February 24, 2020
Principal Residence Exemption Tax Issues When Selling
One of the largest tax breaks Canadians have is the ability to claim the principal residence exemption (“PRE”) on the sale of their homes. The PRE provides a homeowner with an exemption from tax on the capital gain realized when they sell the property that they have designated as their principal residence.
Does the Principal Residence Exemption Really Apply?
In most situations, individuals buy and sell their personal homes without any consideration of the possible effect income taxes may have on the profit realized on the sale of their home.
For many individuals, a large portion of their personal wealth may be vested in their home, which has a large accrued gain.
If you have recently sold or are considering the sale of your home, you need to assess if the principal residence exemption really applies to exempt the sale of your Principal Residence (“PR”) from income tax.
The answer is not always as straightforward as you might think.
Does the Sale Meet the PRE Requirements?
For most situations, your answer to the following questions will determine whether you meet the technical requirements for claiming the principal residence exemption in Canada.
Have you been a resident in Canada for the entire period that you owned your property?
Is the land you own greater than one-half hectare or 1.2 acres in size?
Do you own another property, such as a vacation or recreational property?
Have you ever rented out a portion of the adjoining land and buildings on the property?
Have you ever used the property in the course of earning income from a business or farming operation?
Do you and your spouse (or common-law partner) own separate properties?
Depending on your answers, the principal residence exemption may, or may not, apply to the tax-free sale of your home. It all depends on your specific situation.
Let’s take a closer look at how the PRE rules apply.
Designation of a Property as Your Principal Residence (“PR”)
For a property to be your PR for a particular year, you must designate it as such for the year and no other property may have been so designated by you for the year. Furthermore, no other property may have been designated as the PR of any member of your family unit for the year. For purposes of the latter rule, which applies for 1982 and subsequent years, a family unit is you, your spouse (or common-law partner) and any children under the age of 18.
For 2016 and later tax years, you can only utilize the principal residence exemption if the sale is reported and a designation of PR is made in your tax return for the year of sale. If the disposition is not reported or you forget to file the designation, the full amount of the capital gain will be taxable.
How is the Principal Residence Exemption Calculated?
The mechanism for sheltering the capital gain realized on the sale of a home from personal income tax is based on a formula provided in the Income Tax Act of Canada. The exempt portion of the capital gain is calculated by using the following formula:
A × (B ÷ C)
The variables in the above formula are as follows:
A is the taxpayer’s capital gain otherwise determined.
If the taxpayer was resident in Canada during the year that includes the acquisition date, 1 + the number of tax years ending after the acquisition date for which the property was the taxpayer’s principal residence and during which he or she was resident in Canada; or
If the taxpayer was not resident in Canada during the year that includes the acquisition date, the number of tax years ending after the acquisition date for which the property was the taxpayer’s principal residence and during which he or she was resident in Canada.
C is the number of tax years ending after the acquisition date during which the taxpayer-owned the property (whether jointly with another person or otherwise).
You Must Ordinarily Live in or Occupy the Home
You are not required to live in or occupy your home for a minimum period of time in order for the property to qualify as your principal residence. Based on commentary from Canada Revenue Agency (“CRA”), a home would be considered your PR if it has been ordinarily inhabited by you and your family at any time during the calendar year.
However, it is important to recognize that CRA may look at other factors and circumstances regarding the use of the property during the period of ownership. These factors will include:
How much time you actually resided in the home.
What are your primary sources of income.
And the history of activity you may have experienced around homeownership with respect to your frequency of buying, living, moving and selling properties.
These factors could taint the status of your home as an eligible PR. If CRA were to consider this activity to be indicative of a plan or business pattern to earn profits from real estate flipping it would not be eligible for the principal residence exemption.
Property is in Excess of One- Half Hectare (or 1.2 Acres)
If your home is situated on property that exceeds one-half hectare, the excess land portion is deemed not to have contributed to the use and enjoyment of your home. In this situation, the excess land will not form part of your eligible principal residence, unless you can establish that this excess land was in fact necessary for the use and enjoyment of the residence.
