Election For Principal Residence Exemption to save Canadian Income Tax
A taxpayer who sells his or her "principle residence", which is defined in the ITA, becomes liable for paying tax on the capital gains. However, the Income Tax Act ("ITA") allows the taxpayer to claim an exemption, thereby avoiding the payment of tax on the sale of the "principle residence".
"Principle residence" generally includes:
- A house
- A cottage
- A condominium
- A trailer
- A mobile home
- A houseboat.
A taxpayer and his or her spouse may only designate one principle residence per year, and that residence must be "ordinarily inhabited" for part of the year. Canada Revenue Agency ("CRA") has been very liberal in their interpretation of "ordinarily inhabited". For instance, cottages inhabited for a very short period of time have met the test of being "ordinarily inhabited" and thereby qualify for the principal residence exemption.
Generally only 1.25 acres of property can be considered part of the "principle residence", so if you own a cottage or farm with more acreage beyond 1.25, the remaining portion will normally be subject to tax on the capital gain when sold. Contact one of our Toronto tax attorneys to see if more acreage may qualify in your situation.
Designate Property to Claim Principal Residence Exemption
To claim the exemption, you must designate the property as your "principle residence" in the year of sale. This is done using the forms provided by the CRA including form T2091.
It is possible to designate a home as your principle residence in one year, and the next year designate a completely different property, such as a cottage. The Canadian income tax Act contains a formula for such occurrences when one of those properties is eventually sold to calculate the exemption that will be provided.
Election on Change of Use of Principal Residence
If a taxpayer has completely converted his or her principal residence to an income-producing use, in other words to a rental property, he or she is deemed by paragraph 45(1)(a) to have disposed of the property (both land and building) at fair market value and reacquired it immediately thereafter at the same amount. The resulting capital gain or loss must be reported in the year the change of use occurs. The taxpayer may instead, however, defer recognition of any gain to a later year by electing under subsection 45(2) to be deemed not to have made the change in use of the property. This election is made by means of a letter to that effect signed by the taxpayer and filed with the income tax return for the year in which the change in use occurred.
If the property was the taxpayer’s "principle residence" for all the years it was owned before the change in use, the taxpayer will not have to pay the capital gains tax because of the "principle residence" exemption. However, if the property was not the taxpayer’s "principle residence" then the taxpayer will have to pay the capital gains tax on the gain that relates to the years the home was not the "principle residence".
The above situation is not the only place where a change in use of the property has tax implications. Consider the following example:
Shirley moves to a new city to pursue employment opportunities. While absent from her home, Shirley decides to rent it out. At this time, Shirley’s property has undergone a change of use, which means that there is a deemed sale at fair market value. This sale is sheltered by the principle residence exemption, so no taxes will be paid.
After three years, Shirley decides to sell her original property and remain in the new city. Upon the sale of the property, Shirley will realize a taxable capital gain based on the value of the property at the time of sale, less the fair market value at the date the change in use occurred. If Shirley decided to move back in, rather than sell, the same result would occur, that being a deemed sale and re-acquisition at fair market value.
As indicated above, the taxable capital gain can be avoided with the use of the election under Subsection 45(2) of the ITA. The election deems the change in use not to have occurred, in addition to providing the taxpayer with the option of claiming the principle residence exemption on an extra four years even though the taxpayer was not residing there.
In order for the election to be valid, Shirley may not claim Capital Cost Allowance ("CCA") on her rental schedule, and the election must be filed in the taxation year in which the change occurred.
If you are thinking about selling a property, while owning more than one property, or changing the use of a property, one of our top Canadian income tax lawyers should be consulted to determine the best method of minimizing the amount of taxes you may have to pay. Give us a call to set up an initial consultation with our Canadian income tax law firm.
"This article provides information of a general nature only. It is only current at the posting date. It is not updated and it may no longer be current. It does not provide legal advice nor can it or should it be relied upon. All tax situations are specific to their facts and will differ from the situations in the articles. If you have specific legal questions you should consult a lawyer."