—Updated April 2018—
In late 2016, Finance Minister Bill Morneau introduced tax changes that will impact every homeowner and taxpayer in Canada. Instead of focusing their efforts on specific buyers, the feds chose to close current tax loopholes that directly apply to real estate earnings. In particular, the newly announced rules will tighten and enforce the requirements necessary for claiming the capital gains tax exemption on a principal residence. To help you understand how this impacts you, we’ve answered eight questions about the principal residence exemption and the new rules.
1. What qualifies as a principal residence?
According to the Canada Revenue Agency any residential property owned and occupied by you or family at any time in a given year could be designated as a principal residence. So, if you own and live in a detached or townhouse, a condominium, a cottage, a mobile home, a trailer or even a live-aboard boat, you can designate the property as your principal residence.
The designation of a property as a principal residence is a significant and important financial planning tool because the CRA allows you to shelter the profits earned on the sale of a principal residence from taxes owed.
2. How do capital gains and the principal residence exemption work?
This exemption is key as all property—including your home, cottage, real estate rentals, even stock portfolios—are subject to capital gains tax when they increase in value. Known as a capital gain, this appreciation in the value of an asset is subject to tax which is known, simply, capital gains tax.
From an investor’s perspective the capital gains tax is quite advantageous because it only requires that you pay tax on half the profit earned and only at your marginal tax rate. So, if you end up selling a rental property in Kingston, Ont. you’d have to pay capital gains tax on the $60,000 profit you made from that sale. Under tax rules, you’d only owe tax on $30,000, based on your marginal tax rate. (This simple illustration omits other factors, such as capital cost allowance and expenses paid.) If you earned $60,000 per year, the tax you owed on the sale of the property would be just under $9,575. Earn the same in interest and you’d end up paying the taxman more than $22,565 (just on the investment earnings).
Even better, if the accommodation you’re selling isn’t an investment but your principal residence, the CRA provides a full exemption from all capital gains tax you would’ve incurred.
3. How do the recent changes impact homeowners?
First, there are no changes to the principal residence exemption. Any profit you earn on the sale of your home is still sheltered from tax—making it a key strategy in your financial plan. What has changed, however, is what you have to report to the CRA when you file your tax return.
Up until the recently-announced changes, anyone that sold their primary home did not have to report it on their income tax return.
However, starting with the 2016 tax year you will be required to report basic information such as date of acquisition, date of sale, proceeds of disposition and a description of the property on your income tax and benefit return in order to qualify for the principal residence exemption.
This reporting requirement will now apply to every property sold in Canada 2016 and onwards, even if the entire gain is fully protected by the principal residence exemption.
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4. Is there a penalty for not reporting?
There is no immediate financial penalty for failing to report the sale of your home, however, much like other omissions, if the CRA audits and finds the sale you could be subject to interest on taxes owed, as well as penalties.
“For most Canadian residents, the new proposed requirement to report the sale of a principal residence will be a compliance exercise, but an important one,” says John Sliskovic, private client services tax leader at Ernst Young LLP. “If the sale is not reported, the Canada Revenue Agency could reassess the tax return in regards to the sale at any time. And there will be a penalty for those who file their principal residence designations late.”
What this means is that the three-year limit for when the CRA can start an audit has now been removed for anyone claiming the sale of a principal residence. Put another way, the reassessment period “will now be extended indefinitely,” David Davies, partner at Thorsteinssons, a tax law firm operating out of Vancouver and Toronto, explains in a recent brief.
5. What is the CRA really trying to do?
While most analysts assumed the federal government would target foreign buyers, the decision to tighten up the principal residence exemption qualifications goes one step further. According to the CRA, “this change will improve compliance and administration of the tax system.” But to Davies, the targets are obvious: “Those who sell properties that may not qualify as a principal residence.” For example:
(1) “quick flips” or short holding periods (the home may not qualify as capital property, a condition of being a principal residence)
(2) a house that was not ordinarily inhabited in each year of ownership by the vendor (another condition to qualifying as principal residence)
(3) serial builders who build, then occupy, a house before selling (again, these would be considered inventory and not a capital property)
This seemingly small change will give CRA auditors new audit leads, and will undoubtedly give rise to many more homeowner audits and reassessments. Under the new reporting system, expect to see an increase in principal residence exemption denials by the CRA.