The excess land cannot simply be a used to meet your desired lifestyle. You must be able to demonstrate that the excess property was necessary for the home to be used properly and functionally as a residence. Generally, the use of excess land to support a particular recreation or lifestyle (such as keeping farm animals or for country living lifestyle) could result in the excess land not being considered necessary for the use and enjoyment of the housing unit as a residence.
Where you do have land in excess of one-half hectare, it may still be considered necessary for the use of the property as a residence where for example;
The size or nature of the home combined with its location on the property make such excess land essential for the functional use and enjoyment of the residence.
Or the excess land is required to allow access to and from public roads to the home.
Additional factors such as a minimum lot size or subdivision/severance restriction may also allow the excess land to be considered necessary for the use of the residence.
Bottom line, to be considered for the principal residence exemption it is a question of fact as to whether any excess land is ultimately necessary for the use and enjoyment of the home as your residence.
If You Own More Than One Property Consider Your Options
Here’s what you need to consider when selling a property. You can claim any property that you own and have ordinarily inhabited as your principal residence. Therefore, you need to consider if you wish to designate a seasonal residence such as a vacation property as your principal residence. Bear in mind that you must meet the occupancy requirement for each year that you want to designate for this secondary property.
Note that a seasonal residence, such as a cottage, cabin, or ski chalet can be considered to be “ordinarily inhabited in the year” even if you only use it during vacation periods “provided that the main reason for owning the property is not to gain or produce income.”
If your family owns more than one property, you need to carefully consider how you should utilize your principal residence designation for each property. A determination needs to be done in order to maximize your available principal residence exemption (today or into the future) and minimize the amount of taxes payable on the sale of your properties.
Principal Residence on Land Used in a Business or Farming Operation
If you sell property and a portion of the land has been used in a business or a farming operation, the gain realized on the business or farm use portion of the land will not generally qualify for the principal residence exemption.
For example, if you purchased a 20-acre farm property and have lived in the farmhouse, there would be no taxes payable on the appreciated value of the farmhouse or on the 1.2 acres of the land as this portion of the property value would be eligible for your principal residence exemption. However, any appreciated value gain realized that is attributable to the excess land portion of 18.8 acres, along with any related business use structures on this portion of the property, would be subject to capital gains tax.
You Cannot Earn Income from the Property
Have you used your property to earn income? If so, you may not be able to exempt the profit from capital gains tax. Under the CRA’s rules, a property cannot be considered a primary residence if its overall aim was to earn an income. For instance, if you purchased a duplex and lived in one side while renting out the other, you cannot shelter the capital gains earned on that rental property portion.
Housing affordability and accessibility to affordable housing is creating heightened interest in the development of detached secondary dwellings for many family units. Coach or carriage houses as secondary separate living spaces are being rented out as mortgage helpers to reduce the overall costs of homeownership. These secondary homes are also being used to allow ageing parents or disabled adult children to remain independent while being close to family, or to provide affordable independent living to adult children who may not be able to purchase their own home at this point in their lives.
The principal residence exemption as noted above is only available to a family for a single housing unit in any year. One needs to be mindful that notwithstanding both homes are located on a single property, which cannot be subdivided, the development of a self-contained secondary housing unit with its own entrance and dedicated separate utility services (electrical, plumbing, and heating systems), may bring into question whether or not there exists ownership of more than one housing unit on the property.
The principal residence exemption is often an after-thought for most Canadians who buy a house, live in it, sell it, and claim the exemption. The incidence of taxation arising on the gain realized is generally not an issue in most situations. However, as outlined above, it can get very complicated to determine your eligibility to claim the exemption and how to effectively use the exemption to minimize income taxes payable on the sale of your residence.
Rick Gendemann has developed an extensive background providing accounting, tax, business advisory, estate and succession planning services for privately-held businesses. His practice focuses on businesses operating in manufacturing and food processing, agriculture, real estate development, wholesale distribution and R & D industry sectors. Rick’s practice also includes a focus on delivering income tax consulting and tax planning services to owner-managed businesses and their shareholders. Contact Rick at +1 604 557 5760 or firstname.lastname@example.org.
The above content is believed to be accurate as of the date of posting. Canadian tax laws are complex and are subject to frequent changes. Professional tax advice should be sought before implementing any tax planning. Manning Elliott LLP cannot accept any liability for the tax consequences that may result from acting based on the information contained herein.