Change of Use: Principal Residence to Rental | Tax Guide

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When a Canadian homeowner converts their principal residence into a rental property, the Income Tax Act considers there to have been a deemed disposition of the property at its fair market value (FMV) at the time of the change of use, under subsection 45(1). This means the owner is deemed to have sold and immediately repurchased the property at its FMV, which can trigger a capital gain if the value has increased since purchase. However, if the property was the taxpayer's principal residence for the entire holding period before the change of use, the principal residence exemption under section 40(2)(b) could entirely eliminate this gain. To avoid the deemed disposition, the taxpayer can make an election under subsection 45(2) of the Income Tax Act. This election allows the property to continue being designated as a principal residence for up to four additional years after the change of use, provided no CCA is claimed on the property and no other property is designated as a principal residence during this period. The election must be made in the tax return for the year of the change of use. On the mortgage side, a change of use can have significant consequences. Most residential mortgage contracts require the borrower to occupy the property. Converting it to a rental without notifying the lender may constitute a breach of terms. Additionally, mortgage interest becomes tax-deductible once the property is converted to rental use, since the loan is now being used to earn income.

Deemed Disposition Upon Change of Use

When you stop living in your principal residence to convert it into a rental property, subsection 45(1) of the Income Tax Act (R.S.C. 1985, c. 1, 5th Supp.) provides for a deemed disposition. In practical terms, you are deemed to have sold the property at its fair market value (FMV) at the time of the change of use, then immediately repurchased it at the same price. If the property's value has increased since your original purchase, a capital gain is theoretically realized. However, if the property was your principal residence for the entire holding period before the change, the principal residence exemption under section 40(2)(b) may eliminate the entire gain.

The Subsection 45(2) Election: Deferring the Disposition

Subsection 45(2) of the Income Tax Act offers a valuable option: you can elect not to apply the deemed disposition and continue designating the property as your principal residence for up to four additional years after the change of use. This election is particularly useful if you plan to return to the property or if you wish to maximize the coverage of the principal residence exemption.

It is necessary to not claim capital cost allowance (CCA) on the property during the election period.
It is necessary to not designate another property as your principal residence during the same period.
The election must be made in your tax return for the year of the change of use (or by letter to the CRA in certain cases).
The election can be extended beyond four years if you were relocated by your employer and subsequently return to live in the property.

Impact on Your Mortgage

The change of use has direct implications for your mortgage contract. Most residential loans in Canada contain an occupancy clause requiring the borrower to reside in the property. If you convert the property to rental, it is necessary to notify your lender. Some lenders will accept the conversion without modifying the loan, while others may require amended terms, a refinancing, or in extreme cases, repayment of the balance. If your loan was insured by CMHC, Sagen, or Canada Guaranty, the conversion to rental may not be compatible with the mortgage insurance conditions.

Interest Deductibility After Conversion

A tax advantage of the change of use is that mortgage interest becomes deductible from your rental income. Since the loan is now used to earn income, the interest constitutes an eligible expense under paragraph 20(1)(c) of the Income Tax Act. This deduction is not available when the property is occupied as a principal residence. It is important, however, to properly document the date of the change of use to separate personal interest (non-deductible) from rental-related interest (deductible).

Frequently Asked Questions

What happens tax-wise when I convert my principal residence to a rental?

Under subsection 45(1) of the Income Tax Act, there is a deemed disposition at fair market value at the time of the change of use. If the value has increased since purchase, a capital gain is deemed realized. However, the principal residence exemption may eliminate this gain if the property was your principal residence for the entire previous holding period.

What is the subsection 45(2) election?

The subsection 45(2) election allows you to avoid the deemed disposition upon change of use and continue designating the property as your principal residence for up to four additional years. However, it is necessary to not claim CCA on the property and must not designate another property as your principal residence.

Do I need to notify my mortgage lender about the change of use?

Yes, it is strongly recommended. Most residential mortgage contracts contain an occupancy clause requiring the borrower to live in the property. Converting to rental without notifying the lender may constitute a breach of terms and, in the worst case, could trigger a loan recall.

Does mortgage interest become deductible after the change of use?

Yes. When the property is used to earn rental income, mortgage interest becomes a deductible expense in calculating your net rental income. This deduction is not available for an owner-occupied principal residence.

Do I need an appraisal at the time of the change of use?

It is not mandatory, but it is strongly recommended. The appraisal establishes the fair market value at the time of the change of use, which will serve as the new adjusted cost base for future capital gain calculations. Without an appraisal, it will be difficult to prove the value to the CRA in the event of an audit.