The principal residence exemption

As many of you have undoubtedly heard, the owing of a personal residence is one of the best ways, to build wealth since the gains realized are tax free. Many people in fact buy and/or build many principal residences over their lifetimes, taking even more advantage of this opportunity in our tax laws in Canada. It is worthwhile keeping in mind, that most other countries either tax the gains on principal residences upon eventual sale or limit the amounts that are exempt, like the USA. The downside of this erstwhile biggest tax break in one’s lifetime, is that it is easy to make the wrong decision and other mistakes and is an area that has come under intense scrutiny by CRA in recent years.

Since 2016, a taxpayer must make a declaration of principal residence exemption on the annual tax return in the year the property is sold (Form T2091). Failing this, the exempt status of the sale could be challenged by CRA. Prior to 2016, no designation had to be made on sale if the entire gain was exempt. It was assumed that the designation for that property was for all years owned.

There are two main questions that must be answered when:

1. Is the property a principal residence? Has to be a property that can be normally habitable such as:
Family Home, Cottage, Ski Chalet, Farm, Florida Condo, Canadian or foreign property (not limited to Canadian real estate)

Four Aspects to Qualify:
1. Nature of Property
• Housing Unit – house, apartment, mobile home, trailer, etc.
• Leasehold interest in housing unit
• Shares in Co-Op Housing Corporation

2. Size Limit
• Normally limited to ½ hectare.
• Excess allowed only if necessary for use and enjoyment of the housing unit (somewhat subjective)

3. Ordinarily Inhabited
• Occupied even for a short period of time in a year (seasonal).
• Can be occupied by
– taxpayer
– spouse – common-law partner
– former spouse or common-law partner
– child {Note: Does not include parents, grandparents or grandchildren, and siblings}
• A property under construction cannot be considered occupied in that year.

4. Designation
• Principal residence must be designated.
• CRA’s old position was that no designation is required where gain would be totally exempt.
• Otherwise, form T2091 should be filed.
• But for 2016 on, all principal residence claims must be designated on form T2091
• Pre-1982 – each spouse could claim principal residence (as long as each residence was separately owned)
• Still applies for years owned before 1982.

2. If making the exemption and you own different properties, which one will you designate and for what years?
• To maximize the absolute exemption, one can elect the property with the most gain in an individual year, not necessarily the one with the biggest gain or with highest value.
• The key data elements that one must be able to document in situations where you designating different properties is that you must document the cost of the property or the FMV of the property in situations that you were given or inherited a property.
• Cost is not always as straight forward as one would think. You will have to consider the following, where applicable:
– For Pre 1972 properties, cost is the FMV at Dec 31, 1971
– For properties gifted or inherited, cost will be FMV on date received. An appraisal may be required.
– Capital improvements over the years can be added to the cost base of the property. Good idea to keep receipts and cancelled cheques to substantiate.
– Things like land transfer tax, legal fees and real estate fees if paid by purchasers can be added to cost base of the property.
– If you were lucky enough to claim and file the capital gains exemption for the $100k available up to 1994, it can be added to the cost base of the property.
• The essential method to be used to calculate the gain/exemption is as follows:

Exempt Portion of Gain =
1* + # of years as principal residence
____________________________________
** # of years owned

* for sales after October 2, 2016, the “1 +” only available if resident at some time in year property acquired.
** and resident in Canada at some time in year.

There are of course other issues to keep in mind that can result in unexpected issues. For those engaged in serial flipping of real estate, the CRA would generally deem that an adventure in the nature of trade, and therefore regular business income, not a capital gain. If you fall into these categories, you will get much more intense CRA scrutiny and be looked at differently:

• Builders / habitual renovators
• Real estate agents who move often
• Flippers / shadow flippers
• Buy, demolish, renovate, and sell

For those selling principal residences on a regular basis, in addition to possibly being caught by the above noted trap, for years beginning 2023, selling within one year can deem the gain to business income unless the sale is precipitate by a “life event”. What’s worse, if you lose money, you will not be entitled to a business loss, and deduct against other income.

There are other things that can put the principal residence exemption at risk, such as claiming CCA on the property for tax purposes where partially rented, or when the property undergoes a change in use. Generally speaking, as long as more that 50% of the property is used as a principal residence, the full exemption is still available. Where it falls below 50%, then only a pro-rated exemption may be available.
Where there is an employment related transfer, one can avail one’s self to 3-year exemption on the original principal residence as long a new principal residence is acquired in that period and other conditions are met.
For those engaged in assignment of condo or property transactions, you should be aware that developers are required to report the transaction to CRA (for the last 5 years) and any gains will have to be reported as business income.

In summary the following are the most common “Principal Residence Exemption” errors:
Adopting the wrong principal residence strategy by not designating or designating wrong property.
Issues concerning vacant land or house being constructed, not ordinarily inhabited in the year.
Consideration of excess land.

Adventure in the nature of trade, flips, real estate business not a principal residence.
Not making no change of use election.

Ignoring the additional three-year exemption on no change of use.

Not knowing cost of residence, or failing to include acquisition costs.

Failure to consider possible claim for foreign residence.

Failing to recall use of $100,000 capital gains exemption election in 1994
Ignoring capital expenditures or incorrectly capitalizing interest and/or property tax.

With 2 properties, not doing full evaluation to determine designation strategy.
Counting years where person is non-resident.

Using 1 + rule where property purchased by non resident.

Failing to consider designations of other properties in period of ownership

As mentioned earlier, what at first glance would seem to be a fairly straight forward exemption, is fraught with a lot of potential pitfalls if not adequately planned for ahead of time.

Sérgio Ruivo