What is Principal Residence Exemption and How Does it Work?

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 you claim an exemption on the capital gain tax from the sale of your principal residence.

Definition of Principal Residence

Generally speaking, a principal residence is the property that was “ordinarily inhabited” by the taxpayer in a given tax year. The definition of principal residence can include:

• A house
• An apartment unit or condominium
• A cottage
• A mobile home
• A trailer
• A houseboat

A taxpayer and their spouse can usually only designate one property as a principal residence in a given year as long as they actually lived in the property in question. One principal residence can be designated, ensuring it qualifies as the principal residence of an individual. For further assistance, get in touch with the civil litigation Toronto firm.

Necessary Conditions to Qualify as a Principal Residence

To qualify for the principal residence exemption (PRE), the homeowner must ensure that the property is registered as their principal residence with the local municipal office. Documentation that may be required includes identification showing the homeowner’s address, utility bills, and other proofs of residence.

Importantly, the homeowner must file a Principal Residence Exemption Affidavit with their local assessor’s office, typically by a specific deadline each year to maintain the exemption. This exemption applies to various types of properties, as long as the designation of a property as the principal residence is clear.

Benefits of Principal Residence Exemption

Tax Benefits Associated with PRE

The Principal Residence Exemption provides significant tax relief by exempting a portion of the home’s value from local school operating taxes. This can lead to substantial reductions in annual property taxes, as the exempted value directly reduces the taxable base of the home. For instance, if a home is valued at $200,000 and qualifies for a 50% exemption, only $100,000 of the home’s value is subject to taxation.

How PRE Can Affect Your Annual Property Tax Obligations

By reducing the taxable value of the property, PRE directly lowers the amount of property tax owed by the homeowner each year. This can result in significant savings annually, depending on the home’s value and the local tax rates. These savings can make homeownership more affordable and free up income for other household expenses or investments. For many homeowners, PRE makes it feasible to own a home in areas with otherwise prohibitively high property taxes.

How to Calculate the Principal Residence Exemption?

A taxpayer can’t 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.

From 2017 to 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 the principal residence exemption of $300,000?

In such cases, the ITA provides a formula for calculating the principal residence exemption 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 principal residence exemption 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.

To avoid immediate tax consequences, 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 property is disposed of or the election is rescinded. This is particularly relevant when dealing with residential property flipping and residential property use changes.

Conclusion

Many taxpayer residents in Canada rely on the principal residence exemption only to receive an assessment from the Canada Revenue Agency (CRA) telling them they owe significant sums for capital gains tax. A tax lawyer can help determine if you qualify for an exemption and help plan to minimize the taxes you have to pay. This planning is crucial to ensure the sale of your principal residence results in the least possible tax burden. Contact Cowan & Carter, a civil litigation firm in Toronto for further advice and litigation services.

FAQs About Principal Residence Exemption (PRE)

Can I claim PRE for a rental property?

No, PRE only applies to your principal residence, where you primarily live. If you rent out any part of your property, you can only use the principal residence exemption on the portion that is your primary residence, not the rented sections.

Do I need to reapply for PRE every year?

Typically, once PRE is granted, it remains in effect as long as you continue to meet the eligibility criteria. However, if there is a change in ownership or the use of the property (e.g., part of it is rented out), you must update your PRE status.

Can multiple owners of a single property each claim PRE?

PRE is usually limited to the portion of the property that is owned and occupied by the claimant as their principal residence. If multiple owners live on the property and use it as their principal residence, each may be eligible for a portion of the exemption.

What happens if I move out of my principal residence?

If you move out and the property is no longer your principal residence, you must notify the local assessor to adjust or remove the PRE. Failure to do so can lead to back taxes and penalties.

Is there a deadline to apply for PRE?

Yes, there is a specific deadline each year, typically around May 1st in many jurisdictions. Applications must be submitted by this date for the exemption to apply for that tax year. Ensuring the principal residence must meet all criteria for the income tax return is essential.

By understanding the rules and regulations surrounding the sale of a principal residence, taxpayers can effectively manage their tax purposes and maximize their tax credit. Properly designating the property as a principal residence and understanding how business income can affect the principal residence exemption are crucial steps in managing one’s finances efficiently.

Published on December 1, 2021