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Principal residence disposition - Special topics

From tax expert Gerry Vittoratos
May 03, 2017

In the first article, we learned about the basics of a principal residence disposition. Now we will see special topics that affect the principal residence disposition.

October 3rd, 2016 announcement
Reporting requirements for the sale of a principal residence
The federal government made administrative and legal changes to the designation of a principal residence. As of the 2016 tax year, all dispositions of principal residences have to be reported on the second page of Schedule 3.  A T2091 form is required as well if you do not designate all the years of ownership as a principal residence. Remember that the T2091 DOES NOT get transmitted with the tax return when you efile; it must be mailed separately. For Quebec residents, you need to submit the designation form, TP-274 (mailed), with every designation, and include any federal forms you submitted to the CRA if an election is made under federal ITA 45(2) or ITA 45(3). Failure to comply with these administrative rules entails penalties, which is the lesser of $100/month of late designation or $8,000 for the year.

Change to the “one plus” rule
On the legal side, an amendment will be brought to ITA 40(2)(b), letter B of the principal residence formula, commonly referred to as the “one plus” rule. As per the Notice of Ways and Means motion, letter B will read:

(i)  if the taxpayer was resident in Canada during the year that includes the acquisition date, one plus the number of taxation years that end after the acquisition date for which the property is the taxpayer's principal residence and during which the taxpayer was resident in Canada, or

(ii)  if it is not the case that the taxpayer was resident in Canada during the year that includes the acquisition date, the number of taxation years that end after the acquisition date for which the property was the taxpayer's principal residence and during which the taxpayer was resident in Canada. 
https://www.fin.gc.ca/drleg-apl/2016/nwmm-amvm-1016-l-eng.asp

As per the new subparagraph (i), for any dispositions after the announcement date (October 3, 2016), you can claim the “one plus” provision only if the owner was a Canadian resident on the date of acquisition of the property. If he/she was a non-resident on that date, he/she can no longer use the “one plus” provision of the principal residence formula.
Transfer of a principal residence to a spouse - ITA 40(4) [QITA 272]

If the owner of the principal property transfers a principal residence to their spouse, be it through an inter vivos transfer (living) under ITA 73(1) at cost, or a transfer in the event of death under ITA 70(6), ITA 40(4) can apply on a future disposition of the property. What this provision states is for the purposes of a future disposition of the property by the spouse, the spouse is deemed to have owned the property throughout the period in which the owner possessed it. In other words, the years the spouse can designate for a principal residence designation includes the years the property was owned by the owner before the transfer.

In the case of a transfer from a deceased owner to his/her spouse (ITA 70(6)), a T1255 form must be produced in the final return of the deceased owner to designate the years owned as principal residence. Once the property is actually disposed of, the spouse can then add those years of ownership to the exemption calculation (letter B of ITA 40(2)(b)).
In the case of a “living” transfer (ITA 73(6)), as per paragraph 2.72 of folio S1-F3-C2, there is no requirement of the owner to file a T2091 form in the year of transfer. However, the transferor (owner) should, in any event, complete the designation form and, if it is not filed by the transferor, it should be retained by the transferee (spouse). In the year of disposition, the spouse will produce the designation form for their years of ownership, and also include the designation form from the owner produced at the date of transfer.
Change in use - ITA 45 [QITA 281-283]

Another important aspect of the principal residence designation is the change in use of the property. Change in use rules will apply when a property changes its use, for instance when a principal residence is converted to a rental property and vice versa.

Change in use of an entire building - ITA 45(1)(a)/ITA 13(7)(a)/ITA 13(7)(b)
In the case of the entire property changing use, 2 scenarios can arise:
1 - The property is converted from principal residence to a rental property - ITA 45(1)(a)/ITA 13(7)(b)
In this scenario, the property is deemed to be disposed at the Fair Market Value (FMV) and reacquired immediately at the same value (ITA 45(1)(a)). This transaction establishes the Adjusted Cost Base (ACB) of the property for any future disposition. On the capital cost side of things (ITA 13(7)(b)) , the capital cost (for the purpose of the CCA calculation) of the new rental property will be the lesser of:

  • Fair Market Value
  • Original cost  plus Taxable Capital Gains minus Capital gains Exemption

The principal residence designation can be taken for the years of ownership before the change in use to exempt the taxpayer from a capital gain.
2 - The property is converted from a rental to a principal residence - ITA 45(1)(a)/ITA 13(7)(a)
In this scenario, the property is deemed to be disposed at the Fair Market Value and reacquired immediately at the same value (ITA 45(1)(a)/ITA 13(7)(a)).

