Principal Residence Exemption: Tax-Free Growth Worth Understanding

The Institute for Advanced Financial Education

Edition 306-Nov/Dec 2017

Canadian residents generally enjoy tax-free growth in the capital value of their home through a tax measure referred to as the principal residence exemption. This means that many Canadians can sell their home tax-free, however, there are details to observe and criteria to be met for those who want to benefit from this opportunity.

A principal residence is a housing unit owned by an individual and ordinarily inhabited by that individual or the individual’s spouse, common-law partner, former spouse, former common-law partner, or child. The definition is designed to be very broad, covering a wide variety of types of homes including a house, cottage, condominium, mobile home, trailer, or even a house boat.

Beginning in the 2016 taxation year, individuals must report the disposition of their principal residence and associated claim for principal residence exemption. The formula for the principal residence exemption is: {(1+A)/B} time the gain realized upon disposition where,

  • A is the number of years that the property is designated as the principal residence and the owner was resident in Canada. This would be whole years; for example, 1979 to 2010 would be 32 years of ownership regardless of when in the year the home was bought or sold. The plus 1 is only available if the home owner was resident in Canada at the time of purchase.
  • B is the number of years of ownership

The following is a discussion of key considerations, in very general terms, as they apply to a claim for the principal residence exemption.

What is there is a change-in use?

When there is a complete change-in use of a property (100 percent change), the owner is deemed to have immediately sold the property and immediately reacquired the property. This means the accrued capital gains is triggers when the property ceases to be a principal residence and is changed to a rental property, or when a rental property is changed to become a principal residence.

When use of a property changes from a principal residence to a rental property, the owner could use his or her principal residence exemption to shelter the gain. Alternatively, the individual could elect to defer recognition of the gain to a later year by electing to be deemed not to have made the change in use of the property. This can be achieved by submitting a letter with the individual’s income tax return for the year in which the change occurred. However, any claim for capital cost allowance (CCA) on the property will result in a rescission of the election on the first day of the year in which the CCA claim is made. While this election remains valid, the property could continue to qualify as the individual’s principal residence for up to four years even though the property is not ordinarily inhabited by the taxpayer is a resident of Canada and no other property is designated for a similar claim. This election provides the taxpayer with opportunity to defer the associated income tax liability until the property is eventually disposed of.

Let’s look at an example.

  • Pat and Christ bought their home for $300,000 in 1986.
  • They moved out in 2010 when the home was worth $500,000 and began to rent it to a tenant. This change would be classified as a complete change-in-use of the property.
  • They elected to defer recognition of the deemed gain by filing a letter with the CRA, and chose to not claim CCA on the rental property. Pat and Christ remained resident in Canada.
  • Pat and Christ sold the rental property in 2017 for $750,000, which requires them to recognize a capital gain of $450,000($750,000 proceeds less $300,000 cost).
  • Over the couple’s 32-years of ownership, they can claim 25 years as a principal residence (1986 to 2010), plus they can elect to treat four years of te rental property period as a principal residence.
  • The formula for determining the exemption is (1+29)/32, which results in 93.75% of the $450,000 capital gain being exempt ($421,875).
  • The outcome for Pat and Christ is a tax liability on the remaining $28,125 of capital gain realized in 2017.
  • During the period when Pat and Chris did not reside in the home, they were living in a rental property so did not claim any principal residence exemption in respect of any other property.

A partial change-in-use would occur when a property owner decides to rent out part of the house to an arm’s length individual. Alternatively, a partial change-in-use would occur when an individual no longer rents out a portion of the home and reclaims the space for his or her personal needs. The change-in-use must be substantial, such as building a self-contained dwelling in the basement or converting the front of the home into a business. In such a situation, the change of use rules apply, and the individual will have a partial disposition of that portion of the home that is no longer used for personal use. With a partial change of use, there is no opportunity to make an election to defer the gains as would be available with a complete change in use.

It is the Canada Revenue Agency’s (CRA) administrative practice to not apply the deemed disposition rules where the income producing element is ancillary to the main use of the property, where no structural changes are made to the home and no CCA is claimed on the property. For example, renting out one or two existing bedrooms would generally fit within the CRA’s administrative practice as being ancillary in nature, while building a new self-contained rental unit in the basement would generally not be treated as ancillary.

It is important to note that administrative practices can change and are utilized at the CRA’s discretion.

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