Repurposing Commercial Property into Residential Units: A Post-COVID-19 Transformation in Canada

Authored by Jessica Stuart, LL. B., LL.M., Manager, Richter; and Vincent De Angelis, CPA, Partner, Richter

With contributions by Martin Gilbert, LL. B, Partner, Richter; and Jenna Schwartz, LL. B., B.C.L., Partner, Richter

As the consequences of the Covid-19 pandemic continue to shape our world, the shift towards hybrid and remote working models continues to persist. This profound shift in working patterns has left many commercial spaces underutilized, and, in some cases, vacant. Recent data from an Altus Group report underscores this trend, revealing 35 million square feet of available office space for lease in the Greater Toronto Area alone during the first quarter of 2023. This availability is more than double the pre-pandemic numbers from the first quarter of 2020.[1] Similarly, Montreal’s office vacancy rate has continued to rise, climbing to over 20 million square feet in the second quarter of 2023.[2]

Investors who once saw promising returns from commercial properties are now grappling with the reality of lower demand and reduced rental income. This may lead to an erosion of property values, which will prompt property owners and investors to explore alternative uses for these spaces. Converting these properties into residential units presents an opportunity, not only to preserve the value of the asset, but also to potentially enhance it by tapping into the burgeoning residential real estate market.

The opportunity to convert commercial properties into residential units has captured the attention of governments at various levels, including municipal authorities aiming to promote urban densification while addressing the issue of vacant office buildings. Concurrently, provincial and federal governments have been looking to developers to grow housing inventories to address inflows of immigration. A recent example of the government’s interest in commercial property conversions is Prime Minister Justin Trudeau’s September 14, 2023 announcement offering full GST rebate for new residential rental property construction (for buildings with at least 90% residential units designated for long term rental) and to the conversion of commercial buildings to residential rental units.

What follows is a discussion of salient points to keep in mind where consideration is being given to converting a commercial property into residential units.

Availability of Commercial Buildings Suitable for Conversion

First and foremost, property owners and investors must address the pivotal question of whether their existing zoning by-laws accommodate such conversions. Equally important is the assessment of whether their properties possess the suitability and desirability for residential habitation. It is worth noting that an Avison Young report investigated the potential for adaptive reuse of office buildings in various cities across Canada.[3] Toronto emerged as the city with the highest potential, boasting a substantial 923 office buildings suitable for transformation. Montreal followed closely behind with 611, while Vancouver and Calgary have 548 and 521 adaptable office buildings, respectively. These numbers underscore the feasibility of repurposing existing office structures to meet the growing demand for residential spaces in these urban centres.

Secondly, across the country, there has been a slow, but steady return to offices across many industries. This may result in a reinvigorated demand for commercial properties. Layered into this is the possibility that, as leases expire, traditional workspaces may be repurposed to accommodate hybrid work models. It may be worth considering the conversion of purely commercial properties into mixed-use properties. These mixed-use properties may remain attractive to their present owners, while at the same time attract new investors with an expertise on residential builds and delivery. These two owner groups may leverage their respective expertise and limit overall risk to the greatest extent possible.

Tenant Management Considerations for Commercial to Residential Conversion

Converting commercial properties into residential properties can be an appealing prospect, but it is often accompanied by the substantial cost of cancelling existing leases if the property is not entirely vacant. Alternatively, if only a portion of the building will be converted, property owners may be faced with the logistical challenge of moving tenants from floor to floor to isolate space intended for conversion. When transitioning from commercial to residential use, property owners must navigate the legal, financial and tax implications of terminating lease agreements with current tenants while ensuring that designated areas are vacated and prepared for the conversion process. Depending on the terms of the leases and the market conditions, property owners might experience financial losses due to vacant periods during the conversion.

The payment for the cancellation of a lease may be deductible over the remaining term of the lease, plus all renewal periods. These deductions from income for tax purposes may provide a sort of subsidy for these substantial cash outlays in preparing for a conversion. Likewise, payments to incentivize new tenants that may better suit a mixed-use property may themselves provide for accelerated deductions in certain circumstances. There is also a possibility that these payments may be deemed to include GST/HST and QST, which could entitle the landlord to claim input tax credits or refunds with respect to these taxes.

The accumulation of these preparatory expenses should be organized to minimize net income for tax purposes and, in certain cases, create current year losses for future use. Of course, this is on the assumption that, based on the general performance of these commercial office spaces during the period of the pandemic and following, the losses generated during the conversion process may not have prior year profits to carry back against, and recover previously paid taxes.

