Clients who are considering renting out their homes to earn income need to be aware of the tax rules that govern what’s known as “change in use” of property — particularly when that property is a principal residence.
“[Change in use] is not for the do-it-yourself tax preparer,” said Aurèle Courcelles, assistant vice-president of tax and estate planning with IG Wealth Management in Winnipeg. “You want to make sure you [plan] properly.”
When a taxpayer changes the use of their property — for example, from their own residence to a rental — they are deemed to have disposed of it for its fair market value (FMV) and reacquired it for the same amount.
The property’s adjusted cost base also changes to that amount for tax purposes. The taxpayer must report any resulting capital gain or loss in the year the change of use occurs.
If the property was the taxpayer’s principal residence before the change of use, a gain will not result in taxes owing provided the taxpayer claims the principal residence exemption (PRE) for the property. (The taxpayer need only report any gain relating to the years the property was not a principal residence.)
The taxpayer is allowed to defer the deemed disposition, however, through an election. To qualify, the taxpayer must report the rental income they earn and cannot claim depreciation, known as capital cost allowance (CCA), on the property.
While the election is in effect, the taxpayer can designate the property as their principal residence for up to four years, even if they don’t actually live there, as long as they don’t use the PRE for any other property and they remain a Canadian resident. If a taxpayer’s employer requires them to relocate, they may be entitled to extend access to the PRE beyond four years.
If the taxpayer doesn’t plan to own a second principal residence during the time they take the election, then taking it “can really make sense,” said Debbie Pearl-Weinberg, executive director of tax and estate planning with CIBC Private Wealth in Toronto. The election will shield from tax up to four additional years of gain on the value of the property.
But if the taxpayer does plan to own a second principal residence while renting out the first property, they’ll need to consider how long they intend to live in the second property, whether they plan to eventually move back into the first property and, perhaps most important, which property is more likely to have a larger gain in value over the years of ownership.
Unfortunately, these factors are difficult to predict. “You’d want a crystal ball to know the direction of home prices and when you’re going to sell them,” Pearl-Weinberg said.
The change-in-use rules do not apply if a taxpayer rents out only a relatively small part of their principal residence and continues to live in the rest of the property, provided the taxpayer doesn’t claim CCA on the rented part of the home and makes no structural improvements to that portion of the property.
When all those conditions are met, the taxpayer may claim the PRE for the entire residence, even though they’re generating rental income from part of the home.
However, if one of these conditions is not met — for example, the homeowner converts the basement into a self-contained dwelling — then a partial change of use will apply to the rented portion of the principal residence. There’s a deemed disposition of the rented portion of the house, and proceeds from the eventual property sale will be split between the rented portion and the principal residence either by square metres or the number of rooms, as long as the split is reasonable.
While determining whether a rented portion of a home constitutes a change of use is a judgment call, claiming CCA means the change-of-use rules apply, said Doug Carroll, tax and estate specialist with Aviso Wealth Inc.in Toronto. “Depending on the facts, [the rental] might not have constituted a change of use in the property, but now the CRA is alerted that there is something going on.”
The change-of-use rules also apply when a property is converted from a rental to a principal residence, with a deemed disposition at FMV and automatic reacquisition for the same amount.
The taxpayer can elect to defer the deemed disposition if CCA hasn’t been claimed for the property. The taxpayer may designate the property as their principal residence for up to four years before the change of use occurs.
Carroll advises clients to tread carefully when dealing with these rules. “The PRE is one of the greatest tax benefits that we have in our [tax] system,” he said. “You want to be very careful not to put it at risk.”
Nota bene: Three key points about change-in-use rules and principal residences
Prior to March 2019, the election to defer the deemed disposition was not available to taxpayers when there was only a partial change in use. In the 2019 federal budget, the government announced the election would be available for partial changes in use that occurred on March 19, 2019, or later.
The deemed disposition deferral election must be filed for the tax year during which the change of use occurred. The Canada Revenue Agency will accept a late-filed election at its discretion if the taxpayer hasn’t claimed capital cost allowance for the property. However, the CRA will disallow the late-filed election if the agency believes the election constitutes “retroactive tax planning.”
For a property to qualify as a taxpayer’s principal residence, the taxpayer must own the home or co-own it with another person. The taxpayer, their spouse or common-law partner, or at least one child must live in the house for at least some time in the year. A taxpayer can designate only one property as their principal residence in a year. For tax years after 1981, only one property per family unit can be designated as a principal residence.