It's long been said that a home is the best long-term investment one can make. Indeed, real estate generally increases in value. And when the property is your home, you get a roof over your head while your capital grows. From an investment standpoint, in most cases it's financially more advantageous to make payments to a home mortgage as opposed to paying rent.
But there is another very compelling reason to invest in a home. When you sell, its appreciation in value is exempt from capital-gains tax. With other capital investments, such as stocks and real estate other than your home, one-half of any gain is taxable.
The principal-residence exemption, as it is known, is one of Canada's oldest and best tax breaks. On the surface, claiming the exemption is a very straightforward process: in most cases you don't need to report the sale of your home on your income-tax return. What's more, the tax regulations are very generous, allowing flexibility as to how a property can qualify as a principal residence. However, there are a number of wrinkles and exceptions to consider.
What is a principal residence?
According to the Canada Revenue Agency, the following types of owned homes are eligible as a principal residence:
- house
- condominium unit
- share in a co-operative housing building or duplex
- cottage
- mobile home
- trailer
- houseboat
The definition of principal residence includes up to one-half hectare (1.25 acres) of the surrounding land. But if it can be proven that more of the land is necessary for the "use and enjoyment" of the home -- such as for access to the house or due to the municipality's minimum-lot-size requirements -- then more or all of the property may qualify for the exemption. This circumstance usually affects country homes. See this article for more on cottages and the principal-residence exemption.
To qualify for the exemption, the home must be "ordinarily inhabited" by the owner -- or by his or her spouse, ex-spouse or children. (The definition of spouse includes both married and common-law couples.) You have to live in the home only for a short period of time during the year to meet this requirement. While you are allowed to rent out the property to a limited extent, the primary purpose of ownership cannot be to produce rental or other income.
How to make use of the exemption
If your home has been a principal residence for the entire time you've owned it, in most cases you don't have to report anything on your income-tax return for the year of sale.
However, there are exceptions. CRA paperwork will be required if:
- You do not wish to designate the property as your principal residence for the entire period of ownership, and as a result there may be a capital gain to report for the period(s) during which the home was not a principal residence.
- You made use of the capital-gains election in 1994 to exempt up to $100,000 of unrealized capital gains before Feb. 22 of that year.
In any event, you do not have to provide this information until you sell the property, at which time you would file Form T2091 (or Form T1255 for a deceased person) with the tax return for the year of the sale.
You are allowed to designate a qualifying home as a principal residence for individual years. This allows those who own more than one home to make tax-savvy use of the exemption, depending on property values and their individual tax situation.
For example, one could designate a city home for five years, switch the designation to a cottage, and then switch back to the city house later on. Those who take advantage of this flexibility will need to first calculate the capital gain. This amount is simply the sale proceeds, minus the adjusted cost base of the home and what it cost you to sell it.
The next step is to determine the portion of the capital gain that is exempt. This is done by multiplying the capital gain by one plus the number of years you've designated the dwelling as your principal residence, and then dividing that figure by the total number of years you've owned the residence.
Finally, subtract the exempt capital gain from the total capital gain to determine the non-exempt capital gain. Of the latter amount, 50% will be taxable.
Joint ownership
A home jointly owned by spouses entitles both to share the principal residence exemption -- but for only the same home over a given period. Before 1982, each spouse was able to designate a different property, which allowed two homes to be sheltered from capital-gains tax. And because capital-gains taxation took effect only at the start of 1972, couples need only calculate capital-gains tax on a second home from 1982 onward.
Transferring or gifting a home
If you are contemplating transferring a home that is not designated a principal residence to your spouse or ex-spouse (either directly or through a trust), capital gains as a result of the transaction will not be taxable until the recipient eventually sells the property. And if it is a principal residence, the recipient can ultimately shelter the entire gain in value under the exemption, both for the period of his or her spouse's ownership and their own ownership after the transfer.
A home that you transfer to a child or anyone else other than a spouse or ex-spouse will result in a transaction with a new adjusted cost base being applied as of the transfer date. If the home is not a principal residence, you will have to pay capital-gains tax based on the property's fair market value -- even if it was a gift or sold at a significantly reduced price.
Normally a value based on a professional real-estate appraisal will be acceptable to the tax authorities. The CRA defines fair market value as: "Usually the highest dollar value you can get for your property in an open and unrestricted market, between a willing buyer and a willing seller who are acting independently of each other."
Change in property use
If you own a rental-income property and decide to convert it to personal use and declare it as your principal residence, a transaction is deemed to have taken place and you must declare a capital gain, based on fair market value, when you eventually sell the property. You must attach a letter to your tax return for the year of sale that states when the change in use took place, the fair market value at that time, and the change in value from when the property was acquired. There is a provision in the tax rules -- under subsection 45(2) of the Income Tax Act -- that may allow you to defer payment of capital-gains tax payable on this transaction.
If the change in use was to turn the home into your principal residence, you can use the principal-residence exemption to shelter any increases in value from that point onward. In other words, you establish a new adjusted cost base for the property as of the date the property's use changed.
Similarly, if you turn a home into an income-producing property, a deemed disposition takes place. You can use the exemption to avoid capital-gains tax on the gain in value during the period it was a principal residence. Capital-gains tax will be payable on any increase in value after the property is converted to income-producing.
For tax purposes you can elect to not change the property's use from principal residence to income-producing for up to four years, even though you may not have ordinarily inhabited the dwelling during that period.
