Deemed Disposition on Change of Use
While it is generally understood that a taxpayer will pay taxes based on the capital gain of a property when it is sold, a lesser known rule contained in s.45(1) of the Income Tax Act (the “Tax Act”) deems a disposition of a property at fair market value when there is a change of use of that property. A change of use occurs where a taxpayer who used a property for personal purposes begins using the property for business or commercial purposes and vice versa.
A common example would be where a taxpayer who purchased a home to live in moves to a new residence, but decides to begin renting out their former home. The taxpayer can choose to claim the Principle Residence Exemption for this disposition, which would result in no taxes owing, although this would mean that the taxpayer would not be able to claim the Principle Residence Exemption on any other property for those years.
What often proves to be more problematic is what happens if that same taxpayer later decides to stop renting their property and resumes living in it. This change from renting the property to personally residing in it again would again constitute a change of use and would trigger s.45(1), resulting in any taxable capital gain on that deemed disposition to be included in the taxpayer’s income for the year. Under normal circumstances, a taxpayer can relatively easily pay any capital gains taxes owing on the sale of a property from the proceeds of disposition. Unfortunately, where a deemed disposition under s.45(1) occurs, there are no proceeds, and a taxpayer may struggle to raise the funds necessary to pay the capital gains taxes on a transaction that never really occurred. Call our top Toronto tax lawyers firm to learn more about deemed dispositions and capital gains taxation.
The S.45(2) Election
An important tax planning tool is available under s.45(2) of the Tax Act, that allows a taxpayer to make an election in their tax return to be deemed not to have begun to use a property for commercial or business purposes. The result of this change in use election is that no change of use under s.45(1) would occur. In addition, the s.45(2) election remains in effect until such time as the taxpayer rescinds the election, meaning that a taxpayer can indefinitely defer the deemed disposition under s.45(1) and avoid paying the capital gains tax, at least until the taxpayer chooses to rescind the election or sell the property. An additional benefit is that this election allows a taxpayer to the option to claim the principal residence exemption for an additional 4 years even if the taxpayer did not reside in the property during that time.
If you are learning about this election after a change in use of the property has already occurred, it is still possible to take advantage of this provision. Though penalties may apply, s.220(3) of the Tax Act allows the Canada Revenue Agency (the “CRA”) the discretionary power to accept late filed s.45(2) elections. The caveat is that this is only possible where a taxpayer has not claimed any capital cost allowance, otherwise known as depreciating the property. Talk to our experience Toronto tax lawyers and find out how you can take advantage of this 45(2) election.