1. Definition of Principal Residence
An exemption can be claimed to shelter a capital gain on the disposition of a principal residence. To qualify for the exemption, the residence must meet the definition of a "principal residence" in the Income Tax Act. A principal residence is defined to include a housing unit, a leasehold interest in a housing unit or a share in a co-operative housing corporation. The housing unit must be ordinary occupied as a residence by the taxpayer, the taxpayer's spouse of former spouse or by a child of the taxpayer. A vacation property that is used seasonally by a taxpayer or the taxpayer's spouse or children will qualify as a principal residence even if it is located outside Canada. However, it is only possible to have one principal residence for each family unit. A family unit consists of a taxpayer, the taxpayer's spouse and unmarried children under age 18. Adult or married children may have their own principal residence. Where there are several properties that could qualify as a principal residence, it is possible to designate a particular residence by filing a designation with Canada Revenue Agency. Usually, a designation need not be filed until the property is actually sold.
2. Principal Residence Exemption Formula
The exemption is based on a mathematical formula. A taxpayer will only qualify for a full exemption if the residence qualified as a principal residence each year that it was owned and the taxpayer was resident in Canada during each of those years. The formula is as follows:
((1 + number of years property was principal residence and taxpayer was resident in Canada)/(Total number of years property was owned after 1971)) X (Capital gain at the time of sale)
The extra year allowed by the formula in the numerator allows for the year in which a residence is sold and another residence is purchased. The most common scenario where a taxpayer might not be entitled to a full exemption is where the property was rented for more than one year while owner lived elsewhere.
3. Change in Use
If taxpayer rents his or her residence while living elsewhere for a period of time, the rental will constitute a change in use which will be considered a disposition of the property for tax purposes. On the change from principal residence to a rental property, any gain triggered by the deemed disposition may be sheltered by the principal residence exemption. The adjusted costs base of the property would increase to the fair market value of the change in use. Any subsequent conversion back to residential use would trigger another disposition for tax purposes which would trigger any gains which had accrued since the last change in use. It is possible to avoid the deemed disposition of the property on a change in use by filing a special election to be deemed not to have made a change in use. The property would then qualify as a principal residence for up to four years following the filing of the election even though it is rented during that time. The four-year limitation can be extended if the taxpayer or his or her spouse is not able to reside in the property because his or her place of employment has been relocated more than 40 kilometers from the property. The taxpayer must subsequently resume occupation of the residence either while employed by such employer or before the end of the taxation year immediately following the taxation year in which the employment ceased.
By filing this election, it is possible to defer the recognition of any gain to a later year and possibly ensure that during all years of ownership the property qualifies as a principal residence. If an individual knows that he or she will re-occupy a residence after renting it for more than a year and there is a potential that the property will increase in value during the period it is rented, it may be wise to file the election. The disadvantage to filing the election is that it precludes the ability to claim capital cost allowance (i.e. depreciation for tax purposes) on the property while it is rented. The tax savings on the potential capital gain must be weighed against the additional taxes paid on the rental income due to the inability to claim capital cost allowance. Since the principal residence exemption is only available for the years during which the taxpayer was resident in Canada, there is no advantage in filing the change of use election if the taxpayer will cease to be a resident of Canada.
4. More Than One Property Qualifies as Principal Residence
The most common scenario where planning is required is the existence of both a vacation property and a residence for year-round occupation. Consider the following fact situation. The taxpayer and his wife own a condominium in Toronto which has appreciated only modestly in value since it was purchased. They also own a cottage in Muskoka which has increased significantly in value since it was purchased in 1975. They are planning to retire to Florida and will be selling the Toronto condominium when they move. Their children live in Barrie and enjoy visiting with them at the cottage during the summers. Therefore, they will probably keep the cottage for several more years. Both properties are held in joint tenancy. There is a modest gain on the Toronto condominium which will be triggered on its sale. They can choose to shelter all or a portion of it by claiming the principal residence exemption. However, since 1981 a family unit is only permitted one exemption, they will be using it up with respect to all the years they have owned it. Those years will then be exposed to a gain in respect of the cottage when it is sold. Should they prepay tax by not claiming the exemption when they sell the condominium and hopefully save more tax in the long run by ensuring that all of the gain on the cottage is sheltered? the risk is that the value of the cottage may drop and their tax savings would shrink. If the gain on the cottage is significantly more than the gain on the condominium, it is probably wise to save the exemption for the cottage.
5. Property Owned Before 1982
Prior to 1982, it was possible for each family member to claim his or her own principal residence exemption. The rule limiting each family unit to one exemption became effective on January 1, 1982. This presents a planning opportunity where spouses own properties which were purchased before 1982. Assume the spouses in our previous example acquired both the condominium and the cottage in 1975. Assume title to the cottage was held by the wife because she inherited it from her parents. Title to the condominium was held by the husband. This would enable them to take advantage of the fact that they each could claim an exemption for years of ownership prior to 1982. Assume further that the gain on the condominium is $500,000 at the date of sale in 2013 and that the property was purchased for $50,000. Its fair market value at the date of sale in 2013 is $550,000. Its value on January 1, 1982 has been established to be $70,000. Their decision is further complicated because the income tax rules offer two alternative methods for calculating the capital gain on properties that were owned prior to 1982.
