not claim capital cost allowance, and tell whoever prepares the return in writing
4. Split the expense records cleanly from the date of change, and read rental property accounting for landlords on what is deductible from that point
5. Record the years designated, and remember that a designation on this property is a designation you cannot use on another one. That comparison is set out in the principal residence exemption
6. Report the eventual sale on Form T1079 and Schedule 3, even where the whole gain turns out to be exempt

The distinction between rental activity and a business, which affects several of the deductions available afterwards, is covered in rental income versus business income.

If you have moved out of a home and rented it, or moved into a former rental, and no election was filed or no valuation was obtained, it is worth reviewing while the year is still open. The cost of fixing this at the point of sale is considerably higher.