Changing how you use property? Here’s how to save on taxes

When a Canadian taxpayer changes the use of a property from personal use (such as a principal residence) to income-producing use (such as a rental), or vice versa, the Income Tax Act may trigger a deemed disposition at the property’s fair market value.

This rule ensures that any accrued capital gain is recognized for tax purposes, even though the property has not actually been sold. However, the Act provides relief through two important provisions: Section 45(2) and Section 45(3).

Overview of Section 45(2) and Section 45(3)

Section 45(2) applies when a taxpayer converts a principal residence into a rental property and continues to be a resident of Canada. Provided the taxpayer does not claim capital cost allowance (CCA) on the property, they may file a 45(2) election to defer the deemed disposition and continue to designate the property as their principal residence for up to four additional years while it is being rented. This extension preserves the principal residence exemption (PRE), potentially eliminating capital gains tax on future sale.

Section 45(3) applies when a taxpayer converts a rental property into a principal residence, regardless of whether they are a resident or non-resident. When the taxpayer moves back into the rental property, they may file a 45(3) election with the return for the year of sale. This election allows the taxpayer to defer the capital gain from the deemed disposition triggered at the date of conversion and, importantly, to designate the property as their principal residence for the four years prior to the move-in year, even if it was rented during that time.

The following chart summarizes the key differences:

Case Study 1: Sarah – Using Section 45(2) to Defer and Eliminate Gain

Sarah purchased a condo in Toronto in March 2025 for $400,000, which she used as her principal residence. In May 2025, she relocated to Vancouver for work and began renting out the condo for $3,000/month. Since she remained a Canadian resident and did not claim CCA, Sarah filed a Section 45(2) election with her 2025 tax return. The fair market value at the time of change in use remained $400,000.

In April 2029, the tenant moved out, and Sarah sold the condo for $700,000. Because she made the 45(2) election and sold the property within four years of converting it to a rental, she was able to continue designating it as her principal residence, thereby fully exempting the $300,000 capital gain from tax.

This demonstrates how Section 45(2) can be used to defer the deemed disposition and preserve the principal residence exemption, even during a rental period.

Case Study 2: Vikram – Using Section 45(3) to Exempt Rental Gain

Vikram purchased a Toronto condo in March 2025 for $400,000, which he occupied as his principal residence. In May 2025, he moved to the United States for work and began renting out the condo. Since Vikram became a non-resident of Canada, he was not eligible to make a Section 45(2) election.

The condo was rented until April 2029, when Vikram moved back in. At that time, it was worth $700,000. In April 2030, he sold the condo for the same amount—$700,000. Because Vikram moved back into the property in 2029, he became eligible to file a Section 45(3) election with his 2030 tax return.

This election allowed him to designate the property as his principal residence for the four years immediately preceding the year he moved back in—from 2025 through 2028—even though the property was rented and he was a non-resident during that time. As a result, Vikram was able to fully exempt the $300,000 gain under the principal residence exemption.

Vikram’s case highlights the strength of 45(3): even after a long rental period and non-residency, a taxpayer may claim the PRE for up to four prior rental years, provided they move back into the home and file the election upon sale.

Case Study 3: Sheila – Conflicting Principal Residence Claims

Sheila bought a townhouse in Winnipeg in January 2014 for $300,000 and used it as her principal residence. In December 2017, when the home was worth $600,000, she began renting it out and filed a 45(2) election with her 2017 tax return. In January 2018, Sheila purchased and moved into a new home, which she sold in June 2024 for a $500,000 capital gain.

Since Sheila designated the townhouse as her principal residence through the 45(2) election for 2014 to 2017, she was unable to fully designate her new home as her principal residence for the same overlapping years. As a result, a portion of the $500,000 gain on the new home became taxable.

This example illustrates an important planning consideration: you can only designate one property per year as your principal residence. Filing a 45(2) election preserves the PRE for the rental property but may restrict future exemptions on another home owned concurrently.

Final Thoughts

Sections 45(2) and 45(3) offer strategic flexibility for taxpayers who convert their properties between personal and rental use. Section 45(2) allows Canadian residents to defer gains and preserve the principal residence exemption for up to four rental years, while Section 45(3) allows a taxpayer to defer recognition of capital gains and retroactively apply the exemption for the four years preceding the year of reoccupation—even while non-resident.

Proper use of these elections requires careful attention to residency, timing, election filing, and CCA claims. Taxpayers should consult a knowledgeable tax advisor to optimize the use of these provisions and avoid unintended tax consequences.