What is the principal residence exemption?
The principal residence exemption is an Income Tax Act provision that reduces or eliminates taxable capital gains that would otherwise be realized on the disposition of your primary home. “Home” can mean a house, an apartment, a cottage, a houseboat, a trailer or a mobile home. You must own it, it usually must be on half a hectare (1¼ acre) or less of land and it must be used only as your residence.
How does a property qualify?
In addition to matching the description above, the residence must be occupied (the Canada Revenue Agency’s term is “ordinarily inhabited”) by someone in your family unit during the year – either you, your spouse or former spouse, or any of your children.
“Ordinarily inhabited” may mean living in the home for only a relatively short time. That means a seasonal home such as a cottage or cabin could qualify. But the home will not qualify as your primary residence if the main reason for owning it is to earn income – if you rent out your cottage or your city condo and your family stays there only occasionally, for example.
If you use a portion of the property for purposes other than your primary residence, capital gains on that portion are taxable.
Calculating the exemption amount
The designation of the property as your principal residence is made on your tax return in the year you dispose of the property, but you calculate the exemption based on the property’s use year by year using a formula: number of years as principal residence + 1, multiplied by capital gain, divided by number of years owned.
You can designate only one property as your principal residence in any given year, though it does not have to be the same property each year. Your spouse and minor children cannot have designated another property as their primary residence at the same time.
In considering the land the property sits on, if it is more than half a hectare and that extra land is not considered essential for the property to qualify as a home, the value of the extra land will be excluded from the exemption; that is, you will most likely have to pay capital gains tax on it.
Owning multiple properties
If you own more than one home, or a home and a vacation property, it can be challenging to designate your principal residence because that designation is made only when you dispose of the property, which could be many years after you change your use of your properties – for example, start spending more time at one home than another, or start renting out your summer cottage. Deciding which property to designate as your primary residence each year can affect the exemption you can claim. Usually, it makes most sense to designate the property that has increased in value the most per year, but not always, so go over the various scenarios with your accountant.
If you and your spouse owned more than one property before 1982, it may be possible for you to claim the exemption for two properties in the same year for years before 1982. If you and your spouse owned more than one property before 1994, you may have elected on your 1994 tax return to bump up the tax cost of one of the properties by up to $100,000 to use up your general capital gains exemption.
New in 2016
If your property was your principal residence for every year you owned it you won’t owe any tax on it. However, you now have to report the sale anyway, including the year purchased, sale proceeds and a description of the property, and you must elect to designate the property as your principal residence for all years owned.
If you have owned the property for only a very short time, the CRA might view its sale as “flipping” the property for income as opposed to a capital gain and thus deny the principal residence exemption. Also note that if you do not achieve a capital gain on the sale of your primary residence, but instead lose money, the loss has no tax effect – you have no exemption to claim.
If you change the way you use your property – for example, begin renting it out, or take up residence in a property you previously rented out – special provisions apply. If you start renting out a home where you had lived, the change will be treated as if you had sold the property at market value and then immediately repurchased it for the same price. You will be able to claim the exemption on the sale, but any further gain from that point on will be taxable. There is a tax election that can defer the capital gains tax; work with your accountant to determine whether it can apply in your situation. The consequences are similar if you start living in a property you had previously rented out.
Special considerations apply in cases of marital/relationship breakdown and if the property you wish to designate as your principal residence is outside Canada. In these cases, professional tax and accounting advice is essential. Also consult tax and legal advisors if you are considering having a trust that owns family property claim the principal residence exemption.