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The Principal Residence Exemption

Grigoras Law — Mon, 10 Apr 2023 18:10:43 +0000

Overview

The term “principal residence” refers to a taxpayer’s primary dwelling or housing unit for a specific tax year. The taxpayer, their spouse, common-law partner, former spouse, or child must ordinarily inhabit the residence. A personal trust can also claim a principal residence if it is regularly occupied by a specified beneficiary or their immediate family. Importantly, a taxpayer can only designate one property as their principal residence for a given tax year.

Gains from selling a principal residence are exempt from taxation under the Income Tax Act. This exemption can also apply to seasonal dwellings if they are primarily owned for personal use rather than income generation. However, corporations and most trusts are not eligible for the principal residence exemption.

Income-Generating Properties

The Canadian Revenue Agency (“CRA”) requires income tax reporting for principal residence sales to prevent abuse of the exemption. Properties that are mainly used for generating income, such as rental properties, are not eligible for the exemption. Additionally, if a taxpayer is considered a “house flipper,” their property sales are taxed as business profit rather than capital gain, which means they cannot use the principal residence exemption.

The Principal Residence Exemption

Section 40(2)(b) of the Income Tax Act outlines the conditions under which individuals can exempt gains from the disposition of a principal residence. The exemption amount is calculated using a specific formula that takes into account the number of years the property was designated as the principal residence and the number of years the property was owned. If the property was a principal residence for the entire ownership period, the entire gain is exempt. However, non-residents are not eligible for the exemption.

Transitional Rule

Before 1982, married couples were allowed to designate two principal residences, but after 1982, only one residence is allowed per family unit. To calculate the total gain allowable, taxpayers must consider both pre- and post-1982 gains on each property. For families with multiple principal residences before 1982, the gains accrued up to 1982 are exempt, but only the gains on the designated principal residence after 1982 are exempt.

Transfer Between Spouses or Common-Law Partners

Transferring a principal residence between spouses or common-law partners can be done without tax consequences if both parties are residents of Canada. The transferee inherits the principal residence designation, and the transfer occurs at the transferor’s adjusted cost base. However, expert tax advice should be sought before making any decisions.

Transfer in Year of Separation

In the year of separation, spouses or common-law partners are still considered a family unit and can only designate one principal residence between them. In subsequent years, they become separate family units and can designate different principal residences. It is crucial to include an indemnity clause in the separation agreement to avoid tax issues.

More Than One Principal Residence

When multiple properties qualify as a principal residence, taxpayers must decide which property to designate to maximize tax savings. This decision is especially important during separation when spouses or common-law partners no longer share common interests.

Provincial Legislation

It is essential to distinguish between the term “principal residence” under the Income Tax Act and terms used in provincial legislation, such as “family property,” “family home,” “marital home,” or “matrimonial home.” Provincial laws have their own definitions and rules regarding property rights upon separation, which may differ from the Income Tax Act‘s provisions.

Change in Use of Principal Residence

When a residence is rented or used for business purposes, it is considered income-producing property. In such cases, the taxpayer is deemed to have disposed of the property at its fair market value and re-acquired it at the same value. Any gain for taxation purposes may be eliminated or reduced by the principal residence exemption, which allows homeowners to minimize or avoid paying taxes on capital gains when selling their primary residence. The exemption works by allowing homeowners to exclude a portion of the gain realized from the sale of their home, provided they meet certain conditions.

To qualify for the principal residence exemption, the homeowner must have owned and used the property as their primary residence for at least two out of the five years preceding the sale. Additionally, the homeowner must not have claimed the exemption on another property within the last two years.

It’s essential to understand that the exemption does not apply to the entire gain but rather a portion of it, determined by the number of years the property was used as the homeowner’s primary residence. The formula for calculating the exempt portion is as follows:

Exempt Portion = (Years as Principal Residence + 1) / Total Years of Ownership

By adding one year to the numerator, the formula effectively provides a grace period for homeowners who may have moved out of their principal residence before selling it. This additional year helps ensure that a homeowner can still take advantage of the exemption even if they don’t meet the strict two-out-of-five-years rule.

