Most people believe that any capital gain (increase in value) on the house they own and live in is not taxable. In reality, however, the capital gain is taxable, but a special rule in the Income Tax Act (principal residence exemption) allows taxpayers to reduce the capital gain based on the number of years they live in the house, and designate those years for purposes of the exemption. For the majority of taxpayers, this results in no taxes payable upon the sale of their homes.
The types of properties that can qualify as a principal residence include detached and semi-detached houses, condominiums, cottages, mobile homes and even houseboats. The key requirements are that the property must be owned, must be "ordinarily inhabited," and the land portion cannot in most cases exceed one-half hectare (about 1.2 acres).
Whether a property is "ordinarily inhabited" really depends on the facts of each case. However, the Canada Revenue Agency (CRA) acknowledges that the test may be satisfied even where the owner lives in the property for only a short time. This would cover situations where an owner sold a property early in the calendar year or purchased a property late in the year. Further, the CRA acknowledges that a seasonal residence, such as a cottage, would be ordinarily inhabited if it is used during vacation, as long as the main purpose for owning the property is not to earn income. It is possible to earn "incidental" income without jeopardizing the ability to claim the principal residence exemption.
Where an owner moves out of a home and converts it completely to a rental property, the "ordinarily inhabited" test obviously would no longer be met. In addition, at the time of conversion, the CRA considers such owners to have sold the property at fair market value and to have reacquired it at the same amount. Any income tax on the increase in value can be avoided by using the principal residence exemption or by making a special election to defer the gain to a later year. If the special election is made, the property can qualify as a principal residence for up to four additional years, even though it is no longer "ordinarily inhabited." This would cover situations where the owner was required to move (within Canada) for work or other purposes, and planned to return to his or her present location.
A further consideration is that the land portion of a principal residence cannot normally exceed one-half hectare, since the excess portion is considered not to contribute to the use and enjoyment of the property. Exceptions may be permitted where an owner can show that some or all of the excess portion is required for the use and enjoyment of the house. For example, consider a rural property where the house is situated such that a long laneway is required to reach a public access road. The land needed for the laneway may exceed one-half hectare but may still qualify since it is necessary for the use of the home. Further, where a municipal law or regulation at the time of acquisition requires a minimum lot size or restricts the ability to obtain a severance, the excess portion could qualify. Where there is no excess land and a portion of the property is severed, the principal residence exemption would be available not only on the land with the home but also for the vacant severed portion.
Where more than one residence is owned -- a house and a cottage, for example -- the rules should be examined to minimize tax liability. For years after 1981, only one residence per family unit may be considered the "principal" residence. In some cases, paying tax on the house will be less than paying tax on the cottage, depending on the increase in value over the purchase price. In other cases, splitting the principal residence exemption between the house and cottage might result in lower taxes overall. The exemption is claimed by designating one property as the "principal" residence for every year of ownership. However, there is a "bonus" year built into the exemption formula, which, if claimed correctly allows the gain on one property to be completely exempt while allowing a portion of the gain on the other property to be covered by the exemption when it is sold in the future. A designation of a property as a principal residence is only required in the year of disposition, so no decisions have to be made until one property is sold.
Where a 1994 capital gains election was made on a cottage, additional analysis on the use of the principal residence exemption may lead to a lower tax bill on the sale of the property.
The principal residence exemption rules and calculations are complex. We recommend that you consult with your Collins Barrow advisor to determine how best to apply them in your circumstances.
Ed Mitukiewicz is a tax partner in the Elora office of Collins Barrow.
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