For as long as anyone can remember, Canadians have been buying and selling their personal homes without giving the tax implications of these sales a second thought. Prior to 2016, when a Canadian sold the home they lived in, they were not required to report the sale to the Canada Revenue Agency (“CRA”) as long as they elected to claim the principal residence exemption on the property for the entire time it was owned by them. However, this all changed in 2016 when the Department of Finance made it mandatory to report all sales of Canadian real estate regardless of whether the sale was taxable or not. Below we will discuss what the principal residence exemption is, what you need to report on the tax return, as well as various tips and traps surrounding the sale or deemed sale of your home.
Principal Residence – The Basics
When you sell your home, you can elect to shelter a portion of the gain on that sale from tax by designating the home as your principal residence (“PR”) for any years you used the home personally. This is governed by the following formula:
(Number of Years Designated as PR + 1) / Number of Years Owned x Capital Gain on Sale
For example, you owned your home for 20 years but you are only designating it as your principal residence for 15 of those years. You are now selling your home and will realize a gain of $1,000,000 on the sale. In this case, the calculation would be as follows:
(15+1)/20 x 1,000,000 = $800,000
Therefore, of the $1,000,000 total gain, $800,000 is sheltered by the principal residence exemption. You will recognize a gain for tax purposes on the sale of your home of $200,000 in the year.
Each taxpayer, with their spouse, can designate one property in as their principal residence each year. Further, in order to make this designation, you, your spouse, or your child must have lived in the property at some point in the year, subject to certain exceptions which are noted below. This means that if you own two properties, only one can be designated as your principal residence for any given year during the time both properties were owned. For this reason, when selling one of the properties, it is important to analyze the gain in each year you are sheltering by making the designation for a particular property compared to the gain you would be able to shelter on the other property. When deciding whether to designate a property as your principal residence it may be advisable to consult your accountant or tax advisor, especially if you are unsure of which property to designate.
Other Times the Principal Residence Exemption Becomes an Issue
In the eyes of the CRA, you may have sold your home and not even know it. Subsection 45(1) of the Income Tax Act (“the Act”) deems a person to have disposed of their property when the use of the property changes from personal use to income producing or from income producing to personal use. Essentially what this means is that if you owned a home or a vacation property which you had previously used exclusively for your personal enjoyment (i.e. living there or vacationing there) and you then decide to use the property to earn income by either renting it out or running a business, you will have disposed of the property for tax purposes at its fair market value at the time the use changed. The same rules apply in cases where you are using your property to earn income and then decide to use it instead for your personal use. As some Canadian property values have soared in recent years, barring the use of any available tax elections, this could result in a significant taxable capital gain to the owner of the property. Luckily there are some tax elections which can be used to shelter the gain or deem the disposition not to have taken place at all.
In cases where you are using a property for your personal enjoyment and then later decide to use it to earn income, the first option you have to avoid tax on the change of use is to simply claim the principal residence exemption on the deemed disposition. To do this you need to report the fair market value of the property as of the date the usage changed, and designate the property as your principal residence for all years it was owned up until the time its usage changed. The result this action is that the gain on the property from the time it was purchased until the time the usage changed will be sheltered from tax and the cost base of the property will be crystalized at the fair market value as of the date of the change in use. Up until 2016, when it became mandatory to report these types of dispositions and make the election for the principal residence on your tax return, this was the easiest option as there was no need to report a disposition which was completely sheltered by the principal residence exemption. In many cases, this would have been the default option for most people who weren’t aware of the deemed disposition rules. You will need to contact a real estate professional or appraiser in order to determine what the value of your home is at the change-in-use date and make the principal residence election on your tax return.
The second option available is to file an election under subsection 45(2) of the Act. This deems the change of use not to have occurred. This election is very useful as it serves two purposes: First, if you elect under subsection 45(2) of the Act, you will no longer be deemed to have disposed of your property as of the date of the change-in-use. The second benefit of electing under subsection 45(2) is that you will have the option to claim the principal residence exemption on that property for an additional 4 years while you are using it to earn income. In an environment where house prices in some cities such as Toronto and Vancouver can rise substantially year over year, the ability to shelter an additional 4 years of gains can be incredibly valuable. The following is an example of where this election can be used to completely shelter a capital gain on the sale of a property which has had changes in use during the time it was owned.