Change of use of a portion of a building - ITA 45(1)(c)/ITA 13(7)(d)
In this case, a portion of the building is used for rental, and a portion as a principal residence. A change of use occurs in the case where there is an increase or a decrease in the percentage of use in either direction (rental or personal). There are 2 scenarios that can arise:

1 - Increase in the percentage of use of the personal residence portion - ITA 45(1)(c)(i)/ITA 13(7)(d)(ii)
In this scenario, the proceeds of disposition, for the portion representing the decrease of the rental portion, are deemed at the Fair Market Value of the property. This rule is also applied on the capital cost side (for CCA purposes).

2 - Increase in the percentage of use of the rental portion - ITA 45(1)(c)(ii)/ITA 13(7)(d)(i)
In this scenario, the proceeds of disposition, for the portion representing the decrease of the personal residence portion, are deemed at the Fair Market Value of the property {ITA 45(1)(c)(ii)}. On the capital cost side of the equation (for CCA purposes), the capital cost of the new rental portion is the total of (as per ITA 13(7)(d)(i)):

  • The lesser of:
    • Fair market value of the property
    • Original Cost (Capital Cost)

This amount multiplied by the percentage increase of the rental portion

  • ½ of:
    • The deemed disposition amount determined at ITA 45(1)(c)(ii)

Less the total of:

  •  
    • Capital cost of property multiplied by the percentage increase of the rental portion
    • Twice (2X) the Capital Gains Deduction claimed (if applicable).

Election ITA 45(2) [QITA 284] - Rental property remains a principal residence
In the case of a change in use from a principal residence to a rental property, you can elect to defer the change-of-use deemed disposition by using the election under 45(2). This election is made by means of a letter (no official form has been created by the CRA/RQ) to that effect signed by the taxpayer and filed with the income tax return for the year in which the change of use occurs. By making this election, you can designate the property as your principal residence for up to four years, even if you use the property to earn income. This four-year limit can apply if (as per ITA 54.1(1)):

  • the taxpayer does not ordinarily inhabit the taxpayer’s property as a consequence of the relocation of the place of employment (at least 40 km farther) of the taxpayer or the taxpayer’s spouse or common-law partner
  • the taxpayer or the taxpayer’s spouse or common-law partner is employed by an employer who is not a person to whom the taxpayer or the taxpayer’s spouse or common-law partner is related
  • the property subsequently becomes ordinarily inhabited by the taxpayer during the term of the taxpayer’s or the taxpayer’s spouse’s or common-law partner’s employment by that employer or before the end of the taxation year immediately following the taxation year in which the taxpayer’s or the spouse’s or common-law partner’s employment by that employer terminates; or the taxpayer dies during the term of the taxpayer’s or the spouse’s or common-law partner’s employment by that employer.

There are restrictions to using this election. As per paragraph 2.49 of folio S1-F3-C2, you cannot claim CCA on the property from the moment the change in use has occurred and during the period in which the election is to remain in force. This makes sense because during the election, the building is still deemed as a principal residence and not a rental. If CCA is claimed on the property, the election is considered to be rescinded on the first day of the year in which that claim is made.

Moreover, as per ITA 45(2), this election cannot be used in partial uses of a building as a rental (ITA 45(1)c)/ITA 13(7)d)); only changes in use of the entire building are eligible (ITA 45(1)a)(i)/ITA 13(7)b)).
Election ITA 45(3) [QITA 286.1] - Deferral of capital gains from a change of use from Rental to Principal residence

In the case where a change of use has occurred from a rental property to a principal residence, you can defer the deemed disposition of a change in use by electing under ITA 45(3). This election is made by means of a letter (no official form has been created by the CRA/RQ) to that effect signed by the taxpayer and filed with the income tax return for the year in which the property is ultimately disposed of. If you make this election, you can designate the property as your principal residence for up to four years before you actually occupy it as your principal residence.

When it comes to CCA, the restriction is the same as in ITA 45(2), but in reverse: CCA claim is not possible for any tax year ending after 1984 and on or before the change in use of the property from income-producing to a principal residence (ITA 45(4)).  This election is also not applicable for partial uses of buildings as a rental (ITA 54.1(1)). Moreover, this election is not valid for the purposes of the recapture calculation for CCA purposes.

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