We all love our homes. They are after all, a reflection of our personalities and tastes and where we feel most comfortable. In Canada, the expression “A Man’s/Woman’s Home is his/her Castle” has never been truer, as the cost of a basic home has seemingly become equivalent to the cost of a castle twenty-five years ago.
The blood, sweat and tears expended and the pure dollars spent purchasing, repairing and renovating our homes generally make our homes our single biggest purchase/investment. Thus, we cherish the fact that the gain on the sale of our home is tax-free (subject to the discussion below). Many Canadians rely on the equity accrued in their homes to partially or fully fund their retirements.
The mechanism for sheltering the capital gain realized on the sale of a home from personal tax is the “principal residence exemption” (“PRE”). The PRE is a formula provided in the Income Tax Act that if fully understood, may be used to gain a tax advantage in certain situations.
The actual calculation to determine your principal residence exemption is equal to:
The capital gain on the sale of your home
The number of years you have lived in your home (i.e. designated the home as your principal residence) plus 1
The number of years you have owned the property
If you have lived in your house from the time you purchased it to the date your sell it, the numerator will always be greater than the denominator by one year. If you have moved from one principal residence to another principal residence, the extra one year will be like a sixth toe, essentially useless.
But what if the housing market is not co-operating and subsequent to you purchasing and moving into your new house you cannot find a buyer for your old home? You may be forced to rent out your old home for a few years. Technically, under Canadian income tax rules the change from a principal residence to a rental property will trigger a deemed disposition of your house at its current fair market value (typically the appraised value). If you have always lived in your original house, the deemed disposition will not create an income tax liability due to the application of the PRE. However, you will be deemed to have reacquired your old home at a cost equal to the appraised value at the date you changed the use and any future increase or decrease in value will be a capital gain/loss when that property is sold.
A taxpayer who finds him or herself in the situation described above may be permitted to file an election known as a “45(2) election”. If filed, this election would prevent an immediate deemed disposition of your original home and allows you to treat the original house as your principal residence for up to four years as long as you don’t claim depreciation and you are resident in Canada, even though the property is being rented and you are not living in the property.
So, if you moved out and rented the original house for five years, that dangling one year in the formula above would prove useful, as you could claim the original house as your principal residence for the four years per the 45(2) election and the one extra year per the formula. Any gains realized on the sale of your original home during those years would be sheltered from tax.
The downside to utilizing the 45(2) election is that for the four years the original house is claimed as your principal residence, your new house cannot also be claimed as a principal residence, causing your new home to be partially taxable when eventually sold.
It should be noted that if you file a 45(2) election and rent the original house for more than four years, the election would continue to defer the deemed disposition of the property, however, when the house is eventually sold, a portion of the gain on the house would be taxable in the year you actually sold your house.
Under certain conditions where a move is for employment reasons and the new home is at least 40km from your original residence and you subsequently move back into the home the 45(2) election will not be required and your old home will continue to qualify as a principal residence.
You can only have one principal residence per family, so where you own a cottage and a house, you may have to play with the numbers to see which property has the largest gain per year. You would then designate as your PR the property which has the larger gain per year for the required number of years to fully offset the gain on that property. However, you would still have that dangling one year to use on the other property.
The principal residence exemption is typically an after-thought for most Canadians, buy a house, live in it, sell it and claim the exemption. However, as noted above, it sometimes can get very complicated to determine how to effectively use the exemption. In certain circumstances, care must taken to ensure that the PRE is fully maximized.
Where a reader owns more than one home for any of the reasons noted above, they are strongly encouraged to seek professional advice in dealing with this issue as there are numerous pitfalls and issues as noted above and the advice above in general in nature.
Mark’s writes the blog The Blunt Bean Counter. He is taxation and managing partner for Cunningham LLP, Chartered Accountants, Toronto and an alumni of Price Waterhouse. Mark has presented papers and spoken on accounting, business and taxation matters for the Canadian Bar Association and Law Society of Upper Canada, Canadian and Ontario Dental Associations, The College of Veterinarians of Ontario, The Ontario Psychological Association, Humber & Seneca College and Canadian Women in Communications Association. Has been quoted on taxation issues by the Lawyers Weekly, Canadian Lawyer Magazine, Financial Post and Globe & Mail
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