20 September 1999 External T.I. 9922995 - PRINCIPAL RESIDENCE EXEMPTION

Please note that the following document, although believed to be correct at the time of issue, may not represent the current position of the CRA.
Prenez note que ce document, bien qu'exact au moment émis, peut ne pas représenter la position actuelle de l'ARC.

Please note that the following document, although believed to be correct at the time of issue, may not represent the current position of the Department.

Prenez note que ce document, bien qu'exact au moment émis, peut ne pas représenter la position actuelle du ministère.

Principal Issues:

Whether there is a deemed disposition of property in a case where a taxpayer has partially converted a principal residence to an income-producing use (rental of basement of house)

Position: Question of fact.

Reasons: See paragraphs 36 to 38 of IT-120R4.

XXXXXXXXXX 992299
G. Moore
September 20, 1999

Dear XXXXXXXXXX:

Re: Principal Residence - Partial Change in Use

We are replying to your letter of August 13, 1999, in which you ask for our interpretation concerning the disposition of a property which has undergone a partial change in use from principal residence to an income-producing property.

xxxxxxxxxx

You are asking about the use of a portion of a principal residence as a rental property and whether the future sale of the house would result in any capital gains. You are also asking what you have to do to ensure that you can claim principal residence status on XXXXXXXXXX if you decide that you do not want to sell it and what is the latest date you could sell XXXXXXXXXX without losing the principal residence status for the top two floors of the house.

You will note from the enclosed copy of Information Circular 70-6R3, Advance Income Tax Rulings, that in addition to a charge for the service, such rulings are given only in respect of proposed transactions. Further, a ruling cannot be provided where part or all of the proposed transaction has already been completed, which appears to be the situation in this case (i.e., as explained further in our comments below, the change in use of the property to a rental property would have resulted in a deemed disposition of the property at that time). A determination of what portion of the house can be considered a principal residence in any particular case, based on a review of all relevant facts and documentation, is normally the responsibility of the tax services office serving the area in which the client resides. We will, however, provide some general comments, which are not binding on the Department, but which may be of assistance.

Our Comments

The Department's general interpretation of the provisions of the Income Tax Act (the "Act") which apply to such property is contained in IT-120R4, Principal Residence. In particular, please refer to paragraphs 36 to 38 of that bulletin (copy enclosed). When a taxpayer has partially converted a principal residence to an income-producing use, paragraph 45(1)(c) of the Act provides for a deemed disposition of the portion of the property so converted for proceeds equal to its proportionate share of the property's fair market value. Paragraph 45(1)(c) also provides for a deemed reacquisition immediately thereafter of the same portion of the property at a cost equal to the same amount.

As explained in paragraph 31 of the bulletin, in certain circumstances, a taxpayer may defer recognition of any gain to a later year by electing under subsection 45(2) of the Act to be deemed not to have made the change in use of the property. This election is made by means of a letter to that effect signed by the taxpayer and filed with the income tax return for the year in which the change in use occurred. If capital cost allowance is claimed on the property, no election can be made or if the election has already been made, the election is considered to be rescinded on the first day of the year in which the claim is made. It is the Department's usual practice to accept a late-filed election provided no capital cost allowance has been claimed on the property since the change in use has occurred and during the period in which the election remains in force. A property can qualify as a taxpayer's principal residence for up to four taxation years during which a subsection 45(2) election remains in force, even if the housing unit is not ordinarily inhabited during those years by the taxpayer or the taxpayer's spouse, former spouse or a child of the taxpayer. However, as you will note from our comments below, a subsection 45(2) election cannot be made in your circumstances with respect to the change in use in XXXXXXXXXX.

With respect to the specific situation described in your letter, as we do not have all the relevant facts, we cannot give you a definitive response; however, it appears that the house may not have been ready to be inhabited until XXXXXXXXXX (i.e., you stated that the basement suite was finished and rented in XXXXXXXXXX and the upper two floors were finished in XXXXXXXXXX). Where a taxpayer acquires land in one taxation year and constructs a housing unit on it in a subsequent year, the property may not be designated as a principal residence for the years that are prior to the year in which the taxpayer. the taxpayer's spouse or former spouse or taxpayer's child commences to "ordinarily inhabit" the housing unit. Therefore, it appears that no principal residence exemption can be claimed by you for the period prior to XXXXXXXXXX with respect to the entire property. Since the upper two floors of the house were still under construction from XXXXXXXXXX, but the basement was completed and rented, it is also arguable that the principal purpose of the house for these years was to produce income. Accordingly, you may not be considered to "ordinarily inhabit" that house, as described in paragraph 12 of the above-mentioned bulletin, from XXXXXXXXXX to some time in XXXXXXXXXX, the date when construction commenced to the date when the upper two floors were completed. From some part of XXXXXXXXXX, you may be able to treat the upper two floors as your principal residence since the construction was completed and you did inhabit the upper two floors during those years. In this regard, since the construction was complete, and only one-third of the house was being rented, the Department may accept that the principal purpose was not to produce income for the XXXXXXXXXX years. However, it is always a question of fact whether the principal purpose was to produce income and factors such as the amount of rental income earned versus the cost of the entire property would have to be considered (see paragraph 12 of IT-120R4 regarding the meaning of "ordinarily inhabited" with respect to seasonal residences.)

Where an individual converts a small portion of the principal residence into a rental property, and if the conditions in paragraph 38 of the bulletin are satisfied, then generally, there would not likely be any deemed disposition resulting from the partial change in use of a principal residence. However, in this particular case, since you claimed capital cost allowance on the basement suite of the property in question, the conditions in paragraph 38 of the bulletin would not be met and there would be a deemed disposition at the time that there was a partial change in use of the basement suite of that property. An election under subsection 45(2) or (3) cannot be made where there is a partial change in use of property.

In XXXXXXXXXX, when you rented the remaining two-thirds of the house, there was a partial change in use of the upper two floors of the property to an income producing property. As indicated above, a subsection 45(2) election cannot be made with respect to a partial change in use. A deemed disposition relating to two-thirds of the property occurred at the time that the partial change in use occurred in XXXXXXXXXX and the property would have been deemed to have been reacquired for the same amount immediately thereafter, pursuant to paragraph 45(1)(c) of the Act. The gain on two-thirds of the house accrued from XXXXXXXXXX, the time when construction on the upper two floors was finished (again, assuming this is the earliest date you could be considered to have ordinarily inhabited the property), to XXXXXXXXXX, if any, triggered by this deemed disposition in XXXXXXXXXX may be offset by the principal residence exemption provided you ordinarily inhabited the property during those years (see comments above). Paragraph 38 of the bulletin indicates that is not the Department's practice to apply the deemed disposition rule but rather to consider that the entire property retains its nature as a principal residence if the income producing use is ancillary to the main use of the property as a residence, there is no structural change to the property, and no capital cost allowance is claimed on the property. As it appears that the income producing use is not ancillary to the main use of the upper two floors of the property, all of the above-mentioned conditions are not met. Accordingly, there would be a deemed disposition of two-thirds of the house in XXXXXXXXXX when there was a partial change in use of the upper two floors to a rental property.

Since you have specific questions regarding the tax implications of events that have already transpired, we encourage you to contact the local tax services office. Upon a review of all the pertinent details and documentation, the tax services office will be in a position to provide you with a more definitive response. We would be glad to provide assistance to the tax services office should they so request. We trust this information will be of assistance to you.

Yours truly,

J. Wilson
for Director
Business and Publications Division
Income Tax Rulings and
Interpretations Directorate
Policy and Legislation Branch