Planning the Principal Residence Exemption
In Canada if you sell your principal residence with a gain, it is generally exempt from taxation. While most people probably already know this, there specific rules to consider. Consider the following scenario involving a change in use of a property, from principal residence to income-earning use.
Let’s say it is now 2019 and you (a resident of Canada during all years involved) own a family home, in which you have lived since you originally purchased it in 2003 and you or your spouse have not owned any other property until 2013. In 2013 you acquired a second home and moved into it, and rented out your first home rather than selling it. In 2013, when you rented your first home, it underwent a “change in use.” It changed from being a personal use property to an income-producing property. According to the tax rules, you were deemed to have sold and re-acquired it immediately upon change in use at fair market value, and, assuming that it had increased in value since you acquired it, you realized a gain. The good news is that in this scenario, your gain is exempt from tax since your home was ordinarily inhabited by you as your principal residence for all years from 2003 to 2013.
In the above scenario, you also had the option (under subsection 45(2) of the Income Tax Act) to deem the change in use to not have occurred in 2013. This subsection allows you to consider your first home as your principal residence for up to four years after moving out (from 2014 through 2018 in the above scenario). This would be allowed if have not claimed any capital cost allowance for the home as a tax deduction, and you are not claiming any other property as your principal residence for the same years. This provision requires filing an election with your 2013 tax return (i.e., the year of change). The four year limitation is lifted if you are moving away due to a relocation of your employment, provided certain conditions are met. This provision can be useful if you are moving out of your home temporarily for a few years and are planning to return.
Some planning considerations are as follows. You stand to benefit by filing the 45(2) election if your first home is located in a hot market, while your second home is not, and consequently you are going to realize a higher gain on the ultimate sale of your first home then the second home. Using the election to consider the property with the higher gain as a principal residence would save you more tax.
The desired action might be different if your first property underwent a significant increase in value before you moved out, and then the market stabilized, and is expected to remain stable. In that case, declaring a change in use rather than filing the election would freeze the cost base of the property to the market value on the date of the change in use. Any subsequent increases would be taxable as capital gains, and would be lower with a stable market than with a hot market. In this case, instead of the first home, you’d declare your second home as a principal residence for those four years. This would be helpful for the eventual sale of the second property, should the market take off again years later, just before sale of the second property.
Now let’s say that instead of buying a second property, you rented a home to live in, and rented out your first home. In this case, it would be best to file the 45(2) election, as there is no other property to claim as principal residence during your first four years of absence from your property. Not doing so could cost you extra tax in the year of your eventual sale of the property without any offsetting benefit.
The government realizes that many people do not file the 45(2) election because they do not know about it. As a result, they allow a late election to be filed under Subsection 220(3.2) 600 of the income tax regulations. This would be accepted under certain circumstances.
Planning for the use of the 45(2) election involves estimation and projection and can be risky. In general, when in doubt, it’s usually best to defer tax. Of course, the rules can change at any time, making the future even less certain, especially when planning for multiple years into the future. Needless to say, each individual’s circumstances can vary. The above scenario makes assumptions (stated and unstated) that may not be applicable to you. The takeaway should be that at the very least, it is best to be aware of the rules and give each alternative some thought before deciding on how to proceed.
For more information on how the principal residence rules affect you, we recommend engaging a professional for advice.
Should you wish to discuss your situation, please Contact Us.
Attaul Hamid
Disclaimer:
The contents of this article are written and published to provide general information and are not intended to substitute advice. As individual circumstances, which may be applicable in a specific situation, have not been addressed in this article, readers seeking specific advice may find the information misleading. Such readers are encouraged to consult a professional to obtain complete and relevant advice related to their situation. We have made every effort to prepare the information with care. However, we do not accept responsibility for its use and any outcome arising out of its use. Where opinions are expressed, such opinions do not reflect the facts of the subject matter and should not be considered as advice or recommendation(s).