(a) First Alternative for Calculating Gain on Pre-1982 Property
The first method is to apply the usual formula. This would produce the following results:
(1+7 years [1975 to 1981])/32 years [1981 to 2013] x $500,000 = 8/32 x $500,000 = $125,000 of the capital gain would be exempt.
(b) Second Alternative for Calculating Gain on pre-1982 Property
The second method allows the taxpayer to calculate the gain that has accrued since January 1, 1982. This method required a valuation of the property as of January 1, 1982, which will satisfy Canada Revenue Agency. A professionally prepared valuation by a qualified appraiser would be ideal to substitute a valuation if it were questioned by Canada Revenue Agency. However, a formal appraisal will cost money and few taxpayers like to spend it if they are not certain it will be necessary. If one is able to obtain a record of sale prices of comparable properties in the vicinity of the property being sold, this may be sufficient to establish a reasonable value. If the second method is used to calculate the gain, it would produce the following result:
Proceeds of disposition: $550,000
Less deemed adjusted cost base of $70,000 (the January 1981 value)
Capital Gain subject to tax under the second method $550,000 - $70,000 = $480,000
The first method will exempt $125,000 of the $500,000 gain, subjecting $375,000 of gain to tax. The second method produce a worse result in that only $70,000 of gain will be sheltered, subjecting $480,000 of the gain to tax.
6. Transferring Title From Joint Ownership of Spouses to Sole Ownership of One Spouse
To be able to take advantage of the rules which apply to principal residences owned prior to 1982, title to each of the properties must be held individually by the spouses so that each spouse owns one of the properties. Assume that in the previous example each property was held jointly by the spouses. There is a provision in the Income Tax Act which provides that if a spouse transfers property to the other spouse on a tax-free basis, the transferee spouse will be deemed to have owned the property for the entire period that the transferor spouse owned it, and the property will be deemed to have been the principal residence of the transferee spouse, provided it so qualified while owned by the transferor spouse. The rule will help the spouses in our example because they can simply convey the condominium to one of the spouses just prior to its sale and convey the cottage property to the other spouse. Each spouse is then able to shelter some of the gain on each under the rules related to property owned prior to 1982. However, land transfer tax implications should be considered. With respect to the gains accrued after 1982, a decision will have to be made as to which property should benefit from the exemption. Planning to maximize the principal residence exemption on properties acquired before 1982 can produce results that are in conflict with planning done to minimize probate taxation. One of the common probate planning techniques is to place property owned by a spouse into joint ownership with the other spouse. The probate savings are usually less than the tax savings that can be achieved with the principal residence exemption but some calculations should be done before proceeding to transfer title out of joint ownership.
7. Transfer of Remainder Interest in Principal Residence
Prior to 1994 when subs 43.1(1) of Income Tax Act was enacted, it was possible to transfer a remainder interest in land and effectively transfer future ownership in the land on a tax-deferred basis. While the disposition of the remainder interest was a taxable event, the fair market value was generally low if the individual who acquired the reminder interest was young. This technique would normally be used by parents in favour of their children. Thus, the remainder interest would not fall in for many years giving the remainder interest a low value. It was a technique often employed to pass on the value of a cottage to the next generation on a tax-deferred basis. However, sub 43.1(2) of the Income Tax Act was enacted to prevent this kind of planning by deeming the owner of the property to have disposed of their life interest for proceeds equal to its fair market value and to have reacquired the life estate immediately after at a cost equal to the proceeds of disposition. This resulted in the gain being subject to tax immediately. If the property qualifies as a principal residence, the exemption would shelter the gain from tax. However, when the parents die and the life interest comes to an end, the gain that accrues from the date the remainder interest was created to the date of the parents' death becomes taxable to the individual who holds the remainder interest when he or she subsequently disposes of the property. Because the remaindermen generally do not occupy the property during the years prior to the life tenant's death, the gain that accrues while the life tenants occupy the property is not able to be sheltered by the principal residence exemption of the remaindermen.
In the case DePedrina v. Canada the parents transferred the remainder interest in their home to their two sons and their wives retaining a life interest for themselves. After the second parent died, the sons and their wives sold the property for $1,850,000. They were assessed on the capital gains which were substantial. They appealed the assessment on the basis that it was unfair to tax them on a gain which had accrued when they were not full owners of the property. While the judge was sympathetic, she was constrained by the provisions of sub 43.1(1) and (2). The sons and their wives were entitled to claim an adjusted cost base in the property equal to the appraised value of their remainder interest on the date they acquired it and the adjusted cost base of their parents' life interest. Thus, the gain that accrued since the date the remainder interest created was taxable to them. It is important to be aware of the provisions of s. 43.1 if this type of planning is taken. In DePedrina, one of the sons had built a house on the property and may have been able to claim the principal residence exemption for that portion of the land. However, it is clear from the judgment that the portion of the land occupied by the parents as life tenants was exposed to capital gains tax which could not be sheltered by their principal residence exemption. Had the parents left the property to their sons by a Will, all of the gain would have been sheltered by the parents' principal residence exemption.