The Section 45(2) Election: Changes in Use of Principal Residence in Canada

The Section 45(3) Election: Converting a Rental Property to a Principal Residence

Section 45(3) of the Tax Act mirrors the section 45(2) election but operates in the opposite direction. It is available where a taxpayer converts a rental property or other income-producing property to a principal residence.

The election allows the taxpayer to be deemed not to have changed the use of the property at the time of conversion, deferring any capital gains arising from the rental period until the property is actually sold.

Under section 45(3):

• The deemed disposition under section 45(1) is deferred to the time the property is actually sold or otherwise disposed of.
• The taxpayer may designate the property as their principal residence for up to four years before it was actually occupied as such, provided the taxpayer was a Canadian resident during those years.
• The election is made by filing a signed letter with the taxpayer’s income tax return for the year of the actual disposition of the property.
• If the taxpayer claimed CCA on the property during the rental period, the CCA recapture rules in section 13 will still apply on the actual disposition, even if the section 45(3) election shelters the capital gain.

Section 45(2) vs. Section 45(3): Quick Reference for Canadian Homeowners

 Figure 1: Change-in-Use Election Decision Guide

The Four-Year Principal Residence Extension: How It Works in Practice

The most significant planning benefit of the section 45(2) election is the ability to continue designating the converted property as a principal residence for up to four additional years after the change in use. 

Under the Income Tax Act, the principal residence exemption formula is: 

((number of years designated + 1) divided by total years owned) multiplied by the capital gain. The “+1” year is built into the formula to accommodate a change-in-year scenario, but the four-year extension goes significantly further.

Example: Maya purchases a Toronto condo in January 2018 for $600,000. She lives in it until December 2021 (four years of actual occupancy) and then rents it out from January 2022. 

In December 2026, she sells it for $900,000, a $300,000 capital gain over nine years of ownership. She files a section 45(2) election. She designates the condo as her principal residence from 2018 to 2026, being nine years: four years of actual residence, four years of the permitted extension, and the sale year. 

The PRE formula yields: ((9 + 1) divided by 9) multiplied by $300,000 = $333,333, which exceeds the actual gain, so the entire $300,000 is sheltered. Without the election, the gain accrued during the rental years 2022 to 2026 would be fully taxable.

Capital Cost Allowance and the Section 45(2) Election: The Critical Restriction

Taxpayers who claim CCA on a rental property cannot use the section 45(2) election to shelter the gain from those rental years. This restriction flows from the definition of “principal residence” in section 54 of the Tax Act: a property does not qualify as a principal residence for any year in which the taxpayer claimed CCA in respect of that property.

The CCA restriction has two practical consequences:

• A taxpayer who claimed CCA during the rental period cannot elect under section 45(2) to shelter the gain accrued during those rental years.
• A taxpayer who elects under section 45(2) must not claim CCA on the property while the election remains in force. Claiming CCA after making the election will not retroactively invalidate it for prior years, but it will prevent the taxpayer from designating those CCA years as principal residence years.

Pro Tax Tip: Landlords who believe they may eventually move back into a rental property, or who wish to preserve the section 45(2) election as an option, should carefully weigh the immediate tax benefit of claiming CCA against the potential cost of losing principal residence designation years. The decision depends on the property’s appreciation trajectory and the taxpayer’s marginal tax rate. An experienced Toronto tax lawyer can model both scenarios.

Partial Change of Use and the March 2019 Expansion of Section 45(2)

Prior to March 19, 2019, the section 45(2) election was only available where there was a complete change in use, such as a taxpayer moving entirely out of their home and renting the whole property. A partial change in use, such as converting a basement to a rental suite while continuing to occupy the remainder of the home, could trigger a deemed disposition on the rented portion, but no election was available to defer it.