Miguel Sanchez, a lawyer who lives in a home which he owns in Toronto was just offered a lucrative 2 year contract job in Edmonton. Mr. Sanchez decides to take the job and moves to Edmonton where he lives in a rented apartment. While in Edmonton, instead of allowing his Toronto home to sit idle, Mr. Sanchez rents it out for some extra cash. Without the use of a 45(2) election, he would be deemed to dispose of his Toronto home as soon as he decided to rent it out, on which he would either pay tax or claim the principal residence exemption. Two years later, upon his return to Toronto to move back into the property, he would again be deemed to have disposed of the property at its fair market value and would need to pay tax on the gain which would have accrued while he was away. If however, he decided to file an election under subsection 45(2), there would be no deemed disposition of his Toronto home when he began renting it out, and upon his return there would be no deemed disposition either, as he was deemed never to have used the property for income producing purposes. Further, say Mr. Sanchez decides to sell the Toronto house and move back to Edmonton. The 45(2) election allows him to claim the principal residence exemption for an additional 4 years while he was renting it out; giving him the option to shelter the gains for the 2 years he was in Edmonton.
It is important to note that the 45(2) election is immediately rescinded once a taxpayer claims capital cost allowance or CCA on the property. CCA is basically depreciation on the property for tax purposes. In the example above, if Mr. Sanchez were to have claimed CCA on the Toronto home in the second year he was away in Edmonton, the 45(2) would be deemed to have been rescinded on the first day of the second year, at which point Mr. Sanchez would have to report the disposition at fair market value and either pay the tax or shelter the gain using the principal residence exemption.
What if a property is bought as an income producing property and then later becomes personal use?
As noted above, in situations where you purchase a property to be used to earn income from rental or business and then decide to use the property personally, there is a deemed disposition at fair market value on the date of the change in use. Any gain realized on the deemed disposition will be taxable as the property wasn’t “ordinarily inhabited” by the taxpayer and therefore isn’t their principal residence. There is however some relief in the form of an election under subsection 45(3) of the Act. The 45(3) election is like the 45(2) election except it works in reverse. This election will deem there to be no change in use from income producing to personal use, and will allow a taxpayer to claim the principal residence exemption for the 4 years prior to the election. Like the 45(2) election, the 45(3) election cannot be made if CCA is taken on the property.
To demonstrate this election in action let’s take the facts from our first example and modify them a bit. Let’s say that Mr. Sanchez purchased the Toronto home while working in Edmonton so as not to be priced out of the Toronto market on his eventual return 2 years later. No wanting to leave the home vacant, Mr. Sanchez rented it out but did not claim CCA. Absent a 45(3) election, when he returns to Toronto and moves into the home, Mr. Sanchez will have a deemed disposition for tax purposes which will result in a taxable capital gain and potentially significant taxes owing. However, if he makes the election under 45(3) there will be no deemed disposition and he will be able to claim the principal residence exemption for the first 2 years he owned the property when it is eventually sold.
What happens if only part of my home has a change in use?
It is very common in today’s economy for people to want to earn some extra money outside of their jobs. Some people like to run businesses out of their homes while others may rent out a part of their house which they are not using. Unless the portions of the house used for either business or rental income were used for those purposes from the time the property was purchased, there will be a change in use to the part of the property which the taxpayer began renting or using for a business or home office.
Under subsection 45(1) of the Act, the same rules apply when there is a change in use to part of your property as when there is a change in use of the whole property. In these cases there is a partial disposition of the property based on how much of the property changes its use. Unfortunately, in situations such as these, no elections can be made under 45(2) or 45(3). Where the use changes from personal to income earning, the principal residence election can be claimed to exempt the gain on the partial disposition from tax. It should be noted that if a taxpayer decides to do this then the whole property is deemed to be that person’s principal residence for the years the exemption was claimed on the partial disposition. This means when the property is sold the taxpayer must designate the property as their principal residence for all years the designation was made on the partial disposition. Where the change in use is from income earning to personal, there is no election or designation available to relieve the taxpayer from paying tax on the deemed gain.
There are some limited instances where the CRA will deem the partial disposition on change of use not to have occurred and the new use of the property to be ancillary to the main use of the home. The exemptions are below:
- The part of the home used to earn income is small in comparison to the whole property.
- No structural changes were made to make the property more suited to earn income. For example you did not add an extra entrance for the tenant of a basement apartment.
- You did not claim CCA on the portion of the property being used to earn income.
The discussions above relate solely to Canadian real estate transactions undertaken by residents of Canada. The implications of non-residents owning and selling Canadian real estate will be discussed in Part II of our Canadian Real Estate Series.
The above discussions are meant for educational purposes only and should not be construed as advice on any specific matter. For specific advice related to your tax situation please consult your accountant or tax advisor.
Written by Daniel Rosa, CPA, CA