On October 3, 2016, among a series of other measures, the Department of Finance ("Finance") introduced significant changes to the principal residence exemption rules under the Income Tax Act (Canada). The mandate of these changes was specifically to "improve tax fairness by closing loopholes surrounding the capital gains exemption on the sale of a principal residence." The proposed changes to the principal residence exemption rules effectively limit the ability of certain taxpayers to reduce or eliminate the capital gain on the sale of their home.
General overview of the current rules
Prior to discussing the changes to the principal residence exemption rules, it would be useful to summarize the current rules:
- Canadian resident individuals who realize a capital gain on the sale of their home may claim the principal residence exemption to reduce or eliminate the capital gain for tax purposes. To claim the principal residence exemption, the taxpayer (together with their spouse, if applicable) must designate the property as a "principal residence" for each year the property is owned.
- To qualify for the exemption, the property must also be a "capital property" of the taxpayer. Very generally, a taxpayer cannot shelter a gain if they are considered to be in the business of selling real estate properties. Whether a property would qualify as a capital property or not is outside the scope of this commentary.
- Conceptually, "principal residence" of a taxpayer means a property which the taxpayer (or the spouse, common-law partner or child of the taxpayer) has "ordinarily inhabited." The amount of exemption available is determined by a formula that prorates the amount of gain by the number of years in which the property was designated as the taxpayer's principal residence ("principal residence years") compared to the total number of years that the taxpayer owned the property.
- While the rules only allow one property to be designated as a taxpayer's principal residence for a particular tax year, the principal residence exemption rules recognize that a taxpayer can have two residences in the same year – that is, where one residence is sold and another is acquired in the same year. In such cases, the formula simply adds "1" to the principal residence years to treat both properties as a principal residence (commonly referred to as a "special one-plus rule").
- Where specific conditions are met, non-Canadian properties may also qualify for the principal residence exemption.
- It is also possible for a personal trust to claim the principal residence exemption to reduce or eliminate the gain that the trust would otherwise have on the sale of a home. For this purpose, specific conditions must be met, including: a corporation cannot be a beneficiary of the trust and the trust must designate a "specified beneficiary," meaning a beneficiary (or their spouse, common-law partner or child) of the trust who "ordinarily inhabited" the property.
- Finally, a taxpayer's designation of a property as a principal residence for one or more years is required to be made on their income tax return (Form T2091 for individuals or Form 1079 for trusts) for the year in which the taxpayer has sold the property. Where the principal residence exemption eliminates the entire taxable gain on the property for an individual, the Canada Revenue Agency ("CRA") administratively does not require reporting of the sale or the filing of Form T2091.
- Changes to special one-plus rule – Effective October 3, 2016, the special one-plus rule discussed above now only applies where the taxpayer is a resident in Canada during the year in which the taxpayer acquires the property. Accordingly, an individual who was not a resident in Canada in the year the individual acquired a residence will not (on a disposition of property after October 2, 2016) be able to claim the principal residence exemption for that year. This measure has been put in place to ensure that permanent non-residents are not eligible for the principal residence exemption on any part of the gain from the sale of a residence. However, it appears that the proposed rules do not provide any relief to a non-resident taxpayer who acquires a real estate property and then immigrates to Canada in the subsequent year, nor do they appear to penalize a taxpayer who emigrates from Canada while continuing to own a property that was acquired while being a resident of Canada.
- Additional eligibility criteria
for trusts – The proposed rules introduce additional
requirements in order for a property to qualify as a trust's
principal residence for a taxation year that begins after 2016. The
proposed rules limit the principal residence designation to only
being available to the following types of trusts with a beneficiary
who is a Canadian resident and also a "specified
- An alter ego trust, a spousal or common-law partner trust, a joint spousal or common-law partner trust (or a similar trust for the exclusive benefit of the settlor during the settlor's lifetime);
- A testamentary trust that is a qualifying disability trust; or
- A trust for the benefit of a minor child of deceased parents.
In the context of the current rules, it is a common family estate planning strategy to hold real estate properties in a personal trust with a consideration that the principal residence exemption may be claimed on that property in the future. While the personal trusts affected by the proposed rules may still continue to hold such properties, it would be prudent for affected taxpayers (beneficiaries, trustees or settlors) to assess whether the original planning objectives are still being met.
- Limits to the normal reassessment
period and designations – Under the current rules, the
CRA may at any time assess tax paid and other amounts payable by a
taxpayer for a taxation year, but may not assess after the
"normal reassessment period" for the year.
Notwithstanding certain exceptions, the normal reassessment period
for individuals and trusts is generally three years from the date
of the original CRA notice of assessment.
Very generally, the proposed rules clarify that the CRA has the ability to reassess tax beyond the normal reassessment period (unlimited period) if the taxpayer or a partnership does not report a disposition of a real estate property on the appropriate tax return for the year in which the disposition occurs. The scope of the proposed change is much broader as it applies to any unreported disposition of a real estate property (subject to some exceptions) and not just the disposition of a principal residence. However, the reassessment beyond the normal reassessment period under the proposed rules would only be limited to the unreported disposition of a real estate property. If the return is amended to include a previously unreported disposition of a real estate property, then the normal reassessment period for that disposition would begin from the date of the CRA notice of reassessment.
The proposed rules discussed above effectively override the CRA's administrative policy discussed earlier. The proposed rules apply to taxation years ending after October 2, 2016. Accordingly, starting with the 2016 taxation year, vendors who sell their principal residence (including deemed dispositions) on or after January 1, 2016 are now required to report the sale on their income tax return and make an appropriate principal residence designation to claim their principal residence exemption.
- Other compliance nuances – Where the sale of a home has been reported but an appropriate principal residence designation was not made in the taxpayer's tax return, the CRA will be able to accept a late principal residence designation in certain circumstances, subject to a penalty (maximum $8,000). It is unclear at this time whether the principal residence designation will be allowed at all if the taxpayer reports the sale of the principal residence by amending their original return (as opposed to reporting the sale on the initial filing).
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.