For example, let’s say you purchased a home in 2015 and used it as your principal residence for five years. You then moved out in 2020, rented it out for two years, and sold it in 2022. In this case, the exempt portion of the gain would be calculated as follows:

Exempt Portion = (5 years + 1) / 7 years = 6/7 or approximately 85.7%

As a result, 85.7% of the gain realized from the sale would be exempt from taxation.

Keep in mind that the principal residence exemption only applies to the sale of your primary residence and not to any other real estate investments, such as rental properties or vacation homes. In addition, there are other factors and conditions to consider, like home improvements and extended absences, which can impact the exemption.

Conclusion

In conclusion, understanding the principal residence exemption can help homeowners minimize or avoid capital gains taxes when selling their primary residence. Always consult with a tax professional to ensure you are accurately reporting your gains and taking advantage of any exemptions for which you may be eligible. By staying informed and working with experts, you can navigate the complexities of the tax system and make the most of your investment in real estate.

Considering selling your home or have questions about the principal residence exemption? Unsure about how multiple properties or recent separations might affect your tax liability? Let us help guide you through the complexities of the Income Tax Act.

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The GST/HST Section 167 Election in Asset Purchase Deals

Grigoras Law — Fri, 06 Jan 2023 17:18:28 +0000

The GST/HST Section 167 Election is a clause that can be used in an asset purchase agreement to address the tax implications of purchasing a business. It grants the parties the ability to make a joint election for an exemption from the Goods and Services Tax/Harmonized Sales Tax (GST/HST) on the purchase of all or substantially all of a company’s assets, provided that certain conditions are satisfied. Because it exempts the purchaser from having to pay GST/HST on the transaction, this clause can be very helpful in lightening the tax burden on the purchaser.

If the GST/HST Section 167 Election is not filed in the correct manner, however, it has the potential to generate liability for both the vendor and the purchaser. This is an important factor to keep in mind. Canada Revenue Agency (CRA) will conduct thorough audits to determine whether or not the election is available. If it is discovered that the election is not applicable, the vendor will be subject to an assessment for failing to collect GST/HST, and they may also be subject to interest and penalties. As a result of this, it is essential for the buyer to conduct further due diligence in order to verify that the election is available, and it is essential for the seller to incorporate an indemnification clause into the asset purchase agreement.

The following requirements need to be satisfied in order to be eligible to make the GST/HST Section 167 Election:

(i) The purchaser needs to be a GST/HST registrant if the vendor is a GST/HST registrant;

(ii) The vendor must be supplying a business or part of a business;

(iii) The vendor must have established, carried on, or acquired the business or part of a business;

(iv) The purchaser must be acquiring all or substantially all of the property that is reasonably necessary for them to carry on the business or part of a business; and

(v) The vendor and purchaser must file a joint election in the prescribed form.

It is important to note that the definition of “part of a business” is pivotal in situations in which the buyer is obtaining assets from a number of different sellers or businesses. In this scenario, it is essential to give careful consideration to the question of whether or not the assets that are going to be acquired constitute a “functionally and physically discrete operating unit” or whether or not they are “organized as a separate activity that is capable of operating on its own.”

Within the context of the GST/HST Section 167 Election, the expression “all or substantially all” refers to the percentage of a company’s assets that are being acquired through the transaction. This often refers to 90% or more of the company, but in certain circumstances, the courts have decided that a lesser threshold of 80% to 85% is adequate. It is worth stating that this threshold of 90% does not cover assets that are not required for the operation of the firm, such as accounts receivable.

If, on the other hand, the buyer is only getting a minority stake in the company (less than 90%), it is probably a good idea for them to take additional steps, such as getting a legal opinion, to make sure that all of the conditions of the Section 167 Election are satisfied. For instance, if the buyer is just purchasing the inventory, machinery, and production equipment as well as the goodwill, but they are leasing the actual property, the Section 167 Election is likely to be an option for them. On the other hand, if the buyer is solely interested in the inventory or the machinery, then the transaction does not comprise “all or substantially all” of the business.

