It is not uncommon for individuals to relocate for work or studies on a short to mid-term basis. In these circumstances the individual usually does not want to go through the cost or hassle of selling their residence only to return to the municipality a short time later. As a result, the individual may rent out their house as a way to cover operating costs or create profit during their absence.
When there is a change in use from personal to income producing, the Income Tax Act deems the individual to have disposed of and reacquired the property at fair market value (FMV). The result of the change is that the individual disposes of his/her residence for FMV in the year of the change in use and any increase in value over original cost (plus additions) is a taxable capital gain. If this is the individual’s principal residence the gain is then sheltered from tax due to the principal residence exemption (PRE). The exemption is claimed on Form T2091; however, it need not be filed with your return.
Most individuals are not aware of this situation, but nonetheless a tax liability does not occur due to the PRE. However, there can be other adverse tax consequences in subsequent years if elections are not filed.
A common situation is as follows: an individual relocates for a few years to pursue employment opportunities. The individual has every expectation of returning to her original residence, which she has owned for 5 years, and decides to rent out her home during her absence. At this time, she has a deemed disposal at FMV which is sheltered by the PRE. At her new location she resides in an apartment. She files her tax returns and claims the net rental income on her tax returns.
Three years pass by and she decides to sell her original residence and remain at her new location. As a result, she will realize a taxable capital gain based on the value of the residence at the time of sale, less the FMV at the date the change in use occurred. If she were to move back to her original residence, the same is true; she has a deemed disposal and reacquisition at FMV. She would be taxed on any increase in value of the property while she was absent.
This is where the election allowed under Subsection 45(2) of the Income Tax Act is invaluable. This election deems the change in use not to have occurred and remains in effect until the election is rescinded. This election also allows the taxpayer the option to claim the PRE on an extra four years even though the taxpayer did not reside there. In order for the election to be valid, the following must occur:
- Capital Cost Allowance (CCA), more commonly referred to as amortization or depreciation, must not be claimed on the rental schedule; and,
- The election must be filed in the return for the taxation year in which the change occurred. Canada Revenue Agency will accept a late-filed election if CCA has not been claimed, but penalties may apply.
You must proceed with caution... if you rescind the election (or claim capital cost allowance), you are deemed to have disposed of the property at the beginning of that year and a disposition must be recorded at fair market value in that respective year.
If you have any questions, please consult your local MNP Tax advisor or contact me; we would be happy to assist you.
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