Budget 2019, effective March 19, 2019, expanded the section 45(2) election to cover partial changes in use. The CRA’s position, confirmed in Income Tax Folio S1-F3-C2 at paragraph 2.60.1, is as follows:

• Where a taxpayer converts part of their principal residence to rental or business use, for example by creating a self-contained basement apartment in a single-family home, a section 45(2) election may now be filed to defer the deemed disposition on the converted portion.
• The election for a partial change in use is made in the same manner as a complete change: by signed letter filed with the T1 return for the year of the change.
• If the election is later rescinded, the change in use is deemed to have commenced on the first day of the year of rescission.
• The same CCA restriction applies: the taxpayer cannot claim CCA on the rental portion of the property while the section 45(2) election is in force.

Late-Filed Section 45(2) Elections: Relief Under Section 220(3)

Many taxpayers are unaware of the section 45(2) election until years after a change in use has occurred. Section 220(3) of the Tax Act grants the CRA discretionary authority to accept late-filed elections. The CRA’s administrative policy is generally to grant relief where the following conditions are met:

• The taxpayer has not claimed CCA on the property during the period in question.
• The election is accompanied by a written explanation of why it was not filed on time.
• A late-filing penalty applies at the rate of $100 per month from the original due date to the date of the application, with a minimum of $100 and a maximum of $8,000, under subsection 220(3.5) of the Tax Act.

Taxpayers who converted their principal residence to a rental property and did not file a section 45(2) election at the time should contact an experienced Canadian tax lawyer to assess whether a late-filed election is feasible and advantageous in their circumstances. Where the CRA refuses a late-filed election and the resulting tax liability is significant, a voluntary disclosure application may also be worth considering as a complementary strategy.

The 2023 Residential Property Flipping Rule: Section 12(12) of the Income Tax Act

As of January 1, 2023, the federal government introduced the residential property flipping rule under section 12(12) of the Tax Act, enacted by Bill C-32, the Fall Economic Statement Implementation Act, 2022. 

This rule treats the full gain from the sale of a residential property as business income, not a capital gain, if the taxpayer has owned the property for fewer than 365 consecutive days before the sale.

“The residential property flipping rule has caught a number of taxpayers who assumed their section 45(2) election was sufficient protection. It is not. The flipping rule operates independently: if you have not held the property for 365 days, the full gain is business income and the principal residence exemption does not apply, regardless of whether you filed a section 45(2) election. The exceptions for life events are real but narrowly drawn. Always confirm your holding period before planning a sale.” 

— David J. Rotfleisch, Certified Specialist in Taxation

 

The residential property flipping rule interacts critically with the section 45(2) election and the principal residence exemption:

• The principal residence exemption does not apply to income characterized as business income under section 12(12). Even if a taxpayer has filed a section 45(2) election, the flipping rule overrides the exemption if the 365-day holding period has not been satisfied.
• Certain exceptions apply where the disposition arises from a life event: death or imminent death of the taxpayer or a related person; addition of a new household member through marriage, common-law partnership, or birth of a child; separation or divorce; threat to personal safety such as domestic violence; disability or serious illness; involuntary job loss; insolvency; or destruction of the property due to disaster.
• The exceptions are construed narrowly. Taxpayers should not assume an exception applies without careful analysis of the specific facts.
• The rule applies to properties sold on or after January 1, 2023, regardless of when they were purchased. A property purchased before 2023 and sold within 365 days after January 1, 2023 may be caught by the rule.

Non-Resident Obligations: Selling Canadian Real Estate After Leaving Canada

Canadian real estate is taxable Canadian property under section 248(1) of the Tax Act. Unlike most other capital property, real estate is not subject to the departure tax deemed disposition under section 128.1(4) when a taxpayer ceases to be a Canadian resident. The property remains on the taxpayer’s books at its original ACB and any section 45(2) election continues in force after emigration.

