Real estate: Change of use rules / deemed disposition rules

Most people understand that whenever they sell a capital property, they will pay tax on capital gain under the Income Tax Act (ITA) section 45(1). However, what many don’t understand is that in some scenarios, even without actually having sold the property, they have to pay taxes on a deemed capital gain on the property.

Whenever there is a “change of use” in the property it is considered to have been sold as per the tax law, called the “deemed disposition”. The owner is deemed to have disposed of the property (land and building) and to have immediately reacquired it, with both transactions done at fair market value.

A very common example of change of use is when a person purchases a new home, stops living in the old residence (personal use), and starts renting it out (business or commercial use). At this point, he is deemed to have disposed of his old residence.  Even though in this case tax on the capital gain may be avoided by claiming personal residence exemption, if this was a principal residence. But this means that the taxpayer would not be able to claim the principal residence exemption on any other property for those years.

This does not end here. If the same taxpayer after a couple of years decides to stop renting and resumes living on the property. This will constitute another change of use (from commercial to residential) and trigger another deemed disposition. Any capital gained based on the current market value of the property will be included in the taxpayer’s income.

In an actual sale and capital gain at least, the taxpayer has cashflow to pay the potential taxes (though no one likes to pay taxes), but in deemed disposition cases what is more painful is that the capital gain is on paper only however, the tax bill is actual. And in many cases, taxpayers struggle to pay that liability.

S.45(2) Election: Change in Use of a Property from Personal Use to Income-Producing

The ITA provides a solution to this problem under section 45(2) i.e., a taxpayer can elect to be deemed not to have begun to use a property for commercial or business purposes. Consequently, the change of use rule will not apply, with no deemed disposition and no capital gain. The election remains in effect as long as the taxpayer rescinds the election or sells the property.

If you make this election:

• you must report the net rental or business income you earn
• you cannot claim capital cost allowance (CCA) on the property

While your election is in effect, you can designate the property as your principal residence for up to 4 years, even if you do not use your property as your principal residence. However, during those years you must meet ALL the following conditions:

• you do not designate any other property as your principal residence
• you are a resident or deemed to be a resident of Canada

For example, if a taxpayer started renting out his personal residence in 2020 before ultimately selling it in 2023. Then the taxpayer may claim this property as a principal residence exemption till 2023 even though he was not living there.

You can extend the 4-year limit indefinitely if the change of use happens because of employment conditions and certain conditions are met in addition to the above-listed conditions.

Other examples which trigger deem disposition rule may include: –

• Stop renting the property and occupying it as your residence.
• Demolishing a house to construct a new home.
• The gift of a property.
• Proceeds received from the expropriated property.
• Insurance proceeds from a flood or fire.

S.45(3) Election: Change in Use of a Property from Income-Producing to Personal Use

Where a taxpayer changes the use of a property from income-producing (e.g., rental property, office) to personal use (such as personal residence) change of use rule will trigger another deemed disposition. However, subsection 45(3) provides an election to avoid the deemed disposition on the change in use. A subsection 45(3) election is only applicable where capital cost allowance has not been claimed on the property in question.

This allows the taxpayer to defer the capital gains accrued while the property was rented out until it is ultimately disposed of. This election can allow the taxpayer to claim principal residence exemption for up to 4 years prior to the year of change in use.

The combination of sections 45(2) and 45(3) may not exceed four years.

Late Filing the Principal Residence Exemption

If you forgot or missed designating your property as a principal residence in the year of the sale, you can request the CRA to amend your income tax and benefit return for that year. Though penalties may apply, s.220(3) of ITA allows the Canada Revenue Agency (the “CRA”) the discretionary power to accept late-filed s.45(2) elections.

If you are a real estate investor, manager, or owner, Source Accounting Team can assist you with tax preparation, tax planning, and determining how tax provisions are applicable in your situation. Please get in touch with us at info@sourceaccounting.ca or call 647-930-8130 for further details..

Source Accounting Professional Corporation (CPA) is a full-service accounting firm in Mississauga, helping commercial real estate agent, real estate broker, real estate developer, property manager, real estate agent, mortgage broker, mortgage agent by providing tax preparation, corporate tax filing, accounting, bookkeeping services, payroll solutions, etc. If you are looking for an accountant Mississauga (Brampton, Toronto, GTA) or an accountancy firm Brampton, you are in the right place.

Disclaimer: The above contents are provided for general guidance only, based on information believed to be accurate and complete, but we cannot guarantee its accuracy or completeness. It does not provide legal advice, nor can it or should it be relied upon. Please contact/consult a qualified tax professional specific to your case.