6. How do you report the sale of your principal residence?
Anyone that sold a home in 2016 onwards will have to complete a Schedule 3 and file it with your T1 Income Tax and Benefit Return. If the property was your principal residence for every year that you owned it, you will make the principal residence designation on the Schedule 3. In this case, the year of acquisition, proceeds of disposition and the description of the property are the only information that you will have to report. The CRA notes that, starting next year, the Schedule 3 will be modified in order to allow taxpayers to provide this information.
If the property was also used to earn income, you will continue to fill out Form T2091 (or Form T1255)—which allows you to stipulate what years the property was not your principal residence for all of the years that you owned it.
Davies points out that “failure to report a principal residence sale on a tax return for the year of sale can be cured by late-filing a form. However, the normal three-year limitation period will only start to run once the form is actually filed and, obviously, the filing itself will be an audit flag.” Plus, you will need to ask the CRA to amend your income tax form for the year the home was sold.
If you are late in reporting the sale of a home you could also trigger penalties. According to CRA documentation, “the CRA will be able to accept a late designation in certain circumstances, but a penalty may apply. The penalty is the lesser of the following amounts: (1) $8,000, or (2) $100 for each complete month from the original due date to the date of your request was made in a form satisfactory to the CRA.”
7. What are the rules regarding designation of a principal residence?
However, for a home to be eligible for the principal residence exemption from tax, you must also adhere to a few other CRA stipulations.
No. 1: One per family
A family unit can only designate one property per year as a principal residence. A family unit is you, your spouse (or common-law partner) and any children under the age of 18.
No. 2: Must inhabit the home
For tax purposes, there is no minimum period for which you have to own or inhabit the property in order for it to qualify as your principal residence. From the CRA’s perspective, a home would qualify as a principal residence if you and your family “ordinarily inhabited” the dwelling during the calendar year.
But be warned: The CRA will look at all evidence—including length of time in dwelling, primary income sources and patterns of buying, living, moving and selling—to determine if, in fact, the home is a principal residence or part of a business created to earn money off of real estate flipping.
No. 3: You have choices
Here’s the advantage: You can claim any property you own and “ordinarily inhabit” as your principal residence. As a result, you have the choice of designating a seasonal residence such as a cottage as your primary residence. Just keep in mind that that the occupancy requirement must be met for each year that you want to make the designation.
For example, if you owned a property from 2006 to 2015, but only occupied that property in 2006 and 2007, you could only designate it as your principal residence for two of the ten calendar years during which you owned the property.
To make matters even more confusing—but highly tax-advantageous—when determining the amount of your exemption, you can add in a freebie year in the proration calculation. So, if you designate a property you’ve owned for 10 years as your principal residence for two years, you could actually shelter 30% of the capital gains under the principal residence exemption (2 years + 1 freebie year), according to the CRA.
For families with more than one property, it’s wise to talk to a tax specialist that can help you calculate when and how you should designate each property as your principal residence in order to maximize the exemption and minimize the amount of tax owed on each property.
No. 4: Cannot earn income
Does the property you just sold make you money? If so, you may not be able to exempt the profit from capital gains tax. Under the CRA’s rules, a property cannot be considered a primary residence if it’s overall aim was to earn an income. For instance, an investor who buys a six-plex and lives in one unit, while renting out the other five, cannot shelter the capital gains earned on that property by using the principal residence exemption (PRE).
No. 5: Restriction on the amount of land
The size of land where your primary home sits cannot be greater than one-half hectare (or 1.2 acres) of land. So, if you bought a 10-acre farm and lived in the farmhouse, you wouldn’t have to pay tax on the appreciated value of the farmhouse or on 1.2 acres of the land—because they’d quality for the exemption. However, you would have to pay capital gains tax on the appreciated value 8.8 acres. Now, the CRA has said that you can get apply for a tax exemption on parcels of land that are greater than 1.2 acres, but you will need to prove to that the additional land was required for your use and enjoyment of the property.
No. 6: Remember, any property you own and use
Here’s the clincher, the property you claim as your principal residence does not have to be located in Canada.
8. Where can I get more information?
Finally, if you want more information on how these recent changes will be applied, the CRA will be providing more detailed instructions in the T4037 Guide: Capital Gains 2016.