Blog Tax Planning with the Principal Residence ExemptionNovember 16, 2018
The “Principal Residence Exemption” (PRE) available to Canadians is a valuable provision in the Canadian income tax system that allows the sale of the family home, plus a reasonable amount of land on which it sits, to be exempt from tax liability.
While the concept of the principal residence exemption is simple, there are many rules within the Income Tax Act designed to ensure that this provision is not abused. Should you fail to do a little advance planning in this area, and go about selling your family home without being aware of the rules, you could end up paying much more tax than necessary.
What many Canadians don’t know is that the disposition of the family home is a transaction that should be reported on your income tax forms and could generate a capital gain. Currently, fifty percent of the capital gain is reported as a taxable capital gain on your income tax return. However, claiming the PRE can offset part or all of the capital gain, to reduce or eliminate any income tax on the sale. Most taxpayers fail to file the appropriate forms with their tax returns because they are under the assumption that the gain on the sale of their home is non-taxable. By failing to file this form, you may be prohibiting yourself from taking full advantage of the planning that surrounds the PRE.
Should you fail to file this form in the year the residence is sold, CRA will take the administrative position that you have designated the property as your principal residence and to have elected to claim the principal residence exemption for that property for the years it was owned. This oversight may create issues if your family has more than one home that would qualify as a principal residence during any one taxation year (such as a summer vacation home).
CRA’s presumed election on the sale of one home precludes the ability to elect, for those same years, on another home, which could create a larger tax liability if that second home had a larger capital gain accrued over the years in question. Any time a family owns more than one property that could be classified as a principal residence, such as a home or a cabin, it will be important to assess the tax implications before the first property is sold. The result of not doing so could be paying more tax than necessary.
The formula for calculating the principal residence exemption is:
Proceeds of Disposition x [(1 + no. of yrs designated as a Principal Residence) / no. of yrs owned]
This formula creates tax planning opportunities if you own more than one qualifying residence in a year. The “1+” in the formula shelters gains where a taxpayer sells one residence and purchases another within the same year. However, the use of the 1+ in the formula makes it advantageous for a taxpayer to always claim the principal residence exemption on the sale of a qualifying residence, so that a portion of the gain will be sheltered even if the taxpayer does not designate the property as a principal residence for any particular taxation year (if you own more than one qualifying residence in a year, this strategy will allow for at least 1 years worth of exemption on each property).
Example: Married Couple owning a Primary and a Vacation Property
Bob and Linda are married and together bought their first home in 2000 for $100,000. In 2009, after living in the home since it was purchased, Bob and Linda decide to move and sell the home for $410,000.
In 2008, Bob and Linda also jointly purchase a vacation property in Kelowna, BC., for $400,000. They spend most of the summer in this vacation home. In 2010 the property is still worth $400,000, but they expect the value to increase in the future.
Assuming both residences qualify, Bob and Linda could benefit from a little planning around the Principal Residence Exemption. When the first home is sold there will be a capital gain of $310,000 (proceeds from sale ($410,000) minus purchase price of the home ($100,000)). The exemption may be claimed for each year they owned the property and the exemption can fully offset the gain on the sale.
Since Bob and Linda now also own the Kelowna property, they need to consider whether the exemption for the years 2008, 2009 and 2010 should be preserved for future use on the eventual sale of the Kelowna property. Recreational use property qualifies as a principal residence as long as it is used primarily for personal use, and not some other use.
A married couple and a common law couple may only use the principal residence exemption on one property between them for any particular taxation year. Since the principal residence exemption is optional, and the election is made on a year-by-year basis, it may be claimed for only some of the years during which the property was owned resulting in a partial gain on the property.
It is possible to elect for one year less than the years of ownership, preserving at least one year for use on the other property because of the “1+” in the formula above. The ownership period for the home is 10 years, and Bob and Linda only need to designate the home as their principal residence for 9 years in order to fully offset the gain on the sale. They could also consider designating all years but 2008, 2009 and 2010 to preserve those years for future use on the sale of the Kelowna property.
Usually it is best to use the exemption on the property that has the highest gain per year. The gain per year on the home was $31,000 and to date there has been no gain on the Kelowna property, so it may be best to use the principal residence exemption on the home for 9 years to fully offset the current gain and preserve at least one year for the other property.
- As there is a potentially long time frame involved when employing the Tax Planning with the Principal Residence Exemption, the importance of keeping good records of all transactions and capital costs associated with a particular property cannot be overemphasized.
- Any tax planning considered around the principal residence exemption should always be done in consultation with your accountant.
If you are looking to transition beyond your business, the advisors at Three60 Wealth & Estate Solutions can help. Three60 Wealth & Estate Solutions helps business families reclaim their time, gain peace of mind and achieve their own unique version of success. The team of Calgary-based wealth and estate planners have curated a trusted network of professionals to eliminate your planning blind spots and identify potential opportunities you may not realize you have.
For a truly different financial planning experience, contact our office online or at 403-640-4414 to schedule an introduction meeting.
Authored by: Jason Nagel, Director of Advanced Planning at Three60 Wealth & Estate Solutions Inc.