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There's No Place Like Home: Understanding The Principal Residence Exemption

05/05/2014


The Canadian tax system has what is referred to as the ‘principal residence exemption.’ This exemption allows you to sell a residence that you ‘ordinarily inhabited’ and pay no tax on the capital gain that will arise if the property increases in value from the date of purchase. In general terms, a principal residence is defined to include:

• A house
• A cottage
• A mobile home
• A leasehold interest in a house
• A share of the capital stock of a co-operative housing corporation

Further, ‘ordinarily inhabit’ is not a defined term in the Income Tax Act. This is generally based on the facts of each situation. However, you don’t need to spend a significant amount of time at the residence in order for it to be considered ordinarily inhabited. It is generally accepted that visiting a property for a short period of time each year may allow a taxpayer to meet the ordinarily inhabited requirement for that year.

Prior to 1981, each member of a family unit could designate a property as their principal residence, thus resulting in two properties being exempt from tax upon the sale. This rule has since changed and now a single family unit can only designate one property as a principal residence. This isn’t an issue if your family only owns one home. Where it starts to pose concern is if your family owns more than one property at the same time during a taxation year – for example, a house in the city and a cottage. When it comes time to sell one of the properties, it is important to determine which property will potentially result in the largest capital gain and apply the principal residence exemption on that property.

Another issue to consider is the land adjacent to a principal residence. This land may be quite substantial when you take into consideration acreages and home quarters for a farming family. You are generally allowed to claim up to ½ a hectare of land as part of their principal residence when it contributes to the enjoyment and use of the residence. However, more land may be claimed if you can substantiate a greater amount was needed for the use and enjoyment of the residence.

Another common concern regarding the principal residence exemption is what happens if a property owner rents to a tenant. At this time there will be a change in use of the property. The property has changed from being ordinarily inhabited by the owner to a property that is generating rental income. At this point, you will be deemed to have disposed of the property at the fair market value and reacquired it at the same fair market value. The corresponding capital gain that arose on the change in use will be offset by the principal residence exemption. Bear in mind that when this property is finally disposed of there may be a capital gain not sheltered by the principal residence exemption and be fully taxable. There may be some relief from this taxable capital gain by filing an election to not have the change in use rules apply. This election is done by filing a letter with your personal tax return in the year of disposition. The effect of the election is that a deemed disposition will not arise on the change in use and the property will be deemed your principal residence for four years after the change in use. After the four years is up and if you continue to rent out the property, the change in use rules will then apply. It is important that no capital cost allowance be claimed on the property while the election is in effect. Furthermore, it may not be wise to file this election if you own a second property while the election is in effect. This is because the election deems the first property to be the principal residence. If the second property grew more in value over the four years, you may wish to designate the second property as your principal residence.

While claiming the principal residence exemption may appear straightforward, there are a few items to consider to ensure you minimize the tax paid when owning more than one residence.