Kody Wilson, CPA, CA, Tax Manager
I often get asked by clients how the tax treatment differs for various properties they own, and what the tax ramifications are of designating certain properties for a certain use. It is very common these days for someone to rent out their principal residence while they leave the city for work, and then purchase another property in their new location. It is also common for that person to come back to the same property at some point to once again reside there as their principal residence.
You should always consult with your tax practitioner to ensure you are fully aware of the tax consequences that go along with these types of decisions.
Let’s first examine why this decision is so relevant. Typically, you will pay tax on the gain in an asset from the time you purchased it until the time you sold it. However, the sale of a principal residence is exempt from taxation in Canada, provided certain conditions are met. This provides you with a huge potential tax savings opportunity because a home is typically the most expensive asset you will ever purchase.
When there is a change in use of a property from income-producing to principal residence, or vice versa, there is a deemed disposition at fair market value. So, essentially CRA treats the change in use as a sale, despite the fact no sale has actually taken place, and you have not received any cash.
There is really no difference in CRA’s mind between a deemed sale and an actual sale, which means taxes could be payable on the deemed sale on a change in use. You are then deemed to have reacquired the property immediately at the same fair market value.
What if you expect the rental property to appreciate significantly in the next few years? Is all this growth taxable to you, the property owner, since you no longer reside in the property? The answer would be yes, if it were not for an election (45(2) election), you may file when you to rent out the property. This election allows you to defer reporting the disposition. It also allows you to treat the property, which is now an income-producing rental, as a principal residence despite the fact you no longer live there for up to four years.
This allows up to four years of growth in the property value that may be sheltered from capital gains tax while the property is being rented. It is important to note, however, that only one property may be designated as a taxpayer’s principal residence in a given year, so a choice would have to be made if more than one property is owned at a time.
This election affords you a greater amount of flexibility. You will have the option of designating the property as your principal residence on an eventual sale if the rental property’s value appreciates significantly. However, you do not have to designate it as your principal residence during the rental period should the property not appreciate in value.
There are some restrictions around this election, and some conditions that must be met in order for the election to remain in effect. Notably, capital cost allowance (CCA) cannot be claimed on the property while the election is in effect. This would nullify the election in the year the claim is made.
Let’s quickly examine the reverse situation.
You own an income-producing property that you have been renting out, and now wish to live in the home as your principal residence. I often see this situation when someone returns from an assignment abroad, or a temporary assignment in another city.
The tax ramifications in this scenario are similar to the aforementioned situation in that there is a change in use of the property from an income-producing property to a principal residence, and a deemed sale has taken place.
The property is not eligible for the principal residence exemption in this scenario, assuming the election described above was not filed, and the gain would be fully taxable. This can put a financial strain on you because you may owe money to CRA despite the fact you did not receive any cash from a sale.
CRA recognizes this burden and allows taxpayers to make an election (45(3) election), which would defer the amount payable. If this election is made, there will be no deemed sale in the year of change, and thus the accrued gain would not be taxable at that time.
But wait, it gets even better. This election also allows you to deem this property as your principal residence for up to four years prior to actually moving in, when the property was rented out and you were not living there. While the previous election allows for some forward planning, this election allows for some retroactive planning if a rental property increases substantially in value.
This election also has certain conditions which must be met. CCA cannot be claimed on the property during the period in which it was rented out. It is also important to keep in mind that you must be considered a resident of Canada in order to be able to take advantage of the principal residence exemption in a given year.
As can be seen from the discussion in this article, many tax planning opportunities exist in relation to property ownership. A professional should always be consulted during this process to ensure any tax planning opportunities are fully utilized and you are fully informed before making any decisions.
