What are the tax implications of changing your principal residence into a rental property (or vice versa)?

A change in use occurs if you convert all or part of your principal residence into a property used to earn income, or vice versa. For example, a taxpayer rents out a room in their home for rental income, or a landlord wants to reside in a property that was previously rented out. Regardless of the reason, it’s important to be aware of the tax implications in doing so.

Every time you change the way you use a property, you are considered to have a deemed disposition for Canadian income tax purposes. Barring any elections, you are deemed to have sold and immediately repurchased your property for its fair market value at the time the change in use occurs. If the fair market value on the date of the deemed disposition is greater than its adjusted cost base (ACB) when you last purchased or changed its use, a capital gain will arise.

Full change in use from residential to rental

If your principal residence is converted into a rental property, the capital gain resulting from the change in use can be partly or fully exempt by the principal residence exemption.

Principal residence exemption

• You can only designate one property as a principal residence each year, and it must be a property that you, your spouse, common-law partner, or child(ren) ordinarily inhabited for most of the year
• Individuals cannot designate another property as their principal residence.
• This does not include children who are 18 years old or older, who are married, or who are in a common-law relationship.

Alternatively, you can make an election under subsection 45(2) of the Income Tax Act (ITA) to deem the change in use of your property to not have occurred. This can be useful because the tax implications on a deemed disposition are deferred until the property is sold. The subsection 45(2) election also allows you to designate your rental property as your principal residence for up to four years, even though you or a family member did not ordinarily inhabit the property.

It is important to note that you cannot claim capital cost allowance (CCA) on the property, otherwise, the 45(2) election will be rescinded. To make this election, attach a signed letter to your tax return requesting subsection 45(2) of the Income Tax Act to apply on a specific property for the year the change in use occurred.

Regardless of whether you elect under subsection 45(2), you will need to report the net rental income you earn on the property. To report your rental income and expenses, use Form T776 Statement of Real Estate Rentals.

Full change in use from rental to residential

If a rental property is converted to a residence, there is a deemed disposition of the rental property at the current fair market value. In addition to a capital gain that may arise on the deemed disposition, there may be a recapture of CCA. This means that some or all of the CCA that you have taken in the past may be recaptured and included as income in the year of the disposition.

An election under subsection 45(3) allows you to defer the recognition of the capital gain on the deemed disposition until you sell the property but only if you have not previously claimed any CCA on the rental property. This election also allows you to designate that property as your principal residence for up to four years before you move into it, thereby, qualifying the property for the principal residence exemption. To make the election, attach a signed letter to your income tax return, describing the property in question and stating that you want subsection 45(3) of the ITA to apply. This election must be done before the earlier of the following:

1. 90 days after the CRA asks you to file this election, and
2. The due date of your income tax return for the year you sell the property.

Partial change in use

If only a part of the property’s use is being changed, the portion deemed sold is based on either the number of rooms changed, or the area changed relative to the rest of the property. For example, you owned a home that was 1,800 square feet with five rooms, and you rented out three of the rooms with a total of 1,200 square feet. Either 67% (1,200/1,800) or 60% (3/5) of your home is deemed to have a change in use to rental.

With a partial change in use, you can also elect under subsection 45(2) or 45(3), thereby, deferring the capital gain on the deemed disposition of that partial area. If your partial change in use is from residential to rental, you have the additional option of using part of your principal residence exemption instead of electing under subsection 45(2).

You may not have a change in use if you bought your residence with the original intent of renting out part of the space, or if the change in use is incidental and ancillary. Incidental and ancillary means that the new use of the space is secondary to its other uses. For example, using only a minor portion of your residence for renting is a point in favour of incidental and ancillary use. Conversely, making significant alterations or renovations, such as a separate entrance, to accommodate tenants will generally not be considered incidental and ancillary. Whether the rental income is incidental and ancillary is determined based on the facts of each specific case. In addition, the CRA has provided that no CCA is to be claimed on the property.

Key takeaways

To summarize, when changing the use of a property, here are three key considerations:

1. Regardless of which change in use occurs, remember that a change in use results in a deemed disposition unless an election under subsection 45(2) or 45(3) is made. A valuation of the property must be obtained for the deemed disposition.
2. The elections in subsections 45(2) and 45(3) deem the change in use of the property to have not occurred, therefore deferring any capital gain and/or recapture until the property is disposed of.
3. If you are converting a principal residence into a rental property, remember to be prepared to track rental expenses, as these can reduce taxable income. If converting a rental property into a principal residence, consider the recapture of CCA, as this may increase your taxes.

If you have changed the use of your property during the year and want to know more about the Canadian tax implications and planning options available, the Tax group at Fuller Landau is ready to answer your questions.

About the authors

Nathan Lee was a Junior Tax Specialist in our Tax group during his 2021 co-op term. He is currently completing his Bachelor of Arts – Accounting and Finance degree at the University of Waterloo.

Christina Yam, CPA is a Manager in our Tax group. She can be reached at 416-645-6531 or cyam@fullerllp.com.