Selling your home? Don't get thrown by the principal residence exemption.
Selling your home? If so, you are likely caught up in the usual headaches that come with such a transaction: getting the right selling price, boxing up your possessions and finding a new home to live in. And as a result, you may not be focused on the tax implications that are as much a part of moving as cardboard boxes and packing tape.
We often reassure ourselves that we're covered by the principal residence exemption, which prevents us from having to pay capital gains tax on our homes.
But, the principal residence exemption is not as simple as we like to think. Here`s a summary of some of the more important rules to keep in mind if you want to take advantage of the exemption:
- The home must be ordinarily occupied for personal use by you, your spouse or former spouse, or a child at some time during the year.
- To claim the principal residence exemption on a large lot (over half a hectare – about 1 acre), you must be in a position to establish that the land over half a hectare is necessary for the "use and enjoyment" of your home.
- Restrictions will also apply if part or all of your home is rented out or not used by a family member, or if you have not been resident in Canada throughout the period of ownership.
- As a general rule, a family can claim the principal residence exemption on only one home at a time. So a second home (such as a cottage) is more of a problem: to stop you from trying to claim a separate exemption for another home by putting it in the name of a child, children are restricted from claiming the exemption unless they have reached eighteen in the year or are married.
How it works
Most people think of the principal residence exemption as a black and white matter: either you qualify to sell tax free, or you don't. Actually, this is not the case.
When you sell your home, you must calculate the gain on your residence just like any other capital gain. Then the principal residence exemption itself reduces your gain.
Moreover, eligibility for the exemption is on a year-by-year basis, which might come as a surprise to you. The more years you qualify relative to your total period of ownership, the more your gain gets reduced. To be more precise, the following is the basic formula that normally applies:
As you can see, to get the tax reduction, you must designate the home as principal residence on a year-by-year basis. (If your gain is completely covered by the principal residence exemption, it is not necessary to file the designation form with your tax return.)
The principal residence exemption has also been the focus of various caselaw.
In a 2013 case (Sangha), the principal residence exemption was denied where the house was built with intent to sell it at a profit. The taxpayers lived in the house for a few weeks in an attempt to establish it as a principal residence; however, the house was never furnished and was for sale the entire time.
Another case decided by the Federal Court of Appeal (Cassidy) focused on whether a taxpayer was entitled to the principal residence exemption for a property that was more than half a hectare.
As noted above, in order for any excess land to qualify, it must be necessary for the use and enjoyment of the home. In this case, the home sat on 2.43 hectares of land and was owned by the taxpayer from 1994 to its sale in November 2003.
The taxpayer argued that since he was legally unable to subdivide the land (up until May 2003), the entire 2.43 hectares was necessary for his use and enjoyment since he could not put a home on a smaller piece of land.
In the initial judgment, the Tax Court of Canada agreed with the CRA in denying the principal residence exemption on the basis that the half hectare rule applied only on the date of sale. And since the sale was in November 2003, the restriction on the subdivision was no longer in place.
However, the Federal Court of Appeal rejected that argument and sided with the taxpayer in holding that the principal residence exemption determination is made each year and not just at the time of sale. Therefore the principal residence exemption applied to the entire 2.43 hectares.
Another trap that you may find yourself stumbling into relates to the situation where part or all of the residence becomes non-personal use.
Specifically, where part of the property is rented out, the value of the residence itself must be pro-rated as between personal and non-personal use, and only the personal portion will qualify for the personal residence exemption. But on what basis? The appreciation on a residence is composed of land and building components. In many areas of Canada, most of a gain is attributable to land values rather than building values, especially since buildings tend to depreciate as they get older.
The standard advice is to pro-rate the land gain in the same ratio as building use. But in the right circumstances, you might be able to make an argument that a greater proportion of land is eligible for the personal residence exemption.
Change of use
Easy enough right? Well, here is where the rules get a bit trickier. If the property itself changes from being a home for you or your family to being a rental property (i.e. from personal use to income-producing use), then you will be deemed to have disposed of the property (both land and building) at fair market value and reacquired it immediately thereafter at the same amount.
Any gain otherwise determined on this deemed disposition may be eliminated or reduced by the principal residence exemption.
You are, however, entitled to elect that no change in use is considered to have taken place if you make an election to treat the property as a principal residence. This election can be made by means of a letter to that effect signed by you and filed with the income tax return for the year in which the change in use occurred.
Be aware, however, that if capital cost allowance (CCA) is claimed on the home, the election is considered to be rescinded on the first day of the year in which that claim is made.
If you make this election, the property can qualify as your principal residence for up to four taxation years during which the election remains in force, even if the residence is not ordinarily inhabited during those years by you, your spouse or a child.
However, you must remain a Canadian resident during these years for the full benefit of the principal residence exemption to apply.
This election is advantageous if you move back into the residence since any change from income-producing back to personal use will also result in a second deemed disposition.
If you had made the election that no change in use was to apply to the residence when it first changed from personal use to income-producing use (so that it remained a principal residence), when you move back into the residence at a later date there will be no change of use since the property will have always been deemed to be personal use.
And you can designate four of those years you were away as part of the principal residence exemption to shelter a portion of the gain.
There are ways to get around this four year limitation in certain situations. If you are renting your residence due to the fact that you, or your spouse, are required to move by your employer, none of the years you are away from the residence and renting it will be included in the 4 year limitation period ordinarily imposed by the election (i.e., it can be extended indefinitely). This applies only if the following conditions are met:
(1) you do not ordinarily inhabit the home during the period of the election because your (or your spouse's) employment has been relocated;
(2) the employer is not related to you or your spouse;
(3) the home is at least 40 kilometers farther from the new place of employment than your old place of employment; and
(a) you resume living in the home during the term of your (or your spouse's) employment with that employer;
(b) if your (or your spouse's) employment with that employer is terminated and you resume living in the home before the end of the next taxation year; or
(c) if you (or your spouse) pass away during the term of your (or your spouse's) employment with that employer.
Conversely, if a property which you have being using to earn income becomes your principal residence, there will be a deemed disposition based on the change of use rules.
Again, however, you can defer the recognition of any gain or loss on the deemed disposition arising from the change in use by making the necessary election which operates in the same way as the one discussed above.
Note that this election does not defer the recapture of CCA on the change in use and in fact the election will not be allowed if any CCA has been claimed on the property after 1984 and before the property becomes the principal residence of the taxpayer.
And, to make the story complete, there will also be a deemed disposition if you partially convert your principal residence to an income-producing use, and the partial change is substantial and of a more permanent nature, i.e., where there is a structural change.
The CRA cites certain examples of this occurrence as including the conversion of the front half of a house into a store, a portion of a house into a self-contained apartment (i.e. a duplex, or triplex) or alterations to a house to accommodate separate business premises.
And you would think that if there is going to be a deemed disposition, that the CRA would also give you a break and allow you to make an election as in the case where there's a total change in use. Right? Wrong.
There is no election avail- able where there is a partial change in use. Instead, the CRA has administratively stated that they will not apply the deemed disposition rule (and hence, the property will retain its nature as a principal residence) if all of the following conditions are met:
- the income-producing use is ancillary to the main use of the property as a residence;
- there is no structural change to the property; and
- no CCA is claimed on the property.
Examples of when these conditions can be met include where you carry on a business of caring for children in your home, rent one or more rooms in the home, or you have an office or other work space in the home which is used in connection with your business or employment.
Although you may claim expenses pertaining to that portion of the property used for income-producing purposes, the CRA will jump in to apply the deemed disposition rule if you claim CCA on that portion of the residence.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.