PRINCIPAL RESIDENCE EXEMPTION INCLUDING RENTAL PROPERTY
The principal residence exemption is one of the most widely used tax breaks under the Canadian income tax system. As most readers likely know, the exemption means that in most cases individuals pay no tax on capital gains realized on the sales of their homes. However, there are various conditions that must be met. These are summarized below.
The exemption is available only to Canadian resident individuals. It is not available to corporations or non-residents. However, the exemption can apply to a home owned anywhere in the world and not just in Canada.
The exemption is available only if the home is capital property. If it was purchased with the intention of resale (including "secondary intention"), it is considered inventory, not capital property, and the gain on sale is business profit, fully taxable (not half-taxed like capital property), and the principal-residence exemption is not available. Important note: if you buy a home or condominium pre-construction and sell it within a year or so after final closing – even if this is many years after you signed the original contract – the CRA will automatically presume that you intended to sell it all along (despite your protestations that your circumstances changed), and that the gain is business profit. The CRA actively reviews real estate sales records, and has assessed over a billion dollars of tax on such sales over the past four years, most of it on this kind of sale.
The amount of the exemption is based on a formula, and depends on the number of years of ownership that the home was your “principal residence”. The formula will exempt all or part of the gain on the sale of your home. The formula is:
Exempt part of gain = gain x (1 + number of years of principal residence / number of years of ownership)
Thus, if the home is your principal residence for all of years of ownership, or all years but one, the entire gain will be exempt. (The fraction in brackets cannot exceed 1.) On the other hand, as an example, if the home is your principal residence for 4 years and you owned the property for 8 years, then 5/8ths of the gain will be exempt. The other 3/8ths will be a capital gain, and half of that will be a taxable capital gain included in your income.
The reason for the “1+” in the formula relates to another rule that says you and your family can designate only one home as your principal residence per year (for these purposes, your family includes your spouse or common-law partner and minor unmarried children). Therefore, if you sell a home and buy another one in the same year, as is typically the case, you can designate on resale one of those as your principal residence for that year. The “1+” rule ensures that the principal residence exemption with respect to the other home is not lost with respect to that year.
Your home can be designated as a principal residence for a year if you “ordinarily inhabit” the home during the year. This phrase has been defined liberally by the courts and the CRA. For example, if you stay at your cottage for 2 or 3 weeks during the year, that stay can satisfy the “ordinarily inhabit” requirement.
The designation as principal residence for all relevant years must be made in your tax return for the year in which you sell the home. You must file Schedule 3, “Capital gains and losses”, as well as Form T-2091 “Designation of a property as a principal residence by an individual”. (For sales before 2016, the CRA allowed you to not report the gain at all if you had only one principal residence at a time. Now it must be reported, or you cannot claim the exemption.)
The home can be a regular house, a condominium, a co-operative housing arrangement, a trailer home, or even a houseboat.
Normally, the exemption covers the gain on the sale of the building and up to one-half hectare of the surrounding land. However, if your lot is greater than one-half hectare, the gain on the excess land may qualify for the exemption if you can show that the excess land was necessary for your use and enjoyment of your home. This could be the case, for example, if zoning by-laws have a minimum lot size that is greater than one-half hectare, so that you are required by law to have a bigger lot.
It used to be the case that almost any trust owning and selling a home could qualify for the exemption, as long as the trust was resident in Canada and one of the beneficiaries or family members ordinarily inhabited the home. This rule was changed, so that currently only special types of trusts can qualify, such as certain spousal trusts and qualified disability trusts.
Renting out your principal residence
As noted, in order for your home to count as your principal residence for a year, you normally must ordinarily inhabit the home during the year. However, special rules in the Income Tax Act allow you to designate your home while you are renting out. The special rules apply in two instances. First, if you live in your home and subsequently move out and rent it to someone else, then during the rental period you can continue to designate the home as your principal residence for up to four years. Furthermore, if your move out of the home was caused by a relocation of your employment, the four-year period can be extended, if you subsequently move back to the home during the employment or by the end of the year following the year in which your employment is terminated.
Second, if you own a home that you rent out, and subsequently move in and inhabit the home, you can also designate the home as your principal residence for up to four years while you rented it out.
There are a couple of caveats to the above rules:
First, you are still subject to the "one designated principal residence per year" rule. Thus, if you own another home and designate that other home as your principal residence for a year, you cannot designate the first (rented-out) home for that year.
Second, if you wish to designate the home as your principal residence while you rent it out, you should not claim capital cost allowance (tax depreciation) on the home. Doing so will eliminate or at least reduce your ability to designate it as your principal residence during the rental period.