Key Takeaways
- A complete conversion from a principal residence to a rental property can create a deemed disposition at fair market value, even without an actual sale.
- A subsection 45(2) election may postpone the immediate tax consequence, but it prevents you from claiming CCA while the election remains in effect.
- Renting out a basement or another part of your home can have different tax consequences depending on how extensively the property is changed and used.
Can Turning Your Canadian Home Into a Rental Trigger Capital Gains Tax?
Yes. Converting your principal residence into a rental property can trigger capital gains tax under Canada's change-in-use rules, even if you have not sold the property. The Canada Revenue Agency (CRA) may treat the conversion as a sale at fair market value (FMV), followed by an immediate repurchase at the same value.
This is known as a deemed disposition. However, homeowners may be able to defer the immediate tax consequence by making an election under subsection 45(2) of the Income Tax Act. Understanding this rule before advertising your property for rent can help you avoid an unexpected tax bill.
What Is the Change-in-Use Rule?
A change in use occurs when a property moves from personal use to income-producing use. For example, imagine you purchased a house in Calgary, lived in it for several years and later moved to another city. Instead of selling the original house, you decide to rent it to tenants.
For tax purposes, the CRA generally considers you to have sold the property at its fair market value on the date its use changed. You are then treated as having acquired it again at that same value.
The difference between the property's adjusted cost base (ACB) and its deemed sale value can create a capital gain. However, the principal residence exemption may shelter some or all of the gain attributable to eligible years when the property qualified as your principal residence.
The important point is that the tax event can occur when you start using the property to earn rental income, not only when you eventually sell it.
How Much Capital Gain Could the Conversion Create?
Consider a homeowner who purchased a property for $450,000 and later converts it entirely into a rental property. Assume its fair market value on the conversion date is $680,000.
The simplified calculation is:
- Original adjusted cost base: $450,000
- Fair market value on conversion: $680,000
- Difference: $230,000
That $230,000 represents the preliminary gain before considering the principal residence exemption, eligible adjustments and applicable tax calculations.
It does not automatically mean the homeowner must pay tax on the entire amount. The property's ownership history and principal residence designation matter.
For example, if the homeowner lived in the property as their principal residence throughout the relevant ownership period before conversion, the exemption may eliminate the gain arising up to that point. The exact result depends on the applicable designation rules and individual circumstances.
How Does the Subsection 45(2) Election Work?
Subsection 45(2) offers an important option when you convert your entire principal residence into an income-producing property.
By making this election, you can choose not to be treated as having changed the property's use for the relevant tax purposes. As a result, you generally do not have to report the deemed disposition gain immediately.
To make the election, you must prepare a signed letter identifying the property and stating that you are electing under subsection 45(2). Attach it to your income tax return for the year the change in use occurs. If you file electronically, send the letter separately to your CRA tax centre.
This election does not remove your responsibility to report rental income. You must still declare your rental income and deduct eligible expenses under the normal tax rules.
What Is the Four-Year Principal Residence Rule?
A valid 45(2) election can allow you to designate the property as your principal residence for up to four additional years, even while you live somewhere else.
However, two important conditions apply:
- You must be a resident or deemed resident of Canada during the relevant years.
- You cannot designate another property as your principal residence for those same years.
A special extension may be available when you or your spouse or common-law partner moves because an employer requires a relocation. Additional conditions apply, including the distance between the original and temporary residences and the circumstances surrounding your return. The four-year rule is therefore not an automatic extension for every homeowner who moves away.
Can You Claim CCA After Making a 45(2) Election?
No. You cannot claim capital cost allowance (CCA) on the property while the subsection 45(2) election remains in effect.
CCA is the tax deduction that allows owners to claim depreciation on eligible rental property assets. Although it can reduce rental income in some circumstances, claiming CCA on the property can cause the 45(2) election to be rescinded.
That decision can bring the deemed disposition rules back into effect. Homeowners should therefore compare the potential rental tax deduction against the longer-term consequences before claiming CCA.
What Happens If You Rent Out Only Part of Your Home?
The rules can be different when you continue living in your property and rent out a basement, bedroom or another section.
The CRA generally does not apply the change-in-use rule to a partial rental arrangement when all three conditions are satisfied:
- The rental or business use is relatively small compared with the property's use as your residence.
- You do not make structural changes to the property to accommodate the rental or business activity.
- You do not claim CCA on the rented portion.
If all these conditions are met, the property can generally retain its character as your principal residence. However, converting a section into a self-contained rental unit or making substantial structural changes may create a partial change in use. Depending on the circumstances, a deemed disposition may apply to the portion converted. Since March 19, 2019, elections under subsections 45(2) and 45(3) may also be available for certain partial changes.
Why Should You Record Your Property's Fair Market Value?
Fair market value on the conversion date can become an important figure in your future tax calculations. If you do not make a 45(2) election, the deemed disposition generally uses this value. Keep documents that help establish the property's value, such as an independent appraisal, comparable property sales, real estate valuation reports and records showing the conversion date.
For a property containing both land and a building, keep a reasonable allocation between the two. This distinction matters because land and buildings receive different treatment under the capital cost allowance rules. Good records can make it easier to support your tax reporting if the CRA asks questions later.
Common Mistakes Homeowners Should Avoid
Several decisions can create unnecessary complications:
- Assuming no tax applies because the property has not been sold.
- Missing the opportunity to make a timely 45(2) election.
- Claiming CCA without understanding its effect on the election.
- Treating a substantial basement conversion as an ordinary room rental.
- Failing to preserve evidence of fair market value when the property's use changes.
- Forgetting that rental income remains taxable even when a 45(2) election is made.
If you have already converted your home into a rental without filing the election, do not assume that the opportunity is permanently lost. The CRA has discretion to accept certain late-filed elections under taxpayer-relief provisions, subject to conditions. Professional tax advice is important before relying on this possibility.
TwikUp's Perspective
Converting a home into a rental property is not just a landlord decision. It can change the way the property is treated for tax purposes, sometimes before the owner realizes that anything has happened.
The choice between making a 45(2) election and claiming CCA deserves particular attention. One may preserve the opportunity to defer a deemed disposition, while the other can affect the property's tax treatment and future reporting.
Homeowners should consider how long they expect to rent the property, whether they might return to it, and whether they plan to designate another home as their principal residence. These decisions can influence the eventual tax result.
Before making the conversion, review the CRA's change-in-use guidance and consider speaking with a qualified Canadian tax professional. For a wider look at timing a property sale, read TwikUp's guide to the capital gains tax strategy Canadians may consider when their income is lower.
Disclaimer
This article provides general educational information about Canadian tax rules. It is not personalized tax, legal or financial advice. Tax consequences depend on property ownership, residency, use, election history and individual circumstances. Consult a qualified Canadian tax professional before making a property-use election or claiming CCA.