A home is often the single largest purchase made by many Canadians. Over time, the value of this asset can appreciate significantly. It is well known that the sale of a home designated as a "principal residence" often results in no taxes being payable on the appreciation of the home for Canadian tax purposes.
But what is a "principal residence" and who qualifies to claim the "principal residence exemption"? These and other tax and estate planning considerations associated with owning a personal residence will be addressed in this article.

A great number of Canadians own their own home, whether it is a condominium, townhouse, semi-detached or detached house. In many cases, a family may own more than one home. On the sale of any of these properties, a significant tax liability may be incurred unless the principal residence exemption can be applied to eliminate or reduce the amount of the tax liability.

So What Qualifies as a Principal Residence?

A principal residence can include a house, condominium, cottage, mobile home, trailer, houseboat, or shares in a co-operative building. In addition, the land on which the housing unit is situated is generally considered to be part of the principal residence provided that the land the principal residence is located on is less than ½ hectare. In the case of a farm property, the residential unit situated on the farm property along with the surrounding 1/2 hectare may be considered as the principal residence. Land in excess of ½ hectare is generally not considered as part of the principal residence unless it is necessary for the use and enjoyment of the housing unit. There are a few instances where the land in excess of 1/2 hectare will be considered necessary for the use and enjoyment of the housing unit. Examples of where this may occur include local municipal zoning by-laws requiring minimum residential lot sizes exceeding ½ hectare, or where the excess land was required to provide access to and from public roads.

To designate a property as principal residence, an individual must own the property, either solely or jointly with one or more other individuals. In addition, the owner, his or her spouse, former spouse, or children must also ordinarily inhabit the residence during some part of the year. The definition of spouse under the Income Tax Act includes a common law spouse which includes a same or opposite sex partner who cohabited with the owner in a conjugal relationship for a continuous period of no less than 12 months.

A cottage property used by the family during the summer can qualify as a principal residence unless the main reason for owning the property was to gain or produce income, then there may be some exceptions. If an elderly surviving parent moves into a nursing home and his or her home is subsequently occupied by one of the children, then that home will continue to be the principal residence of the parent.

Where an ex-spouse lives in the home owned by the other ex-spouse, such property qualifies as the principal residence of the ex-spouse who owns the property. For example, if former spouse A lives in the home owned by former spouse B, former spouse B can continue to designate that home as his or her principal residence even though former spouse B does not live there. Vacant land on which a home is subsequently built will not qualify as a principal residence until such time as the home is inhabited. A portion of the home can be rented or used as a home based business without impairing the ability to designate the entire property as a principal residence provided that the main use of the property is for residential purposes. In addition, there must be no structural change to, and no capital cost allowance (depreciation expense) claimed on the portion of home that is rented or used as a home based business. If the home has been structurally altered for the purpose of earning income, or if capital cost allowance has been claimed, then the portion of the home so affected will cease to qualify as a principal residence.

A principal residence that was subsequently converted to a rental or other income producing property can still be designated as a principal residence for a period of up to four years subsequent to the conversion provided that no capital cost allowance was claimed on the property during this period. The owner must also file an election with the Canada Customs and Revenue Agency ("CCRA") (formerly Revenue Canada). The four year period can be extended indefinitely if the owner or the owner's spouse is required to relocate due to changes in their employment location with their employer. As well, once such employment ceases, the owner resumes ordinary inhabitation of the home. If a property was initially acquired to earn income, and the owner later personally inhabits the property, the preceding period during which the property was owned and used as an income producing property can also be treated as a principal residence for a maximum period of four years. Again, an election must be filed with CCRA and no capital cost allowance can be claimed on the property during that period.

Each family unit may designate only one residence as their principal residence per year after 1981. A family unit includes the owner, his or her spouse (except where the spouse was throughout the year living apart from, and separated under a court order or written separation agreement), and unmarried minor children. In the year two individuals become spouses of each other, each person can still designate a separate principal residence for that year. Prior to 1982, each member of the family unit may designate a separate home as his or her principal residence each year.

Principal Residence Exemption

The gain arising from the sale of a home is the difference between the proceeds of sale minus the adjusted cost base (normally the purchase price plus cost of any capital additions). This capital gain can be reduced if a capital gains election was applied to the home as of February 22, 1994, as part of the elimination of the $100,000 general capital gains exemption (note that the time period to make a late capital gains election has expired). The gain can further be reduced or eliminated through the application of the principal residence exemption, which is discussed below. If the sale of a principal residence results in a loss, such loss can't be claimed as a personal residence is considered a personal use property.

The amount of the capital gain on the sale of a property that can be reduced through the principal residence exemption may be approximated by the following formula:

1 + numbers of years designated as principal residence x capital gain number of years the property is owned.

Where only one home is owned by a family, that home will be the family's principal residence and any gain arising from the subsequent sale of the home will be reduced to nil based on the above formula. If more than one home is owned concurrently for any period after 1981, and each of the homes qualifies as a principal residence, then the
following should be considered in applying the principal residence exemption:

• the home with the greatest average annual increase in value should be designated as the family's principal residence for the maximum number of years
• the maximum number of years that a property should be designated as the principal residence is the number of years of ownership minus one (due to the bonus year in the numerator of the formula)

For example, Mrs. Jones acquired a home in the city in 1987 for $50,000. In 1992, she purchased a cottage also for $50,000 which her family uses during the summer. The fair market values today (2001) for the home and the cottage are $125,000 and $80,000 respectively. Mrs. Jones is thinking of selling both properties this year.

