The implementation of various amendments to the Income Tax Act (Canada)1 on December 14, 2017, saw a marked tightening of the mechanisms that allow a taxpayer to qualify for, and make use of, the principal residence exemption ("PRE"). The PRE provides an exemption from income tax on a taxpayer's capital gain on the sale of their principal residence.2 While Canada remains a country where the sale of one's principal residence is (generally) exempt from capital gains tax, the ability to apply the PRE has become much less intuitive.
The aim of this paper is to provide a short summary of some of the road blocks a taxpayer may encounter, and some potential options to negotiate them.
General Understanding of the PRE rules since 2017
In order to be eligible for the PRE, there are several requirements that must be met; these requirements are in respect of both the property being disposed of and the taxpayer claiming the benefit. In no particular or-der, the following should be considered by any taxpayer wanting to claim the PRE:
- The property must be a "principal residence" as defined in the ITA. The definition includes, among other types of properties: houses (including the adjacent land, up to half a hectare), vacation homes, condominiums, and a share in a co-operative housing corporation;
- As a general rule, only one residence can be claimed by the family unit at a time.3 For the purposes of the PRE, the "family unit" includes the taxpayer, the taxpayer's spouse, and any un-married children under 18;
- The property must be ordinarily inhabited by an individual, their spouse or former spouse, or a child;4
- The property must be a "capital property". Practically, this means that if the property was "flipped" a short time after the purchase, it may not qualify for the PRE;
- A change in Canadian residency status can affect the ability to claim the PRE; and
- Restrictions can apply to any property that was rented out for a part of the ownership time.5The PRE eligibility is considered on a year-to-year basis for each year of ownership. This is reflected in the formula used to calculate PRE, as set out in paragraph 40(2)(b):6
PRE & Non-Resident Individuals
The PRE can be claimed only by an individual who has been a resident in Canada throughout the year(s) that the exemption is being claimed. For a resident, the "plus one" in the above-noted formula corrects for the fact that (usually) an individual will sell one property and purchase a new one in the same year. However, the same leniency is not granted to non-residents. Indeed, with the recent amendment to s. 40(2)(b), there is a removal of the "plus one" in the formula if the person disposing of the property is a non-resident after December 31, 2016. Previously, a person who was a non-resident throughout the entire ownership of the property could have a portion (or even all) of the gain on disposition exempt from tax.
Individuals who are selling a property and who are thinking of emigrating would be prudent to consider their timing so as to maximize the amount of years the PRE is available to them.
When a US Citizen is Involved
Unlike Canada, the United States taxes its citizens (whether residing in the US or not) on their worldwide income. This income includes capital gains on the sale of their principal residence. A Canadian resident who maintains their US citizenship may face taxes in the US on the sale of their principal residence. Indeed, the Internal Revenue Service (IRS) permits only a partial exclusion of the capital gains on the sale of the principal residence: USD$250,000 if the taxpayer files as a single, and USD$500,000 if for a US citizen married couple who file jointly. Any excess amount will be taxed at a rate up to 24%.7
While the exclusion amounts may seem generous, especially with the dramatic rise in real estate prices in cities such as Toronto, Montreal, and Vancouver, this may result in Canadians residents who maintain their US citizenship owing US taxes unexpectedly come filing season (while having no Canadian tax liability in respect of the sale of this home).
There are some ways for US citizens living in Canada to mitigate their potential tax exposure with the sale of their principal residence. If the US citizen is married to a Canadian citizen, the easiest solution is to simply put the property in the name of the non-US citizen from the outset. This solution is ideal for both spouses. On the one hand, the couple is able to avoid US tax upon the sale of the property, as the property in question is strictly the Canadian spouse's property. On the other hand, should the marriage dissolve (either through a breakdown or a death), the US citizen would also be protected: given that they are married, they are afforded statutory property rights by the Family Act,8 meaning that should the marriage dissolve, the US citizen would still be entitled to their portion of the matrimonial home. Evidently, this requires some thoughtfulness at the time of purchase, which, depending on the status of the relationship at the time of purchase, may not always be possible.
There are other options available, such as the gradual gifting of the interest in the property from the US citizen to the non-US citizen within the US gift tax limits; any such planning should be done with US counsel's tax advice and are beyond the scope of this overview.
PRE & Trust Law
With the recent amendments to the ITA, new restrictions on a trust's ability to designate a property as a principal residence were introduced by limiting the type of trust that is eligible as well as the beneficiaries. In order to claim PRE, the trust that holds the property must fit into one of the following categories: 1. Alter ego trust; 2. Spousal or common-law partner trust, joint spousal or common-law partner trust, or certain trusts that are for the exclusive benefit of the settlor's life; 3. A testamentary trust that is a qualified disability trust; or 4. A trust for the benefit of a minor child of de-ceased parents.
