Capital Gains and CRA Guide T4037
Capital gains are taxed favorably in Canada. Whenever a taxpayer realizes a capital gain, the gain is split equally (50%) into a taxable portion and a non-taxable portion. In other words, your tax rate (whatever it may be) is only applied to half of the capital gain you realized. Capital gains can be a significant portion of some taxpayers’ income and, if applicable, must be reported on T1 or T2 income tax returns. CRA guide T4037 is a document prepared by the Canada Revenue Agency that explains common capital gains tax situations. One capital gains situation that applies to many Canadian taxpayers is the sale of a principal residence. This article will examine the updated capital gains rules for principal residences including the change in use rules.
The Principal Residence Exemption
The principal residence exemption is a well known and often utilized income tax exemption that exempts a Canadian taxpayer from paying capital gains tax on the disposition of the taxpayer’s principal residence. The exemption can be claimed for any property that the taxpayer or his spouse/children ordinarily inhabit. In other words, the exemption applies to a taxpayer’s primary home but can also apply to a capital property that you own and reside in periodically such as cottages or vacation homes.
Reporting Requirements on Disposition of Real Property
Taxpayers have to report the disposition of their residence, including the proceeds of disposition, the acquisition date, and a description of the property even if the principal residence exemption applied for all years the residence was owned.
Designating a Principal Residence
Taxpayers have to designate their home as a principal residence when they sell or are considered to have sold all or part of it if they want to claim the principal residence exemption. The applicable form is T2091(IND) and will require you to enter amounts found on income tax form Schedule 3 “Capital Gains (or Losses)”. The form has three functions: 1) to designate the property as the principal residence; 2) to claim the principal residence exemption; and 3) to calculate the principal residence exemption amount.
When is a taxpayer considered to have sold all or part of their principal residence?
You can be considered to have sold all or part of your property even if you didn’t actually sell it. In tax law, we refer to this fiction as a “change in use” of the principal residence which has tax implications and also affects a taxpayer’s ability to claim the principal residence exemption. The “change in use” provision is found in s. 45(1) of the Income Tax Act and is a deemed disposition rule. This means the tax act creates a realizable capital gain for tax purposes even if the property wasn’t sold to another person. The gain is triggered by a change in use from income production such as a rental or place of business to some other purpose such as personal use and vice versa. One common example of a change in use of a principal residence is when a taxpayer begins to rent out the basement of their detached home to a tenant.
As you can see, a taxpayer may not realize that their activity is considered a “change in use” under the Income Tax Act which attracts tax consequences through the deemed disposition rule. On the flip side, the Canada Revenue Agency may believe a “change in use” has occurred when it hasn’t and assess a taxpayer for taxes that they do not owe.
Sorting it Out – Contact a Canadian Income Tax Lawyer
Our Canadian income tax lawyers have extensive experience with the principal residence exemption and change in use issues. We have successfully defended taxpayers against CRA tax auditors proposing to increase their taxable income by realizing additional taxable capital gains. Given the increased reporting requirements in place for the sale of a principal residence, the CRA now has more information that it can use to flag taxpayers for tax audit. If you’ve been audited, assessed or need advice with respect to principal residence exemption or change in use issues, contact our expert Canadian Tax Lawyers today.