Change in Use Rules for Principal Residence Exemption

Complete vs. Partial Change of Use

When a property transitions from personal use to income-generating use (or vice versa), the tax implications can be significant. Understanding the "change of use" rules is essential for maximizing the principal residence exemption (PRE) and avoiding unexpected tax consequences.


Change in Use Example

Consider Candice's situation:

  • Purchased a home in Year 1 for $100,000
  • Used as principal residence until Year 8 (when worth $150,000)
  • Converted to rental property and filed subsection 45(2) election
  • Property value in Year 13: $290,000
  • Sold in Year 15 for $300,000

If Candice never revokes her 45(2) election:

  • Sale proceeds: $300,000
  • Adjusted cost base: $100,000
  • Capital gain before exemption: $200,000
  • PRE calculation: $200,000 × (8+4+1)/15 = $173,333
  • Taxable capital gain: $26,667

However, if she strategically revokes the election in Year 13:

  • Deemed disposition in Year 13: $290,000
  • Adjusted cost base: $100,000
  • Capital gain before exemption: $190,000
  • PRE calculation: $190,000 × (8+4+1)/13 = $190,000 (fully exempt)
  • New adjusted cost base: $290,000
  • Capital gain on actual sale (Year 15): $10,000 (fully taxable)

This strategic approach eliminates the larger gain through the PRE while only leaving a minimal $10,000 gain taxable.


Partial Change of Use: The Grey Area

Since 2019, the rules have been clarified for partial changes in use, but important nuances remain:

  1. Incidental Use (Home Office/Rented Room):
    • CRA's administrative policy: No deemed disposition if no Capital Cost Allowance (CCA) is claimed
    • If you claim CCA on a portion of your home, that portion no longer qualifies for the PRE
    • You can still claim CCA on movable assets (office furniture, appliances) without affecting PRE eligibility
  2. Substantial Change (Converting to Duplex):
    • Deemed disposition applies to the income-earning portion regardless of CCA claims
    • The PRE will only apply to the personal-use portion going forward
  3. The Basement Rental Question:
    • The line between "incidental" and "substantial" change remains subjective
    • For safety, consider filing a 45(2) election when renting out a significant portion like a basement
    • This preserves PRE eligibility for up to 4 additional years


Strategic Considerations

When deciding whether to make a 45(2) election:

Elect if:

  • You have no other principal residence (you can always rescind if property decreases in value)
  • The annual gain on your existing residence exceeds potential gains on a new residence

Don't elect if:

  • You've owned the residence for many years and future value increases will be minimal
  • Gains on a new residence will be significant, especially with short ownership periods

Remember that a 45(2) election can be revoked by writing to CRA, resulting in a deemed disposition on January 1 of the year of revocation—sometimes creating a strategic advantage as shown in Candice's example.

By understanding these rules, homeowners can make informed decisions that maximize their tax benefits while complying with CRA requirements.