The Canada Revenue Agency (CRA) employs a stringent methodology when considering whether or not the property being purchased from the seller enables the purchaser to carry in the same type of work as the vendor. The CRA does not take into account the property that the buyer already possesses while making this assessment; therefore, it is possible that they will have a problem with a transaction in which the buyer receives all of the vendor’s property other than the real estate. In these types of scenarios, satisfying the “all or substantially all” requirement may require the buyer to enter into a lease agreement with the seller of the real estate in order to access the property.

Other twists to be mindful of include the nature of the underlying transaction, which may lead to GST/HST applying regardless of whether the Section 167 Election is filed. Likewise, if the Section 167 Election is used in a situation where it’s inapplicable or invalid, the vendor may be reassessed for failing to collect the applicable taxes.

In conclusion, the GST/HST Section 167 Election is a useful instrument for lessening the tax burden on the purchaser in an asset purchase agreement. However, in order to avoid liability, it is essential to carefully analyze the eligibility requirements and to file the election in the correct manner. When navigating the complexity of GST/HST in an acquisition of a business, it is always a good idea to seek the guidance of a tax professional as well as a business lawyer.

Ensure your asset purchase agreement leverages the GST/HST Section 167 Election to minimize tax liabilities. Retain a business lawyer to navigate these complexities and secure your tax benefits.

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Spousal Liability for Tax Arrears: A Guide to Section 160 of the ITA

Grigoras Law — Fri, 06 Jan 2023 06:26:04 +0000

Have you ever given any thought to the possibility of transferring some of your property to your spouse or common-law partner? If you owe tax debt, it is imperative that you are familiar with the rules that are outlined in Section 160 of the Income Tax Act, R.S.C. 1985, c. 1 (5th Supp.). (“ITA”). The Canada Revenue Agency (CRA) has the authority under this provision to hold both the transferor and the transferee jointly and severally liable for any unpaid taxes that exist at the time of the property transfer.

This means that if you transfer property to your spouse or common-law partner when you have an outstanding tax obligation, you and your spouse or common-law partner could be held liable for the entire tax debt. Even in the event that the spouse who is in default has initiated the bankruptcy process, the spouse who is not in default may still be susceptible to a claim under Section 160 brought by the CRA. Make sure you know whether your spouse has tax arrears; if so, the tax obligation should be resolved first or, alternatively, accounted for in the computation of the transfer.

If you are looking to make a proposal under the Bankruptcy and Insolvency Act, R.S.C. 1985, c. B-3 (“BIA”), you may try to include a provision that restricts the applicability of the remedial provisions of Sections 95 and 96 of the BIA; alternatively, you as the debtor/transferor may have successfully overcome the threshold requirements in Sections 95 and 96 such that they don’t apply. For example, the period of time in which transfers scrutinized under Sections 95 and 96 of the BIA has lapsed.

As a side note, related to Sections 95 and 96 of the BIA, for many years, the law has recognized the importance of protecting creditors from debtors who are insolvent and try to give away their assets to third parties instead of using those assets to pay off their debts. Legislation prohibiting debtors from fraudulently giving away assets in order to avoid paying debts has existed for centuries. This type of behavior was first made illegal in England during the reign of Queen Elizabeth I in the 1500s and has been prohibited in Ontario’s Fraudulent Conveyances Act since the late 1800s. The principle behind this prohibition was stated in the 1870 case of Freeman v. Pope, in which Lord Hatherley LC said, “[a] debtor must be just before he can be generous – and that debts must be paid before gifts can be made.” Sections 95 and 96 of the BIA codify this “just before generous” rule.

However, a tax debtor’s ability to avoid Sections 95 and 96 of the BIA has no bearing on CRA’s authority to use Section 160 to assess the tax debtor’s spouse. Section 160 is not subject to any limitation period (i.e., see Section 160(2) of the ITA, which states: “the Minister may at any time assess a taxpayer in respect of any amount payable because of this section…,” and Section 16(1)(i) of the Ontario Limitations Act, 2002, S.O. 2002, c. 24, Sched. B, which states that “there is no limitation in respect of a proceeding to recover money owing to the Crown in respect of fines, taxes and penalties.”).

When you are preparing or reviewing a proposal, be sure to include the relevant language in the proposal in order to remove the CRA’s rights of assessment under Section 160. Protect yourself from this danger.

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