As the city home is the only residence owned by Mrs. Jones between 1987 and 1991, this home must be designated as the principal residence for these 5 years. For the ten year period between 1992 and 2001, Mrs. Jones can designate either the city home or the cottage as her principal residence each year. The average annual increase for the city home is $5,000 per year [($125,000-$50,000)/15 Years] and $3,000 per year [($80,000-$50,000)/10 years)] for the cottage. Mrs. Jones should therefore designate the city home as her principal residence for 9 out of the possible 10 years. She need not designate it for the entire 10 year period since the principal residence exemption formula only requires the city home be designated as principal residence for 14 out of the 15 years to exempt all gains (due to the additional one year in the numerator of the above formula).

Mrs. Jones can designate the cottage as her principal residence for the remaining year. This way, not only will the gain on the sale of the city home be exempt from tax, Mrs. Jones can also apply the principal residence exemption to reduce 20% [(1+1)/10] of the taxes payable on the sale of the cottage. How is a Home is Designated as a "Principal Residence" The designation of a property as a principal residence is made on Form T2091 (IND), Designation of a Property as a Principal Residence by an Individual (other than a personal trust), which is completed and filed with the tax return for the year in which the property was disposed of. However, this form need not be completed unless a capital gain on the disposition of the property remains after using the principal residence exemption formula described above, or if Form 664 was filed previously to report a capital gain on property owned at the end of February 22, 1994. If a principal residence exemption formula is applied to eliminate the capital gain on the disposition of a property without filing the Form T2091, that property will be considered to have been designated as the principal residence for the years in question. This may have the effect of excluding another property that was owned during the same period, and which had a higher average annual price appreciation, from being designated as the principal residence for the same period. It will also mean that the additional one year in the numerator of the formula may not be accessible for the next property. It is therefore suggested that a T2091 be filed whenever a property is disposed of in cases where more than one property is owned at the same time.

Non Residents

The principal residence exemption is generally only available to Canadian residents. An individual who ceases to be a Canadian resident can not claim the principal residence exemption on a property for any year subsequent to the year of becoming a non-resident.

Thus because of the bonus year in the formula, a portion of the gain from the sale of the principal residence will be taxable if the individual is not a resident of Canada for two or more calendar years.

Ownership of the Home by a Trust

A trust relationship is a relationship between the trustee and the beneficiary. The trustee holds legal ownership to the property for the benefit of the beneficiary who is the beneficial owner of the property. If a trustee disposes of a property that is
part of the trust assets, and the property was inhabited by a beneficiary of the trust, a beneficiary's spouse, or a beneficiary's children, then the trustee may be able to utilize the personal residence exemption to exempt or reduce any resulting gains.

For each year that the trustee designates such property as principal residence, the beneficiary and members of his or her family unit is prohibited from designating another property as their principal residence.

If a trustee distributes a property to a beneficiary in satisfaction of the beneficiary's capital interest, the trustee is deemed, subject to certain exceptions, to distribute the property at the trust's cost. The receiving beneficiary will acquire the property at the same cost. In this case the trustee will not claim the principal residence exemption since there is no benefit to do so. When the property is subsequently sold, the beneficiary may claim the principal residence exemption for those years that the trustee owned the property if the beneficiary, the beneficiary's spouse, or the beneficiary's children had lived on the property while the trustee owned the property.

Deduction of Mortgage Interest

It is not uncommon for individuals to borrow to invest by mortgaging their principal residences. If the borrowed money is used directly to earn business or investment income, the interest paid on the mortgage may be deductible. An individual who comes into a large sum of money and wishes to invest may first want to consider paying down the
mortgage. The individual can then re-mortgage the home and use the borrowed funds to invest. This way, interest paid on the mortgage may be deductible. The mortgage interest will not be deductible if the individual invests the sum directly without first paying down the mortgage. The reason is that it is the actual and direct use of the borrowed money that will determine whether the interest paid may be deductible.

Inheritance Issues

Provincial family law legislation generally provides for a division of family assets between the spouses upon a marriage breakdown. However certain items, such as gifts and inheritance received during marriage, generally do not form part of the family assets and therefore, are not subject to division upon a subsequent marriage breakdown. This exclusion from family assets may be lost if monies received from a gift or inheritance was used to pay down the mortgage on a matrimonial home. If this is a concern to the spouse receiving an inheritance, they should obtain independent legal advice from a qualified family law lawyer as every province has their own unique rules.

Estate Planning Considerations - Joint Ownership with a Non-Spouse

A frequent question often asked by a surviving spouse who wishes to avoid probate fees or to simplify the administration of the estate is whether or not to register title to their principal residence in joint names with their children. While probate fees can be avoided by the creation of a true joint tenancy, other unintended consequences can also result. By registering the principal residence in joint names with an adult child, the child is deemed to have acquired 1/2 interest in the client's principal residence. On a subsequent sale, the child may be liable for tax on 1/2 of any resulting gains since the principal residence exemption will not be available to the child unless he or she lived in the home. The child's 1/2 interest in the home may also be exposed to marital or creditor claims. To circumvent such adverse consequences, some advisors have recommended that their clients transfer only the legal title to their principal residence and not the beneficial title to their children. It should be pointed out that if this is the case, the client's objective of avoiding probate taxes may be defeated since no true joint tenancy will have been created. Furthermore, there could be legal and other costs (such as land transfer fees) involved for changing legal ownership of a property.

Note: The above information is based on the current and proposed tax law in effect as of the date of this article. The article is for information purposes only and should not be construed as offering tax advice. Individuals should consult with their personal tax advisors before taking any action based upon the information contained in this article.

This article provided by Roman Hahn at RBC Investments.