The sale of a principal residence is one of the rare situations in our lifetimes where we can realize substantial profits on a tax-free basis. The principal residence exemption is available on the sale of a property that is owned by you. Properties that are jointly owned with another individual qualify as well. Properties that qualify include a house, cottage, condominium, apartment, trailer, mobile home or houseboat.
The property must be ordinarily inhabited in the year by the taxpayer or by their spouse or common-law partner, former spouse or common-law partner, or child. The term ordinarily inhabited is not defined in the Income Tax Act and needs to be assessed on the basis of the facts. Generally, any property that is used personally by the taxpayer or the family members listed above during a year will qualify for the principal residence exemption. Properties that are primarily used to generate income from a business or rental activity will not qualify unless certain elections discussed below have been filed in respect of the year.
The principal residence exemption reduces or eliminates the capital gain recognized on the sale of the property. The capital gain is calculated as the proceeds of disposition less costs to sell (commissions and legal fees most commonly) and the adjusted cost base. The adjusted cost base includes the original purchase price as well as any capital improvements during the period of ownership. Capital gains were not taxable in Canada prior to 1972. If you purchased the property prior to 1972, your acquisition date of the property will be deemed to be December 31, 1971 and the fair market value of the property as of this date will be deemed to be your original purchase price.
Since 1982 a taxpayer and their family unit can only designate one property as their principal residence for a year. The family unit includes their spouse or common-law partner and minor children. Two properties could be designated as a principal residence by a family unit prior to December 31, 1981 depending on the ownership.
In the year of sale, you are required to report the disposition on your income tax return and designate which years the principal residence exemption will apply. There is a “plus 1” rule in the Income Tax Act that allows you to designate a property as your principal residence for one additional year over the total number of years owned to account for situations where you sold a property and purchased a new property in the same year.
If you own multiple properties that are eligible to designate as a principal residence and dispose of one during the year, it is important to assess the unrealized capital gain on the other property prior to filing your income tax return. It may be advisable to forgot some or all of the principal residence exemption on the property sold in the current year in order to increase your tax savings on a future sale. Other considerations such as cash flow, the time value of money and expected income tax rates need to be taken account in this analysis as well.
Special rules apply to land. If you originally purchased land and constructed a residence, the principal residence exemption can not be claimed for the years during construction prior to the property being ordinarily inhabited. As a result, there may be a taxable capital gain in the year of sale even if another property has not been designated as a principal residence during any of the years of ownership. The land must also contribute to the use and enjoyment of the housing unit as a residence in order to qualify as part of the principal residence. It is commonly accepted that land of less than half a hectare will qualify. If land exceeds half a hectare, the taxpayer must support that the excess land is necessary for the use and enjoyment of the residence. This is assessed on a case-by-case basis. Common examples are an inability to subdivide the land due to laws or regulations, or if excess land is needed to provide access to public roads.
If you convert a personal-use property to an income-producing property or vice versa, you are deemed to dispose of the property at fair market value at that time and repurchase the property for the same amount. There may be a capital gain on this deemed disposition. There are elections available under subsections 45(2) and 45(3) of the Income Tax Act that allow you to treat the property as your principal residence for up to four additional years before or after the change in use occurs.
The effect of these elections is to defer the gain to a future year. The taxpayer must be a resident of Canada during the four-year period and Capital Cost Allowance can not be claimed against any income earned from the property in order for both elections to apply.
The principal residence exemption can be one of the most beneficial rules within the Income Tax Act.
For more information, please contact firstname.lastname@example.org or 1 844-GYTD-CPA