Change in use rules: a deemed sale at FMV, unless 45(2) or 45(3)

What does each change in use trigger, and which election stops it?

Under ITA 45(1), a change in use of property is a deemed disposition at fair market value, followed by an immediate reacquisition at the same amount laws-lois.justice.gc.ca. Your client reports any gain in the year of the change, and the part of the gain for years the property was a principal residence isn't taxed canada.ca.

The 45(2) and 45(3) rules, the four year limits and the letter requirement come from the CRA's principal residence page canada.ca; the 45(3) deadline and the 45(4) CCA bar are in the Act laws-lois.justice.gc.ca. Both elections also work for a partial change, such as a new basement suite, since March 19, 2019 canada.ca.

How does the 45(2) election work when a home becomes a rental?

A 45(2) election treats the home as if its use never changed, so no gain is reported when the tenants move in. Your client still reports the net rental income on Form T776, but can't claim CCA on the property canada.ca.

While the election is in force, your client can designate the home as a principal residence for up to four years, as long as no other property is designated for those years and your client is resident or deemed resident in Canada canada.ca. That's the real cost: one designation per family unit per year means a client who buys a new home while the old one is rented can't shelter both for the same year (see the principal residence exemption page).

Claiming CCA ends the election. The Folio treats a CCA claim as rescinding the election on the first day of the year of the claim canada.ca, and 45(2) then deems the change in use to happen on that day laws-lois.justice.gc.ca. The deemed sale at fair market value lands in that later year instead.

The four year limit falls away under section 54.1 when your client, or a spouse or common law partner, moves because the employer asked, the home is at least 40 kilometres farther from the new workplace than the temporary residence, and your client moves back while still with that employer, by the end of the year after leaving it, or dies during the employment canada.ca.

What happens to a $900,000 home turned rental without an election?

Take a client who bought a home in 2019 for $600,000 ($360,000 building, $240,000 land) and starts renting it out in 2026, when it is worth $900,000 ($480,000 building, $420,000 land). No 45(2) election is filed.

The exemption wipes out the gain, and the "plus 1" in the formula covers 2026, so that year stays free if your client buys a new home (the formula is on the principal residence exemption page). Had the gain been taxable, only half of it would be included in income laws-lois.justice.gc.ca.

The trap is the building. Under 13(7)(b), when a property starts earning income, its capital cost is the lesser of its fair market value and its cost plus half of the excess of fair market value over cost, reduced by twice any lifetime capital gains deduction claimed on it laws-lois.justice.gc.ca. So the CCA base starts at $420,000, not $480,000, even though the whole gain was sheltered. The Folio's Example 6 makes the same point: a house that cost $160,000 and was worth $200,000 got a $180,000 capital cost after the exemption covered the gain canada.ca.

With a 45(2) election instead, nothing is reported for 2026 and the home can stay designated for up to four rental years, but your client gives up CCA for as long as the election lasts. Whether that CCA is worth claiming at all is on the rental property CCA page.

How does the 45(3) election work when a rental becomes a home?

When your client moves into a former rental, 45(1) deems a sale at fair market value on that date, and the gain for the rental years is taxable that year. A 45(3) election defers the deemed disposition until your client actually sells, and lets your client designate the home as a principal residence for up to four years before moving in canada.ca.

The deadline is written notice by the earlier of 90 days after the CRA sends a demand for the election and the filing due date for the year your client actually disposes of the property laws-lois.justice.gc.ca. Unless the CRA asks first, the letter can go in with the return for the year of sale canada.ca.

The CCA bar has no exception. Under 45(4), the election is deemed not made if CCA was allowed on the property for any year ending after 1984 and on or before the change, whether your client, a spouse or common law partner, or a trust under which either is a beneficiary claimed it laws-lois.justice.gc.ca.

Even where 45(3) is available, it only covers the capital gain. Moving into the building is a 13(7)(a) deemed disposition of the depreciable property at fair market value laws-lois.justice.gc.ca, so any CCA claimed before 1985 comes back as recapture in the year of change, and the election can't defer it canada.ca. For a client who claimed CCA after 1984, the gain and the recapture both land in the year of the move; the recapture math is on the recapture and terminal loss page.

Does renting out a basement count as a change in use?

Not always. Without an election, the CRA generally doesn't treat a partial change as a change in use if all three conditions hold: the rental use is relatively small next to the use as a principal residence, there are no structural changes to make the property more suitable for renting, and no CCA is claimed on the rented part canada.ca.

Miss one condition, for example by building a separate suite or claiming CCA, and that portion is deemed sold at its share of fair market value and bought back at the same amount. Your client can designate that portion as a principal residence for the year of change on Part 2 of Schedule 3 and page 2 of Form T2091(IND) canada.ca. If CCA is claimed in a later year, the Folio applies the deemed disposition from the time the rental use began canada.ca.

Since March 19, 2019, the 45(2) and 45(3) elections are available for partial changes too canada.ca. On the eventual sale, split the price between the residence part and the rented part on a reasonable basis such as square metres or rooms, and report the gain on the rented part canada.ca.

How do you report a change in use and fix a missed election?

Each election is a signed letter, attached to the return, that describes the property and states that 45(2) or 45(3) applies canada.ca. When the change is a deemed disposition of a principal residence, the CRA wants the disposition and the designation reported in the year the change of use occurs canada.ca, on Schedule 3 and Form T2091(IND), the form that designates the property and calculates the gain canada.ca.

A missed 45(2) or 45(3) election can be filed late. Regulation 600 lists both as prescribed provisions for 220(3.2) laws-lois.justice.gc.ca, so the CRA may accept one if your client applies within ten calendar years after the end of the year, with a penalty of the lesser of $8,000 and $100 for each complete month late laws-lois.justice.gc.ca. For a late 45(2), the Folio adds a condition: no CCA claimed since the change canada.ca.

The penalty in practice: a 45(2) election due with the 2023 return on April 30, 2024 and filed on October 15, 2026 is 29 complete months late, so the penalty is $2,900.

A loss on the home is never allowed, because it is personal use property canada.ca. GST/HST has its own change of use rules under the Excise Tax Act; the sales tax side is on the GST on residential real estate page.