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June 13, 2024

Tax Tips

Change in Use / Principal Residence
Subject: Change in Use
Number: 04-05
Date: 3/5/2004
Be Aware of Changing a Principal Residence to Investment Property or Vice Versa

It is not uncommon for taxpayers to convert their principal residence, wholly or partly, to business or rental use. Unfortunately, adverse tax consequences may arise for the unwary as the change of use may result in a deemed disposition of the property which may trigger a taxable capital gain unless the full amount of such gain qualifies for the principal residence exemption.

The first consideration in determining the tax effects is to review the extent to which the property was converted to income-producing use. In the case of a partial conversion, there will be no deemed disposition of the property, provided all of the following conditions can be satisfied:

- the income-producing use is ancillary to the main use of the property as a residence

- there is no structural change to the property

- no capital cost allowance is claimed on the property

There is a partial conversion where a taxpayer rents one or more rooms or where a taxpayer has an office in his home which is used in connection with his business or employment. These partial conversions would be tax-free.

In situations where a taxpayer has converted his entire principal residence to an income-producing use, there will be a deemed disposition of the property. However, by filing an election under subsection 45(2) of the Income Tax Act, the taxpayer may defer the recognition of the gain. The election remains in effect for up to four taxation years unless rescinded by the taxpayer. An indefinite extension to the four year limitation is available under section 54.1 of the Income Tax Act for certain employees who have converted their residence to income-producing use as a result of a change in their employment location.

When a taxpayer has made a substantial conversion of his residence to income-producing use, and subsequently converts it back to use as his principal residence, there will be a second deemed disposition of the property. This second conversion is more likely to trigger a taxable event if the property has increased in value during the period it was used for income-producing purposes or if capital cost allowance had been claimed during that period of time. The property would not qualify as a principal residence during the period it was used for income-producing purposes.

TAX TIP OF THE WEEK is provided as a free service to clients and friends of the Tax Specialist Group member firms. The Tax Specialist Group is a national affiliation of firms who specialize in providing tax consulting services to other professionals, businesses and high net worth individuals on Canadian and international tax matters and tax disputes.

The material provided in Tax Tip of the Week is believed to be accurate and reliable as of the date it is written. Tax laws are complex and are subject to frequent change. Professional advice should always be sought before implementing any tax planning arrangements. Neither the Tax Specialist Group nor any member firm can accept any liability for the tax consequences that may result from acting based on the contents hereof.