When there is a change in use of real estate, either from income-producing to personal-use, or from personal-use to income-producing, there is a deemed disposition. The owner is deemed to have disposed of the property, and to have immediately reacquired it, with both transactions done at fair market value.
Change in Use From Income-Producing to Personal-Use
When the property use changes completely or partially from income-producing to personal use, the deemed disposition can result in a capital gain. This is calculated by deducting the adjusted cost base of the property from the fair market value at the time of change in use. Where only a part of the property has changed use (duplex, fourplex, basement suite, etc.), then there will be a deemed disposition only for that portion of the property.
When there is a capital gain, under certain circumstances the gain can be deferred by making an election under subsection 45(3) of the Income Tax Act. The election may not be made if capital cost allowance (CCA) has been claimed on the property for any taxation year ending after 1984. If any CCA was claimed prior to 1985, this may result in a recapture of that CCA. To make the election, a letter should be filed with the income tax return for the year in which the property is eventually sold (or earlier if demanded by CRA).
Change in Use From Personal-Use to Income-Producing
When the property use changes from personal-use to income-producing , the deemed disposition can result in a capital gain. This is calculated by deducting the adjusted cost base of the property from the fair market value at the time of change in use. The fair market value at the time of change in use is the new adjusted cost base of the income-producing property. Note that if the property is not located in Canada, and the new adjusted cost base is over $100,000 in Canadian dollars, there will be a requirement to complete form T1135 foreign income verification statement each year in the future while the property is owned.
Any gain resulting from this deemed disposition may be eliminated by the principal residence exemption (PRE) if the property has always been the taxpayer's principal residence. If the property has been the principal residence for only a portion of the time it has been owned, then the gain could still be partially eliminated by the principal residence exemption.
S. 45(2) Election - Defer Capital Gain Until Property Sold
The taxpayer may also defer recognition of the resulting capital gain (if any) by electing under subsection 45(2) of the Income Tax Act to be deemed not to have made the change in use. This defers the recognition of the capital gain until the property is ultimately sold. This election cannot be made if there is only a partial change in use of the property. The election should be made when the change in use happens. Once this election has been made, the property can still qualify as the taxpayer's principal residence for up to 4 taxation years, even if the property is not inhabited during those years by the taxpayer. However, the taxpayer must still be a resident or deemed resident of Canada during those years in order to designate the property as the principal residence. This can only be done if no other property is designated as the principal residence for that same period.
What if I Rent Out Part of My Home or Cottage, or Have a Home Office?
When you rent out a part of your home or cottage, or convert part of your home to a home office, you are considered to have changed the use of that part of the home from personal-use to rental property. Depending on the circumstances, when you eventually sell your home, or have a deemed disposition because you stop renting part of it, you may have to report a capital gain on the portion of your home that you rented out.
The CRA Rental Income Tax Guide, T4036, and S1-F3-C2: Principal Residence (see partial changes in use) state that if all of the following conditions are met, you will not be considered to have a change in use: - the part of the home used for rental purposes is small in relation to the size of the whole property, - you do not make any structural changes to the property to make it more suitable for rental purposes, and - you do not claim any capital cost allowance on the part you are using for rental purposes.
If all of the above conditions are met, you will not have to report a capital gain when the property is sold or the rental is stopped. Otherwise, you will have to report a capital gain based on the portion of the house that was rented.