Tax analysis: taxation of rental income from the main residence – Property taxes

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Change of use of principal residence, principal residence exemption and election under subsection 45(2)

When there is a change in use of your principal residence, a deemed disposition occurs under subsection 45(1) of the Income Tax Act. The Tax Act of Canada provides that a taxpayer will be deemed to have disposed of property for proceeds equal to its fair market value and then acquired it immediately thereafter at a cost equal to its fair market value when changes the use of a principal residence to: a rental property. If the deemed proceeds of disposition of the property exceed its tax base price, the taxpayer would be subject to a capital gain. In most cases, half of the capital gain would be a taxable capital gain.

The good news is that the Canadian government allows a taxpayer to eliminate or reduce the capital gain on the disposition of a taxpayer’s principal residence. This tax relief is called the principal residence exemption. The principal residence exemption rule is actually contained in two provisions: section 54 which contains the definition of principal residence and paragraph 40(2)(b) which describes the formula used to calculate the net capital gain of a taxpayer from the disposition of the principal residence. . It is important to note that a taxpayer and their spouse or common-law partner can only designate one principal residence for each tax year after 1981. A very useful resource from the CRA is the Income Tax Folio S1-F3-C2 “Principal Residence” income. If you have any questions regarding the principal residence exemption, please contact our top Toronto tax law firm.

Additionally, under subsection 45(2) of the Income Tax Act, a taxpayer may elect not to be considered to change their principal residence upon conversion to a rental property. The immediate tax benefit resulting from this is that the taxpayer would not have to declare a capital gain at the time of the change of use. Instead, any accrued capital gain on the property will be deferred until realized on a future disposition. In addition, the taxpayer who makes this election can designate the property as his principal residence for up to 4 years even if the property is not used as his principal residence, provided that all the specified conditions are met. The subsection 45(2) election is an excellent tax planning tool. To learn more about the subsection 45(2) election, please contact one of our experienced Canadian tax lawyers.

Rental income from the main residence

What would happen if a taxpayer started using part of their principal residence to earn rental income? In such a scenario, would there be a deemed disposition? Would the principal residence still qualify for a principal residence exemption if you decide to sell it later in the future? In this article, we will discuss the tax consequences of a principal residence that generates rental income.

Transformation of part of the main residence into a rental property

As explained above, if a taxpayer changes their principal residence to a rental property, the deemed disposition under subsection 45(1) that would otherwise occur will not occur by making an election under subsection 45(2). Prior to March 19, 2019, such an election could not be made when a partial change in the use of property occurred. However, the Canadian government has amended the Income Tax Act to allow taxpayers to elect that the deemed disposition that would otherwise occur on a partial change in use does not apply. Thus, as of March 19, 2019, a taxpayer will be able to elect that the deemed disposition that normally results from a partial change in use of an asset does not apply. If you have any questions regarding the election, please contact our qualified Toronto tax law firm.

Earning rental income from the main residence

If you derive income from your principal residence, for example from renting a room, your principal residence will still be exempt from Canadian income tax on any capital gain resulting from the disposition, provided the income is incidental to your use of the property, you do not make any changes to the property, you do not claim capital cost allowance (depreciation) on the property, and you meet all of the conditions for claiming the principal residence exemption.

Pro tax tip: You can still claim the principal residence exemption even if you earn rental income from your principal residence

For most Canadians, their home is their greatest asset. In addition to having to pay the purchase price of their home with income (usually after-tax income), a homeowner must also consider whether any gain from the sale of the home is taxable. As noted above, any gain from the sale of a principal residence is potentially tax exempt due to the principal residence exemption. In addition, even if you earn rental income in addition to your main residence (for example by renting a room), you can still claim the main residence as long as the income is incidental to your use of the property, you do not make any changes. made to the property, you are not claiming capital cost allowance (depreciation) on the property and you meet all of the requirements to claim the principal residence exemption. If you have any questions about principal residence exemptions, please speak to one of our expert tax lawyers in Toronto.


What are the advantages of using the subsection 45(2) election?

When a deemed disposition occurs, the taxpayer is subject to tax even though there has been no sale. Thus, the taxpayer may not have cash to pay the associated tax. Thus, by electing subsection 45(2), a taxpayer does not have to calculate and pay capital gains tax. In addition, the election allows the taxpayer to shelter more years by claiming an additional principal residence exemption even if he did not use the property as his principal residence.

How many properties can you claim principal residence exemptions in a given tax year?

You can only claim the principal residence exemption on one property per household (both spouses) per year. The principal residence exemption is only claimed when a property is sold and at the time of sale you will determine for which years you wish to claim the exemption.

The content of this article is intended to provide a general guide on the subject. Specialist advice should be sought regarding your particular situation.


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