Making the Most of the Principal Residence Exemption
Canadians don’t have to pay capital gains taxes on their principal residences. However, the definition of “principal residence” is quite flexible making it possible for families who own a second property, such as a cottage, to save substantial amounts on their taxes.
Douglas Gray and John Budd, in their book The Canadian Guide to Will and Estate Planning, explain that your principal residence isn’t necessarily your “main place of residence.” If you own a vacation property, “as long as you, your spouse or at least one of your children occupy the vacation property for some period or periods of time during the year, that is enough to bring you within the principal residence definition.”
“The fact that you show your home address on your income tax return does not mean that you are designating your house as your principal residence.” Further, “it is not generally necessary for you to decide which property is to be designated as the principal residence for capital gains tax purposes until the year that either property is sold or disposed of.”
Calculating your taxes owing on a property sale begins in the usual way by taking the proceeds of disposition and subtracting your adjusted cost base to get the capital gains amount. Then you get to reduce this capital gains amount by the “exemption fraction,” which is based on the number of years it was your principal residence. The exemption fraction is
1 + number of years after 1971 the property is designated as your principal residence
divided by
number of years after 1971 you owned the property.
Partial years count as full years in this fraction. The purpose of the “1+” in the numerator is presumably to deal with the fact that a family with just one property may move in the middle of the year, but only be allowed to designate one of their homes as their principal residence for that year.
An Example
Sue and Bob bought their home in 1994 and a cottage in 2004. They sold both in 2013 for a $200,000 gain on the house and a $150,000 gain on the cottage. They owned the house for 20 years and the cottage for 10 years.
If they designate the house as their principal residence for the entire 20 years, they will have to pay capital gains taxes on the cottage gain of $150,000. But, look at what happens if they designate the cottage as their principal residence for 9 years and the house for 11 years:
Cottage exemption fraction = (1 + 9)/10 = 100%.
House exemption fraction = (1 + 11)/20 = 60%.
Now the cottage gain is entirely tax-free and they only have to pay capital gains taxes on 40% of the $200,000 house gain, or $80,000. This is a reduction in capital gains of $70,000 compared to declaring the house as their principal residence for the entire 20 years. Assuming Sue and Bob pay 23% capital gains taxes, they save $16,100.
For families with vacation properties, it definitely pays to understand these rules when it comes time to sell homes and cottages.
I am not a tax expert. I relied on the information in Gray and Budd’s book to construct this example. Seek professional tax advice, particularly when dealing with large sums of money.
Douglas Gray and John Budd, in their book The Canadian Guide to Will and Estate Planning, explain that your principal residence isn’t necessarily your “main place of residence.” If you own a vacation property, “as long as you, your spouse or at least one of your children occupy the vacation property for some period or periods of time during the year, that is enough to bring you within the principal residence definition.”
“The fact that you show your home address on your income tax return does not mean that you are designating your house as your principal residence.” Further, “it is not generally necessary for you to decide which property is to be designated as the principal residence for capital gains tax purposes until the year that either property is sold or disposed of.”
Calculating your taxes owing on a property sale begins in the usual way by taking the proceeds of disposition and subtracting your adjusted cost base to get the capital gains amount. Then you get to reduce this capital gains amount by the “exemption fraction,” which is based on the number of years it was your principal residence. The exemption fraction is
1 + number of years after 1971 the property is designated as your principal residence
divided by
number of years after 1971 you owned the property.
Partial years count as full years in this fraction. The purpose of the “1+” in the numerator is presumably to deal with the fact that a family with just one property may move in the middle of the year, but only be allowed to designate one of their homes as their principal residence for that year.
An Example
Sue and Bob bought their home in 1994 and a cottage in 2004. They sold both in 2013 for a $200,000 gain on the house and a $150,000 gain on the cottage. They owned the house for 20 years and the cottage for 10 years.
If they designate the house as their principal residence for the entire 20 years, they will have to pay capital gains taxes on the cottage gain of $150,000. But, look at what happens if they designate the cottage as their principal residence for 9 years and the house for 11 years:
Cottage exemption fraction = (1 + 9)/10 = 100%.
House exemption fraction = (1 + 11)/20 = 60%.
Now the cottage gain is entirely tax-free and they only have to pay capital gains taxes on 40% of the $200,000 house gain, or $80,000. This is a reduction in capital gains of $70,000 compared to declaring the house as their principal residence for the entire 20 years. Assuming Sue and Bob pay 23% capital gains taxes, they save $16,100.
For families with vacation properties, it definitely pays to understand these rules when it comes time to sell homes and cottages.
I am not a tax expert. I relied on the information in Gray and Budd’s book to construct this example. Seek professional tax advice, particularly when dealing with large sums of money.
Interesting concept. I wonder how you accurately get an assessment, though, for the house value at the time it ceases to be your principal residence. I guess that's where you call in the experts to help.
ReplyDelete@Bet Crooks: According to the authors, there is no need for an assessment. You just calculate the capital gain in the usual way as though the concept of a principal residence didn't exist and then reduce this gain according to the number of year the residence was and was not your principal residence.
DeleteTo make this more clear, suppose that you buy a house and use it as your principal residence for 10 years and then not your principal residence for 5 more years. You might think that you pay capital gains taxes on the gain over the last 5 years, but this isn't the case. What you actually pay is 1/3 of the gain over the last 15 years. So, there is no need for an assessment after the first 10 years.
Interesting! Usually the government are sticklers for claiming things in the years they actually happened. Since house prices don't rise linearly, I had thought they would force you to use a real assessment at the various key dates. I guess it's another example of why it can be valuable to call on the experts for advice when there are big $$$ in taxes to be paid (or avoided.)
Delete