However, a taxpayer who emigrates and retains Canadian real estate faces a distinct set of obligations:

• Non-residents who rent out Canadian real property are subject to Part XIII withholding tax under section 212 of the Tax Act. The default withholding rate is 25% of gross rental receipts, remitted monthly by the tenant or property manager.
• A non-resident landlord may elect under section 216 of the Tax Act to file a Canadian income tax return and pay tax on net rental income at graduated rates, rather than the 25% gross withholding rate. This election typically produces a lower tax liability where the property has significant deductible expenses.
• When a non-resident sells Canadian real property, the purchaser is required to withhold a portion of the purchase price (generally 25% of the gross proceeds, or 50% if the property was used in a business) under section 116 of the Tax Act, unless the non-resident seller has obtained a Certificate of Compliance from the CRA before or promptly after closing.
• The principal residence exemption remains available to non-residents for the years the property qualified as the taxpayer’s principal residence, including any years covered by the section 45(2) election’s four-year extension, provided those years have not expired.

Pro Tax Tip: Non-residents planning to sell a former Canadian principal residence should apply for a section 116 Certificate of Compliance well in advance of closing. Failure to obtain the certificate results in the purchaser withholding a significant portion of the sale proceeds, which can create a cash-flow problem at closing even where the ultimate tax liability is small or nil due to the principal residence exemption.

Quebec Residents: Parallel Change-in-Use Rules Under the Quebec Taxation Act

Quebec residents are subject to a parallel income tax regime under the Quebec Taxation Act (the “QTA”), administered by Revenu Quebec. The QTA contains provisions that mirror the federal change-in-use rules, found at sections 281 to 283 of the QTA.

Practical points for Quebec residents:

• A Quebec resident who converts their principal residence to a rental must file a section 45(2) election under the federal ITA and a corresponding election under section 282 of the QTA. Two separate signed letters are required, one to the CRA and one to Revenu Quebec.
• The four-year principal residence extension and the CCA restriction apply under both the federal and Quebec regimes.
• Quebec’s Form TP-274-V (Designation of Property as a Principal Residence) must be filed with the Quebec provincial return for the year of the sale, mirroring the federal T2091(IND) obligation.
• Penalties for late-filed elections under the QTA are similar to the federal $100-per-month penalty structure, to a maximum of $8,000.

Quebec residents should not assume that filing the federal section 45(2) election automatically satisfies Quebec’s requirements. Separate filings are required. Failure to file the provincial election can result in a provincial deemed disposition and capital gains tax liability under the QTA, even if the federal election is properly filed.

Reporting Requirements: T1 Return and Form T2091(IND)

Since 2016, taxpayers are required to report the sale of a principal residence on their T1 income tax return in the year of sale, even if the full gain is sheltered by the principal residence exemption. The disposition must be reported on Schedule 3 (Capital Gains and Losses), and Form T2091(IND), Designation of a Property as a Principal Residence by an Individual, must be completed and filed.

Failure to report the disposition by the T1 filing deadline can result in:

• A penalty of $100 per month, to a maximum of $8,000, under subsection 220(3.5) of the Tax Act.
• Loss of the ability to claim the principal residence exemption for that year if the CRA does not accept a late designation.
• A reassessment by the CRA to include the full capital gain in income.

“Change-in-use planning is not a set-and-forget exercise. The election needs to be filed on time, CCA decisions need to be made with the full picture in mind, and the four-year clock needs to be tracked annually. The taxpayers who get into trouble are almost always the ones who made good decisions at the start but then lost track of the planning over time. A seasoned Canadian tax lawyer should review the position every few years to make sure nothing has slipped.”

— David J. Rotfleisch, Certified Specialist in Taxation

About the Author

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David J. Rotfleisch

David J. Rotfleisch, a leading Canadian tax lawyer, is not only a certified specialist in taxation but also a chartered professional accountant. Most recently, David is a pioneer in Canadian crypto taxation.

As of April 2020, he was one of 12 Ontario Certified Specialists In Taxation™.

Learn more about David J. Rotfleisch