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.
