For tax purposes, a property can be classified in several ways. It can serve as a primary residence, a rental property, a commercial property, or various combinations of these uses. A property can also be classified as capital property or inventory. As the owner of a property, you can change how you use it, such as converting a principal residence into a rental property or vice versa.
Change of Use and Deemed Disposition of a Property
Generally speaking, when the use of a property changes, the tax rules deem (treat it as though) the property was sold at fair market value and immediately repurchased at the same price. This triggers a capital gain (or loss) and can put a taxpayer in a cash crunch – the property is not sold, but the resulting capital gain or loss must be reported in the year the change of use took place. You do not have to pay tax on gains related to years the property was your primary residence; however, taxes are payable on gains realized when the property was not your primary residence.
Filing an Election Under Subsection 45(2) of the Income Tax Act
To mitigate this, subsection 45(2) of the Income Tax Act (ITA) allows a taxpayer to file an election that allows you to defer the deemed disposition (and associated capital gains tax) that would otherwise occur when you change the use of your property. It can also help preserve your ability to claim the principal residence exemption for up to four additional years while the property is being rented out, provided you meet certain conditions.
If a taxpayer fails to file the election, the CRA will, in some circumstances, accept late elections.
Completing Related Tax Forms and Schedules
To make a 45(2) election, it must be clearly documented and properly reported on the applicable tax forms. The following steps and considerations apply when preparing and filing the necessary forms and schedules:
1. Drafting a Written Election Statement
A written statement must accompany the taxpayer’s income tax return for the year in which the change in use occurs. This statement should clearly indicate that the election under subsection 45(2) is being made. It must describe the property in sufficient detail to identify it and specify the date on which the change in use occurred.
2. Reporting on the Income Tax Return
Although no immediate capital gain is triggered by the election, the taxpayer must still report the election appropriately. This involves:
T1 General (Individuals). Attach the written election statement to the paper-filed return or submit it separately if filing electronically. Ensure it is submitted by the due date of the return for the year in which the change in use occurred.
T2 Corporation Income Tax Return (if applicable). A corporation electing under subsection 45(2) must include a similar statement with its return.
3. Completing Schedule 3 (Capital Gains or Losses)
If no election is made, a deemed disposition at fair market value would typically be reported on Schedule 3 of the tax return. However, when an election is validly filed under subsection 45(2), this schedule does not require an entry for the property until a subsequent disposition or change in use that ends the deferral. At that point, the capital gain must be reported, with the adjusted cost base determined as if the election had not been made.
4. Documenting Capital Cost Allowance (CCA) Claims
Once a property is considered to have been converted to income-producing use, CCA may be claimed. However, claiming CCA invalidates the election under subsection 45(2). Taxpayers must ensure that no capital cost allowance (CCA) has been claimed on the property if they intend to rely on the election. This condition should be verified before filing the return.
5. Keeping Adequate Records
Supporting documents such as property purchase agreements, real estate appraisals, and financial records related to rental income or business use should be retained. CRA may request these materials to substantiate the details of the election and the basis for deferral of capital gains.
6. Consideration of Subsequent Events
If a later change in use occurs (e.g., reconversion to personal use or sale of the property), the taxpayer must revisit the tax treatment and may need to file another election under subsection 45(3) or report the resulting capital gain. Schedule 3 and other applicable forms must be completed accordingly in that subsequent year.
Completing the related tax forms and schedules requires careful attention to the election’s eligibility criteria, the reporting processes, and long-term tax consequences. It is highly recommended that you speak to us for professional tax advice if the property has appreciated significantly or involves mixed-use scenarios.
Special Situations and Exceptions
While subsection 45(2) provides a mechanism for taxpayers to defer capital gains when converting a principal residence into an income-producing property, certain special circumstances can influence its application or restrict its availability. These exceptions should be reviewed carefully before relying on the election.
Ceasing to Be a Resident of Canada
If a taxpayer elects under subsection 45(2) and subsequently emigrates from Canada, the deferral of capital gains may be curtailed. When an individual ceases to be a resident, a deemed disposition of property occurs under subsection 128.1(4), potentially overriding the 45(2) election. The departure tax triggered by emigration can accelerate the recognition of accrued gains on the property, even if the property is not sold.
Trust and Corporate Ownership
Subsection 45(2) applies only to individuals who own property directly. Properties held in trust or by a corporation do not qualify for the election. In particular, beneficial ownership by a trust, even where the property is used as a residence by a beneficiary, is insufficient for the purpose of claiming the election or the principal residence exemption. These ownership structures require distinct tax planning and reporting strategies.
Late or Retroactive Elections
The Canada Revenue Agency may accept late-filed subsection 45(2) elections under specific administrative relief provisions. Taxpayers must demonstrate that the conditions for relief under subsection 220(3.2) or Information Circular IC07-1R1 are met, including evidence of reasonable error and prompt corrective action. However, late elections are not guaranteed and should not be relied upon as a substitute for timely compliance.
As experienced and licensed CPA tax consultants, we help our clients handle all tax and accounting issues. Give us a call today at 1 844 340 5771 to schedule an assessment.
