In Canada, changing the use of a property (e.g. converting a principal residence to a rental property or vice versa) may have important tax consequences. The most important thing to do in this process is to have a professional appraisal to establish the Fair Market Value (FMV) of the property at the time of the change. This article explains why an appraisal is necessary in the case of a change in property use, and the effect it may have on your taxation.
Understanding the Deemed Disposition Rule
In Canada, a change in the use of property is a deemed disposition by the Canada Revenue Agency (CRA). This is tax-wise the same as you have sold the property at its FMV and re-bought it at the same value. Consequently, any gain or loss on capital should be reported during the year of change of use.
As an example, when you make your principal residence into a rental property, the CRA will treat this as a sale at the FMV of the property. There is a possibility of you making a capital gain, which may be taxed, in case the value of the property you bought has appreciated.
The Role of an Appraisal in Determining FMV
An appraisal is an independent, professional opinion of FMV of your property as of the date of change in use.
This valuation is essential for several reasons:
Accurate Tax Reporting
An accurate FMV is needed to compute any capital gains or losses that the deemed disposition will cause under the CRA. An appraisal makes sure that the value given is the actual market value of the property, and this will assist you to adhere to the requirements of the tax and evade any possible penalty or audit.
Supporting Elections to Defer Capital Gains
In some cases, you can be in a position to make an election under the Income Tax Act to postpone the capital gains tax that arises as a result of change of use.
For instance:
Section 45(2) Election: In the event that you rent out your principal residence, you may defer the capital gain until the time that the property is sold by electing under section 45(2). Under this election, you can extend the period that you can treat the property as your principal residence up to four more years, but only under certain requirements.
Section 45(3) Election: You may elect to defer the capital gain where you convert a rental property to your principal residence until the sale of the property. In this election, you can make the property your principal residence up to four years before the conversion.
In both, the FMV of the property as of the change of use must be appraised, which is essential to determine the capital gain and eligibility to these elections.
Establishing Capital Cost for Depreciable Property
In case the property has depreciable assets e.g. a building, the appraisal assists in determining the capital cost of the assets at the date of the change of use. This is relevant in the calculation of Capital Cost Allowance (CCA) and how the depreciation would be recaptured when the property is eventually sold.
The Appraisal Process
Obtaining an appraisal involves several steps:
Choosing a Qualified Appraiser: Select a licensed appraiser that has experience in the kind of property and the particular market environment that is applicable in your case.
Property Inspection: The appraiser will inspect the property thoroughly and determine the condition, size, location and any other aspect that would affect the value of the property.
Market Analysis: The appraiser will conduct an analysis of the sales of similar properties in the market to establish a starting point of the FMV.
Report Preparation: The appraiser will also prepare a comprehensive report that will describe the procedures and information employed in the establishment of the FMV. This report plays a critical role in the tax reporting and it might be demanded by the CRA.
The shift in the use of a property in Canada results in a deemed disposition which necessitates the need to calculate the FMV of the property during the shift in the use. Professional appraisal guarantees proper tax reporting, elections to defer capital gains and the capital cost of depreciable property. As it is a complex process, it is recommended to seek advice of a qualified real estate agent or tax advisor to go through the process successfully and make sure that all tax laws are adhered to.
With the knowledge of how an appraisal is significant in the scenario of the altering use of the property, you are able to make decisions which are informed and which are aligned to your financial needs and taxation requirements.