In addition to the above-mentioned criteria, the trust must also have a "special beneficiary". A special beneficiary is a beneficiary of the trust that has ordinarily inhabited the property,9 and is a Canadian resident in that particular year.
Creating New Trusts
If the intent is to form a new trust to be settled for the purpose of estate-planning and with the view that it will own a principal residence, the trust will have to fit within one of the above described categories. If the trust does not and/or there is no special beneficiary, the trust will not be able to claim the PRE at the time of sale.
Pre-existing Trusts – moving forward:
There is a high likelihood that trusts that were settled prior to the amendments will not meet the criteria to qualify for the PRE. The slight "silver lining" is that the Minister of Finance has provided transitional rules which enable trusts to claim the PRE up to and including 2016. This is done as a two-step process that splits the ownership of the property into a "pre-2017" period and a "post-2017" period.
For these purposes, the trust is deemed to have "disposed" of the property on December 31, 2016, at fair market value. The capital gain is then calculated for the property at this point in time, and, provided that the trust is eligible under the pre-amendment rules, this amount qualifies for the PRE.
The Minister of Finance's transitional rules then treat the trust as having "re-acquired" the property on January 1, 2017, at a cost equal to the sum for which the trust "disposed" of the property during the "pre-2017 period." Unless the trust meets the criteria outlined above, the PRE will not be available to the trust after such date, and any gain realized after January 1, 2017, will be subject to tax.
The values found in both periods are then added and that is the total taxable gain for the disposition of the property.
A second potential way to reduce the capital gains that must be included at disposition pursuant to the amended rules in the ITA is the allocation of the property to a beneficiary prior to its disposition. Indeed, should the situation arise where a beneficiary of the trust is a Canadian resident who occupies and designates the property as their principal residence post-2017, the PRE can be applied by the Canadian resident.
There are of course limitations to this strategy.
First, should the beneficiary of the trust die prior to the distribution, the trust would lose any ability to access the PRE for the post-2017 years. This strategy would also not be applicable if the beneficiary in question did not comply with the other parameters of the PRE rules (i.e. he or she did not ordinarily inhabit the property). It should also be noted that a valuation on January 1, 2017, would be required and if there was any gain realized in the hands of the trust, this option would also be unavailable to the taxpayer.
It would seem that for trusts that have been settled prior to the amendments, the most prudent course of action is to crystalize the gains up to January 1, 2017, apply the PRE to that amount, and distribute the property out to the beneficiaries.
Concluding Thoughts
The new rules have followed a discernible trend that has seen the federal government tightening the strings on deductions available to taxpayers: the rules are stricter, they provide less flexibility with regards to family and estate planning, and the new rules also enable the CRA to reassess the sale of a principal property beyond the three year mark. While it is unlikely that there will be a complete elimination of the PRE, it is clear that practitioners and home owners alike will have to continue to be vigilant in the planning and disposition of real property in Canada.
Footnotes
1. RSC 1985 (5th Supp.), as amended (the "ITA"). For the purposes of this article, all references to a statute refer to the ITA unless otherwise specified.
2. ITA, section 54 and subsection 40(2).
3. The determination over which property to classify as the "principal residence" may be challenging when the taxpayer owns both a home and a cottage. Samantha Prasad's article "Cottage Life: Selling your Cottage", 2017 The Tax Letter 35:7, provides a more in-depth look at how a taxpayer may make this determination.
4. The term "ordinarily inhabited" is not defined in the ITA, it is considered a question of fact. For example, the Canada Revenue Agency (CRA) describes in its Income Tax Folio S1-F3-C2: Principal Residence that a person who disposes of a property in the same year they acquired it will still be "ordinarily inhabiting it," while a person who purchases a property and keeps it for a longer period of time, but uses it as rental income, will not necessarily ¿t the criteria. It should be noted that an election under the ITA s.45(2) can be made if a property does not meet the "ordinarily inhabited" test in certain circumstances.
5. The rental of the home does not need to be restricted to the entire home; it can apply to part of the home as well. This provides an interesting aspect of the PRE to consider with the rise of households using letting services such as Airbnb to rent out a room or even their entire households for weekends in order to gain additional income.
6. The visualization of this formula is taken from Samantha Prasad and Ryan Chua "Changes to the Principal Residence Exemption: Home Sweet Home?" 2017, Minden Gross Newsletter 1-7.
7. Matthew Getzler "Buyer Beware: The Sale of your Principal Residence May Not be Tax-Free After All" 2016, Minden Gross Newsletter 11 - 3.
8. It should be noted that common-law partners have different statutory rights depending on the province or territory in which they reside. In particular, only British Columbia, Saskatchewan, Northwest Territories, and Nunavut expressly provide that common-law and married couples share in property rights; all other provinces do not provide this protection for common-law couples.
9. The special beneficiary also includes a beneficiary who has had a spouse or common-law partner, former spouse or common-law partner, or child that ordinarily inhabited the property.
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.
