Capital gains tax when renting out your former principal residence

In your case, Hugh, there were tax implications in the year you made the change, even though you did not sell it.

Change in use of a principal residence to a rental property

When you sell your principal residence—or when you are deemed to dispose of it—you need to report this on your tax return. Since 2016, any disposition of a principal residence must be reported on Form T2091.

When you dispose of your principal residence, assuming it qualified as such for all the years you owned it, you will not report a capital gain or owe income tax. But the transaction needs to be reported, nonetheless.

When you convert your principal residence into a rental property, this deemed sale should also be reported, Hugh. The “sale” price is the fair market value at the time of the conversion.

In your case, you may be able to continue to treat the property as your principal residence for a period of time, through filing a subsection 45(2) election.

What is subsection 45(2) election?

A taxpayer who moves out of their home and rents it may be able to file a special election under subsection 45(2) of the Income Tax Act. This election allows you to treat the property as your principal residence for up to four years—or in some cases, indefinitely.

In order to claim the election:

1. You must be a resident, or deemed resident, of Canada.
2. You cannot designate another property as your principal residence.
3. You must report the rental income on your tax return.
4. You cannot claim capital cost allowance (depreciation).

So, your case, Hugh, is a classic one for claiming a 45(2) election. You are temporarily renting out your home while renting somewhere else.

According to the Canada Revenue Agency (CRA): “To make this election, attach a letter signed by you to your income tax and benefit return of the year in which the change of use occurs. Describe the property and state that you want subsection 45(2) of the Income Tax Act to apply.”

So, there isn’t a specific form to file to claim this election.

A taxpayer in Canada may be able to extend the four-year limit indefinitely, but this requires your employer or your spouse’s employer to ask you to relocate. It sounds like you relocated in order to look for work, Hugh, so this extension will not apply.

Filing an election late

The 45(2) election is supposed to be filed in the year you move out of the home. The deadline is the tax filing deadline for your tax return that year. This would be April 30 for most taxpayers, and June 15 for those who are self-employed or whose spouse is self-employed.

The CRA can accept a late-filed subsection 45(2) election, if your situation matches one from a list of extraordinary circumstances.

There is jurisprudence to support late-filed election. In Irene Gjernes v. Canada Revenue Agency, the CRA was ordered to reconsider a disallowed 45(2) election that was filed late by the taxpayer despite no extraordinary circumstances.

For the late-filed election, the CRA can levy a penalty of the lower of $8,000 or $100 per month past the due date. If the tax savings are more than the penalty, a late-filed election may be worth the penalty risk.

Capital gains tax when changing the use of a property

Since a home that is converted into a rental property is subject to a deemed disposition at the time of conversion, the fair market value at the time the rental began is the adjusted cost base (ACB) for capital gains tax purposes. A subsection 45(2) election could defer this conversion date.

So, when you sell, Hugh, the appreciation could be subject to capital gains tax. The capital gain would be equal to the sale price, minus the selling costs, minus the ACB.

Sale price – selling costs – ACB = capital gain/loss

If you did any renovations after renting the property, this may increase the ACB.

One-half of the capital gain is taxable, but if your capital gains for the year exceed $250,000 under the new 2024 capital gains rules, two-thirds of the excess could be taxable. Income tax on the taxable capital gain generally ranges from about 20% to about 50%, depending on your income in the year of sale and your province of residence.

The depreciation (capital cost allowance) claimed while the property was rented would also become taxable (recaptured) at the same rate (from about 20% to about 50%).

Read more about capital gains:

• Can you save tax by moving into your rental property?
• When does the “plus 1” rule apply to a principal residence?
• Would a senior get a tax credit for selling their house if they move out?
• Can you claim a principal residence exemption on real estate occupied by a child?

About Jason Heath, CFP

Jason Heath is a fee-only, advice-only Certified Financial Planner (CFP) at Objective Financial Partners Inc. in Toronto. He does not sell any financial products whatsoever.

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