The Principal Residence Exemption

A house is often a person’s most valuable asset, making the principal residence exemption the biggest tax break most people can get. What most people are not clear about is when your house can be considered your principal residence. For example:

• If I rented out a part of my house, can I still claim a principal residence exemption? (yes, but it depends)
• I started renting out my house and no longer live there, does that mean I have made a deemed disposition of my principal residence? (no, but it depends)
• If I only lived in the house for a few days in a year, can it still be considered my principal residence? (yes, but it depends)

They key is always in the details and hopefully this post will shed some light on when the principal residence exemption is actually applicable.

First of all, all this information is freely available in the CRA’s Income Tax Folio S1-F3-C2 on the topic of principal residence. Be forewarned that it is a length webpage but it is thorough and may cover specific situations not covered in this post. It should be noted that from a legal perspective, the CRA Income Tax Folio’s are only the CRA’s interpretation of the Income Tax Act. When we create a tax plan or represent you in a tax dispute, we also rely on case law and other legal arguments which produce a more favourable interpretation of the Income Tax Act specific to your situation. If you have a specific situation in mind please contact us.

With that being said, let’s go over some topics that frequently come up when we talk about the principal residence exemption.

The principal residence exemption only exempts capital gains

You should keep in mind that if the CRA claims that the sale of your property resulted in business income and not capital gains, then the principal residence exemption will not apply whether you lived in the property or not. This is because a precondition for the exemption is that the income must be a capital gain.

The CRA may reassess a sale as business income based on several factors which they use to imply a house flipping transaction. Not only would you lose the exemption, but 100% of the profit will be taxes based on your marginal tax rate and you will liable to pay HST/GST with interest.

Ownership considerations

To claim the principal residence exemption on the sale of a property you must own the property. This might seem obvious but there are several further implications.

In a situation where the title of the property is held as joint tenants between several people; upon the sale of the property, the capital gain will generally be split between the parties equally. The principal residence exemption will only be available to the taxpayer who can meet the requirements to designate the property as their principal residence. The same applies for property owned as tenants-in-common subject to whatever percentage ownership on title.*

Who can use the principal residence exemption?

You can only designate one principal residence for a particular tax year for your family unit. Note that it is family unit and not individual, this has both advantages and disadvantages. Advantage, you can designate a property you do not live in, but a member of your family unit lives in, as your principal residence. Disadvantage, you cannot designate multiple principal residences among your family unit.

A family unit consists of:

• You
• Your spouse or common-law partner throughout the year, unless the spouse or common-law partner was living part due to a judicial separation or separation agreement.
• Your child, except those who are married, in a common-law partnership, or 18 years or older.
• If you are 17 years or younger and are not married or in a common-law partnership: your parents and siblings who are not married, in a common-law relationship, or 18 years or older.

The ordinarily inhabited rule

This is usually where people get confused because there is a lot of grey area in determining whether a property is ordinarily inhabited by a member of your family unit. There is the obvious situations, where you live at the property throughout the ownership period. But depending on the circumstances, the exemption could also be applicable if your child intended to live in the property but never got the chance. It comes down to the reason you owned the property in the taxation year you are claiming the exemption. But since people very rarely write down the exact reason we do certain things, we can usually only offer circumstantial evidence that hints at the reason. This is why record-keeping for these tricky situations is so important and why a dispute with the CRA requires very careful and structured arguments.

Generally speaking, if the evidence shows that the main reason you owned a property is for profit or income production, then it will generally not be considered ordinarily inhabited; the capital gain attributed to that year may not be exempted by the principal residence exemption. Or if the evidence suggests that the property was acquired with the intention of flipping for a profit, the entire gain may be considered business income.

What if I rented out only a part of my home?

This is another grey area. The general rule is that if you are renting out a part of your principal residence, then that portion of the property is not covered by the exemption. For example, this would apply if you had a commercial store front as part of the property.

There is an exception for people who rent out their basement or a bedroom in their house. If the following conditions are met, the principal residence exemption will apply to the entire property:

• The income-producing use is ancillary to the main use of the property as a residence.
• There is no structural change to the property to make it more suitable for rental purposes.
• No Capital Cost Allowance is claimed on the property.

Change in use

When you go from living in your property to renting it out, there is a change in use. For tax purposes under s45(1) of the Income Tax Act, you are deemed to have disposed of it at fair market value and reacquired it at the same price. This deemed disposition updates your adjusted cost base for calculation future capital gains which will not be shielded by the principal residence exemption. You are required to report this change oinuse in the tax filing of the year of the change.

There are two ways to postpone the deemed change of use from principal residence to income property:

1. A s45(2) election which allows you to keep the principal residence declaration on the property even after you move out for up to four years, and
2. S54.1 also allows the principal residence exemption if you move due to requirements to relocate due to employment.

Both of these are extremely valuable in tax planning but there are specific requirements and there may be adverse tax consequences. The links above will go to a post with more details.

You can also postpone a change of use deemed disposition when going from an income property to your principal residence with a s45(3) election. In this situation, the property may be designated as the principal residence for a period of up to four years before the change of use. This election too has its own set of requirements.

If you have any further questions, please contact us.

Information current as of December 4th 2020.

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* Off-topic but I think it bears mentioning. This is an especially important consideration in an estate plan. In an attempt to avoid probate fees, some people might want to include a child on title of their principal residence as a joint tenant. But if this occurs, the transferring parent will be deemed to have disposed of half their interest in the property and any gain on the half owned by the child will no longer be subject to the principal residence exemption if the property is not the child’s principal residence. The taxable portion of the capital gain could be significantly more than any probate fees saved.