Principal residence exemption and Capital Gains Tax

Contrary to the popularly held belief that any capital gain – or increase in value – made on a primary residence is not taxable, in Canada it is! However, there is a stipulation in the Canadian Income Tax Act know as the: ”Principal residence exemption” which allows taxpayers to pay a reduced rate on the capital gains accrued.

Specific properties that qualify for principal residence exemptions including the obvious which include: Standard houses, dethatched and also semi detached houses, to the less obvious structures such as: Condominiums, cottages, mobile-homes and house-boats. The criteria attached here is that the structures are one-half a hectare (1.2 acres) or smaller and they must be ordinarily inhabited. Furthermore, no capital gain is taxable on a principal residence if such a residence has been your principal residence for the whole time that you owned it.

In explanation: The term ordinarily inhabited is defined loosely in accordance with each individual case. The catch here for taxpayers is that according to the Canada Revenue Agency (CRA) the property is ordinarily inhabited even if a homeowner stays only a relatively short period in the given residence. So even if you sold a property early in the year, or bought a property late in the year – the principal residence exemption will still come into effect, granted the property meets the criteria to qualify it as ordinarily inhabited. In addition to this, holiday homes would also qualify as ordinarily inhabited if used during vacations as long as the primary purpose of owning such a property is not commercial.

You can still earn some incidental income and qualify for the principal residence exemption, although vacating your home with the successful intention of bringing in a tenant will disqualify the residential status as ordinarily inhabited. In the event of such a conversion of inhabitant status the CRA recognizes that a transaction has taken place, however, it is such considered that the property has been sold and reacquired at the same price for which it was sold for. In this light you can avoid any income tax on the increase in value of such a property. You could also defer the payment of such capital gains tax to a later year. The only way property can still qualify as a principal residence and for the principal residence exemption even if the grounds for the property being ordinarily inhabited are not met is if a special election is sought. This, fortunately enough, makes it less expensive for Canadian residents who need to relocate for purposes such as work and return to their primary residence at a later stage, as such a property can qualify for principal residence exemption for four years, in this case.

When it comes to the size of a property, as mentioned earlier, in order for a property to qualify for the exemption it must not exceed half a hectare. However, there is an exception here – if the property owner can prove that the portion of the property that exceeds the half hectare contributes to the ”use and enjoyment” of the property or residence then the exemption may still be granted. Such examples include: A long driveway that joins the road which exceeds half a hectare. In cases where local municipal laws stipulate minimum lot size or do not allow severance (the authorized separation of a piece of land) of the lot – the excess plot of land will still qualify for this exemption. If there is no land in excess of half a hectare and severance is acquired – both lots will still qualify.

Prior to 1981 each individual Canadian tax payers could stipulate one property as a principal residence. So if a taxpayer and their spouse owned a house and cottage, respectively, they could designate both properties individually and both properties could qualify for principal residence exemption. However, since 1981 you can only stipulate one property as your principal residence per family unit in Canada. However, there is a bonus year built into the principal residence exemption which allows you to cover a portion of a secondary residence capital gain in view of a future sale whilst still covering your principle residence´s capital gain completely. The equation looks as follows:

(Number of year’s principal residence +1) X Capital Gain

Number of years home is owned

The bonus year in this equation further stipulates that if you move, both your old and new residence will be your principal residence for the year of the move although only one of them can be stipulated as a principal residence in this year.

Bear in mind – you only have to decide which your principal residence is during the year that you sell one of your properties. Furthermore, you can decide for how long you want to elect a residence as a principal residence. This allows you to evaluate your options properly. Say for example you have a cottage and a house and you have owned the cottage for 10 years and you sell one of them at a profit you need to decide whether to designate the sold property as your principal residence and for how long. This determination should depend on which property has the most significant capital gain – as you cannot stipulate both properties as a primary residence for these 10 years (in this example). So if the cottage has a greater capital gain – it should be designated as the principal residence, and if the house has one – then the house, in this example, should be designated as your principal residence.

So in summary, for these and other reasons the correct application of the principle residence exemption can drastically reduce or even eradicate capital gains tax paid by property owners in Canada. Knowing how to apply it is the secret.