Change of use of a residence or a cottage

The election of subsections 45(2) and 45(3) I.T.A.

What is a change of use? 

A change of use occurs when a building changes its vocation. This change of use may be total or partial. 

A total change of use occurs when a property that was used as a principal residence or cottage for personal use becomes a property used to produce income (for example, the long-term rental of that house). In this case, it may be interesting to consider the election under subsection 45(2) I.T.A.

A change of use also occurs when a property that was used to produce income (for example, a cottage owned for rental purposes) becomes a property that is used as a principal residence (for example, that same cottage as a principal residence). In this case, it may be interesting to consider the election under subsection 45(3) I.T.A. 

A change of use can have many unintended consequences if a taxpayer does not take the time to get informed. It may be useful to seek the help of a tax specialist to question the choices that can be made and the consequences of these choices. A solution may be suitable for one taxpayer but not for another and vice versa. 

What are the consequences of a change of use?

Generally, where no election is made, the change in use results in a deemed disposition of all (if it is a complete change) or part (if it is a partial change) of the property at fair market value ("FMV") and a reacquisition at that same value. This deemed provision treats a change of use as a sale, even if it is a notional one. A sale that can generate a lot of taxes even though the property was not actually sold. 

Complete change of a property from a principal residence to an income producing property

In this particular case, the principal residence exemption in section 54 I.T.A. may totally eliminate or reduce the gain on this deemed disposition. However, the subsection 45(2) I.T.A. election may have other favourable consequences for the taxpayer if all the required conditions are met. 

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Election under subsection 45(2) I.T.A.

What does this mean?

By making this election, the taxpayer can defer the inclusion of the gain in computing taxable income to a future year, since the election ensures that there is no deemed disposition at the time of the change in use. 

If all the conditions are met, the provision would allow the taxpayer to be taxed on this gain only when the property is actually disposed of. In addition, this election allows the taxpayer to benefit from the exemption for the principal residence for four additional years without having to live there normally. 

What are the conditions? 

To be eligible for the full consequences of this election, the taxpayer (or another member of the taxpayer's family unit) must not designate any other property as a principal residence during the four years following the change in use. The taxpayer must also be a resident or deemed resident of Canada. 

By making this election, the taxpayer gives up the right to claim capital cost allowance ("CCA") to reduce rental income (which must be reported). If the taxpayer takes CCA, the election is cancelled as of the first day of the year and the deemed disposition is effective, thereby forfeiting the election.

To make this election, a letter signed by the taxpayer to this effect must be attached to the income tax return for the year of disposition. If the return is filed online, it is also necessary to complete a document to this effect on the CRA Website.

Changing an income-producing property to a principal residence

The capital gain or loss arising from this deemed disposition may have to be reported in the year. However, an election under subsection 45(3) I.T.A. may have favourable consequences for the taxpayer if all the required conditions are met. 

Election under subsection 45(3) I.T.A.

What does this mean? 

By making this election, the taxpayer can defer the recognition of the capital gain to a future year since this election, like the previous one, ensures that there is no deemed disposition on the change in use. 

If all the conditions are met, the disposition could be made only on the actual disposition of the property. In addition, this election allows the taxpayer to designate the property as his or her principal residence for the previous four years without having normally lived there. 

What are the conditions? 

To be eligible for the full consequences of this election, during the four years preceding the change of use, the taxpayer (or a member of the taxpayer's family unit) must not have designated another principal residence. The taxpayer must also have been a resident or deemed resident of Canada. 

The taxpayer must not have taken CCA in the past on the property, and note that the tax authorities do not usually allow past returns to be adjusted to cancel the depreciation expense. Unfortunately, the deemed disposition will not be avoided.

To make this election, the taxpayer will have to attach a signed letter to the tax return for the year of actual disposition of the property, or complete a document on the CRA website if the return is filed online. 

Partial changes of use

A change in use may also apply to only part of a property. In order to avoid the deemed disposition of part of the property, it is possible to make the election under subsection 45(2) or 45(3) I.T.A. However, all the conditions mentioned above must be met.

Conclusion

When there is a change of use, whether total or partial, it may be advantageous to be able to defer the tax consequences of a deemed disposition to a later year. In addition, it may be advantageous to be able to designate a property as a principal residence for four additional years without having to live there normally. To do so, when all the conditions are met, an election under subsection 45(2) I.T.A. or subsection 45(3) I.T.A. may be made. 

If you have more specific questions regarding your particular case, please do not hesitate to consult one of our experts.