Real Estate: Understanding Change of Use and Deemed Disposition Rules 

When individuals sell a capital asset, they typically anticipate paying tax on the capital gain, as outlined in the Income Tax Act (ITA) section 45(1). However, many are unaware that under certain circumstances, they might owe taxes on a “deemed” capital gain, even if they haven’t actually sold the asset. 

This “deemed disposition” arises when there’s a “change of use” in the property. For instance, if someone buys a new home and decides to rent out their previous residence, this shift from personal to commercial use triggers a deemed sale. Although the capital gain tax might be waived by claiming a personal residence exemption, it restricts the taxpayer from claiming this exemption on any other property during that period. 

Moreover, if the same individual later decides to move back into the previously rented property, another change of use occurs, leading to another deemed disposition. This can result in a capital gain based on the property’s current market value, which will be added to the taxpayer’s income. The challenge here is that while the capital gain is theoretical, the tax bill is very real, often causing financial strain. 

Solutions Provided by the ITA 

• S.45(2) Election: This section allows taxpayers to elect not to be considered as having started using a property for commercial purposes. This means there’s no deemed disposition or capital gain. However, during this election: 
• Rental or business income must be reported. 
• Capital cost allowance (CCA) on the property cannot be claimed. 
• The property can be designated as a principal residence for up to 4 years under specific conditions. 
• S.45(3) Election: This section comes into play when a property’s use changes from income-producing to personal. It provides an option to avoid the deemed disposition. This election is valid only if the CCA hasn’t been claimed on the property. It allows deferring capital gains until the property is eventually sold. 

Other Triggers for Deemed Disposition: 

• Moving into a previously rented property. 
• Demolishing a house to build a new one. 
• Gifting a property. 
• Receiving proceeds from expropriated property. 
• Getting insurance proceeds due to disasters like floods or fires. 

Late Filing of the Principal Residence Exemption: If you’ve overlooked designating your property as a principal residence during its sale year, you can request the CRA to amend your return for that year. While penalties might apply, the CRA has the discretion to accept late-filed s.45(2) elections.