Capital Gains Tax When Renting Your Former Primary Residence

Do you pay capital gains when you rent out a former principal residence?

Changing the use of a property—from a principal residence to a rental, or the reverse—has tax consequences under Canadian law. Even if you don’t sell the house when you move out, the act of converting your home into a rental triggers a deemed disposition for tax purposes in the year the use changes.

In your situation, Hugh, that deemed disposition is what creates a tax event in the year you moved out, unless you take steps to elect otherwise.

Change in use: from principal residence to rental property

When you dispose of your principal residence—or are deemed to have disposed of it—you must report that on your tax return. Since 2016, any disposition of a principal residence must be reported using the appropriate form (for example, Form T2091 for principal residence designation). If the property qualified as your principal residence for all years you owned it, no capital gain is reported, but the disposition still needs to be declared.

If you convert your principal residence into a rental property, the tax system treats that conversion as a deemed sale at fair market value on the date the use changes. That deemed sale must be reported unless you make a valid election to defer the change.

You may be eligible to treat the home as your principal residence for a limited time after moving out by filing a subsection 45(2) election, which can prevent immediate recognition of the deemed disposition.

What is the subsection 45(2) election?

The subsection 45(2) election under the Income Tax Act allows a taxpayer who moves out of a principal residence and rents it out to continue treating the property as a principal residence for up to four years after the move, in many circumstances. This election can, in very limited cases, be extended beyond four years if an employer requires the relocation.

To qualify for the election you generally must:

1. Be a resident, or deemed resident, of Canada.
2. Not have designated another property as your principal residence for the same years.
3. Report any rental income from the property on your tax return.
4. Not claim capital cost allowance (depreciation) on the property while the election is in effect.

In practical terms, your situation—moving to rent elsewhere while leasing out your former home—is a common scenario where a 45(2) election applies. To make the election, you attach a signed letter to your income tax and benefit return for the year the change of use occurs, describing the property and stating that you wish subsection 45(2) to apply. There is no special printed form for this election; the letter suffices.

If your move was to seek work rather than because your employer required a relocation, the extended indefinite period available in some employer-driven moves will likely not apply.

Filing a late subsection 45(2) election

The 45(2) election should be filed in the year you move out—the deadline is the tax filing deadline for that year (generally April 30 for most taxpayers, June 15 for self-employed individuals and certain spouses). The Canada Revenue Agency (CRA) can accept a late-filed election, but normally only where there are extraordinary or exceptional circumstances.

Examples of circumstances the CRA may accept include:

• Tax consequences occurred that the taxpayer did not intend and the taxpayer took reasonable steps to comply with the law (for example, reliance on a bona fide but later disputed valuation).
• The election was late because of circumstances beyond the taxpayer’s control—natural disasters, disruptions to postal services, serious illness, or severe emotional distress such as a death in the immediate family.
• The taxpayer relied on incorrect information provided by the CRA.
• The late filing resulted from a mechanical or clerical error such as using an incorrect tax amount.
• All parties accounted for the transaction as though the election had been made.
• The taxpayer was unaware of the election provision despite taking reasonable care and acted promptly once aware.

There is legal precedent where courts ordered the CRA to reconsider a late-filed 45(2) election, so late filings can sometimes succeed even absent the usual extraordinary circumstances. Be aware that penalties can apply for late election filings: the CRA can assess a penalty equal to the lesser of $8,000 or $100 per month past the deadline. If the tax benefit from making the election exceeds the penalty, filing late may still be worthwhile.

How capital gains are calculated after a change of use

Because converting a home to a rental is treated as a deemed disposition, the property’s fair market value at the date the rental use begins generally becomes its adjusted cost base (ACB) for future capital gains calculations. If you validly file a subsection 45(2) election, you may defer that deemed disposition and preserve the original cost basis for the election period.

When you eventually sell, the capital gain is calculated as:

Sale price – selling costs – adjusted cost base (ACB) = capital gain (or loss)

If you made renovations or capital improvements after converting the property to a rental, those costs can increase the ACB and reduce your future capital gain. One-half of the capital gain is normally taxable. Note that recent changes to capital gains rules (effective 2024) affect how larger capital gains may be taxed; in some cases a greater portion of gains above certain thresholds can be taxable. The tax on the taxable portion of a capital gain depends on your total income and your province of residence, and can vary widely.

Any depreciation (capital cost allowance) claimed while the property was a rental is subject to recapture when the property is sold; that recaptured amount is included in income and taxed at your marginal rate in the year of sale.

Further reading on capital gains and principal residence topics

• Can you save tax by moving into your rental property?
• When does the “plus one” rule apply to a principal residence?
• Would a senior get a tax credit for selling their house if they move out?
• Can you claim a principal residence exemption for a property occupied by a child?