The Ownership Structure

The conversion of commercial space to residential or a mixed-use property may necessitate a split of ownership in the underlying property in anticipation of, or the conclusion of, the conversion project. As an example, there may be cases where only parts of the commercial property may undergo a conversion and new investors will wish to retain ownership of the portion of the property solely dedicated to residential rentals or condominiums for sale. Here it may be beneficial to split the existing property in parts to accommodate investors’ business terms. All this must be managed so as not to generate a disposition for the existing owner of the property as a whole for income tax purposes. Otherwise, a material and untimely income tax liability may result.

It is easy to imagine that each commercial property will have its own unique challenge and opportunity for conversion. Consequently, this will require well-organized plans, budgets, and investor term sheets to organize an ownership structure that works for all stakeholders involved in the conversion. Simple boilerplate off-the-shelf ownership structures will not be optimal here.

Residential Rental or Condominium for Sale

Mixed-use properties may include condominiums for sale and residential units for rent. For income tax purposes, the distinction may result in two different outcomes. We will assume for this discussion that the value exceeds the cost of the portion of the property deemed sold in the case of each conversion of a commercial rental building into condominiums for sale, and in the case of a conversion of a commercial rental building into residential rental units.

Condominium for Sale

Moving from commercial rents to condominiums for sale may or may not in itself generate a disposition at the time the change is envisioned for income tax purposes. However, such a change may impact the taxability of the ultimate gain at the time of sale. This may represent a difference in income tax rates and will ultimately impact the amount of income to include for tax purposes at the time of sale. Customarily, owners of rental properties will realize a capital gain (only half of which is taxed) on the ultimate sale of their property. By contrast, a full income inclusion results from a sale of condominium units.

The position of the Canada Revenue Agency (CRA) on conversion of all or part of the property from rental use to condominiums for sale is uncertain, but the CRA has provided administrative guidance as to when a conversion occurs. For example, the property would not be considered deemed disposed at the time of conversion. That said, the owner must not continue claiming depreciation for tax purposes for the portion of the property converted. The gain on the ultimate sale of the property as a condominium for sale will have a mix of capital gain and income.

By contrast, the case law suggests that a conversion from capital property to inventory may be considered for tax purposes to be a “deemed disposition” of a property in its entirety or in part.[1] This may create an immediate income tax liability. The only benefit here is what may be some certainty with respect to the capital gain treatment of the property deemed disposed at that time. The CRA has openly suggested that it will not apply to such jurisprudence.

From a sales tax perspective, the conversion from commercial property to condominiums for sale would likely not constitute a change in use since the sale of condominium units would constitute a taxable supply.

Understanding the different outcomes and the metrics here will be key in realizing a controlled outcome. This will involve interacting with your advisors at the inception stage of the conversion of the property.

Residential Rentals

Opting for a conversion to rental apartment units can provide a consistent stream of rental income, offering stability and long-term investment potential. Owners can offset rental income with deductions for eligible expenses and may claim capital cost allowance on depreciable property. Moving from the rental of commercial space to residential provides more certainty in the outcome of any transition for income tax purposes. The tax treatment prior to and following the conversion to residential rentals should remain the same, which is likely capital gains treatment on the ultimate sale of the converted property.

That said, there may be sale tax considerations to navigate here. In completing any real estate project leading to the construction of residential rental units, there is a self-assessment and a payment of sales tax based on the underlying fair market value of the property once available for rents. This self-assessment of taxes lead in general to a material payment of taxes. As previously mentioned, the federal government’s announcement of September 14, 2023 may have a favourable outcome here for an owner undertaking the commercial conversion. At the time of writing this article, the details of the proposal were not available.

Following the conversion, a mixed-use property that includes residential rentals would result in a decrease of the owner’s percentage of commercial activities, and, as such, would reduce the input tax credits or refunds the owner is entitled to resulting in an additional operational cost. This additional GST/HST and QST cost has to be taken into consideration in the property owner’s financial model. This is the case if the ownership of the residential portion of the property remains under the same ownership as the commercial rental portion.

Other Considerations

Ultimately, the choice between converting to condominium units or rental apartments depends on a property owner’s financial goals, risk tolerance, and the specific market conditions of the location in question. Both options have their advantages and disadvantages, and it is crucial to conduct a thorough analysis well in advance of moving forward with a project.

A comprehensive financing strategy and a technical analysis of tax considerations is essential for a successful transition from commercial to residential properties. Property owners should collaborate with financial advisors, tax professionals, lenders and real estate professionals to create a robust financial plan that supports the objectives of the conversion project. As the landscape of real estate continues to evolve in response to changing work dynamics and housing needs, careful planning remains a cornerstone of navigating these transformative shifts.