What is a principal residence?
With the average price of Canadian homes rising at rates higher than ever, it’s not unusual for homeowners to want to try to reduce taxes owing on any potential taxes that may result from the sale of a property. Luckily for many homeowners, the Canadian Income Tax Act (“ITA”) lets taxpayers claim an exemption on the capital gain tax from the sale of their “principal residence”.
Generally speaking, a principal residence is the property that was “ordinarily inhabited” by the taxpayer by the taxpayer in a given tax year, and can include the following:
- a house;
- an apartment unit or condominium;
- a cottage;
- a mobile home;
- a trailer; or
- a houseboat.
A taxpayer and their spouse can usually only designate one principal residence in a given year so long as they actually lived in the property in question.
How is the principal residence exemption calculated?
Of course, this means that a taxpayer can’t just designate multiple properties as their principal residence during the same period and expect the full tax exemption. For example, suppose a taxpayer had two residences, Property A and Property B, from 2011 to 2019. From 2011 to 2016, this taxpayer lived in and designated Property A as his principal residence. Then from 2017 until 2019, the taxpayer lived in and designated Property B as his principal residence. At the end of 2019, the taxpayer decides to sell Property B for a total capital gain of $300,000. Could the taxpayer claim a principal residence exemption of $300,000?
In such cases, the ITA has a formula when one of those properties is eventually sold to calculate the capital gains owing on a principal residence. The amount by which the taxpayer’s principal residence exemption is determined can be calculated through a formula, simplified for our purposes as follows:
A × (B / C)
The variables in the above formula are:
- A is a taxpayer’s capital gain on the property sold.
- B is, assuming the taxpayer was a resident of Canada at the date of acquisition, the number of tax years for which the property was the taxpayer’s principal residence
- C is the number of tax years for which the taxpayer owned the property
Filling in the numbers from our above example into this equation, the taxpayer’s total principal residence exemption comes out to $100,000 while their capital gain tax owing is now $200,000. In summary, while the taxpayer can still claim an exemption for the years they lived in Property B from 2017 to 2019, they would still owe taxes on the capital gain proportionate to the years that Property B was not a principal residence from 2011 to 2016.
Change of Use of Principal Residence
When a taxpayer changes their principal residence into an income-producing building, they are deemed by the ITA to have sold the property (both land and building) at the fair market value and repurchased it immediately at the same amount. Consequently, there may be capital gain as a result of this deemed disposition.
In such cases, there are two things a taxpayer can do to avoid immediate tax consequences. First, if the property had been the taxpayer’s “principal residence” for the entire period of ownership, the principal residence exemption cancels out the capital gains tax. Alternatively, the taxpayer can file an election under 45(2) wherein the taxpayer would be deemed to have not started using the property to earn income until the taxpayer either disposes of the property or rescinds the election.
There are far too many taxpayers in Canada who rely on the principal residence exemption only to receive an assessment from the Canada Revenue Agency telling them they owe enormous sums of money for capital gains tax. A tax lawyer can help you figure out whether or not you actually qualify for the principal residence exemption and help plan to minimize the amount of taxes you have to pay.
DISCLAIMER: Please note this article is not legal advice. Always consult a lawyer for legal advice regarding your particular situation. The article is not necessarily a complete and accurate picture of the law – it is an article of a general nature.
Published on December 1, 2021