Looking to buy that vacation home? Where will you get the extra cash? The principal residence exemption may help you; when you sell a home that qualifies as a “principal residence” – a significant amount of savings you can garner in tax savings.
If, during your lifetime, you and your spouse together have only ever owned one personal-use home at a time, you will usually be able to exempt all the capital gains on those sequentially-owned homes. However, if you and your spouse ever owned two personal-use homes during the same period – e.g. your “city home” and your “vacation home”, then at least some of the capital gains on one of those homes will eventually be subject to taxation.
When you sell the first home, you must decide whether you will designate it as your principal residence and exempt the capital gains on that first home, or whether you will pay the capital gains taxes on that sale so that you will be able to fully exempt the gains on your second home when you eventually sell it. This decision could be one of the most significant financial decisions you will make.
Definition and Rules
Tax legislation defines a “principal residence” as an accommodation owned by a taxpayer (either solely or jointly), and ordinarily inhabited by the taxpayer, the taxpayer’s spouse or common-law partner, former spouse or common-law partner, or child. Whether a property was “ordinarily inhabited” in a given year is determined based on the facts of each case, but generally, a property needs only to be inhabited for a short period of time in the year to meet the test. For example, you would be considered to ordinarily inhabit your vacation home even if you only used it during your annual vacations, as long as the vacation home was not primarily an income-producing (rental) property to you.
There are many types of properties that could qualify as a principal residence, including a house, an apartment, a cottage, a mobile home, a trailer, a houseboat, a farm, or a share in a co-operative housing corporation. For farms, the principal residence generally will be deemed to include the first ½ hectare of land on which the property is situated, and in certain cases can include surrounding land in excess of ½ hectare.
You can only designate one property as your “principal residence” for any given year, even if you own more than one property that could qualify. Also, you must share that designation with your spouse or common-law partner and your children under the age of 18. (Prior to 1982, spouses could “double up” on the principal residence exemption.) You don’t have to designate any property as your principal residence until you sell a property and want to claim the exemption.
In order to designate the property as your principal residence, you should attach Form T2091 (IND), Designation of a Property as a Principal Residence by an Individual (Other Than a Personal Trust) to your income tax return for that year. In situations when you were deemed to have disposed of the residence because you died, your legal representative must complete a T1255, Designation of a Property as a Principal Residence by the Legal Representative of a Deceased Individual and attach it to your terminal tax return.
However, these forms must only be attached to your tax returns when you have a taxable capital gain to report. In Quebec, you must attach Form TP/ 274 even if the capital gain is entirely exempt. If you own two homes during the same period that could qualify for the principal residence exemption, then at least some of the capital gains on one of those homes will be subject to taxation. When you decide to sell your first home, you must decide whether the principal residence exemption should be used on that home. To make that decision, you will need to estimate:
- the number of years you will continue to own and occupy the second home, and
- the future capital gain on the second home.
Example:
Anne and Henry are married, and they own two homes that could qualify as “principal residences” for all years of ownership – i.e. their “city home” and their “vacation home”. They purchased the city home 10 years ago and the vacation home 5 years ago. Their marginal tax rate, now and in the future, is and will be 40 %. Anne and Henry are selling the vacation home today and will realise a capital gain of $ 100,000. They will not be buying a replacement vacation home, but will continue to own their city home. They expect to continue tolive in the city home for a further 10 years, and when they sell it in 10 years time, they expect to realize a capital gain of $250,000.They have two choices.
Choice #1:
They could designate the vacation home as their principal residence for 4 of the 5 years they owned it, meaning that when they sell the city home, they will at most be able to designate it as their principal residence for 16 of the 20 years they will have owned it. On the vacation home sale, the exempt portion of the capital gain will = [$100,000 *(4 + 1)/5]=$ 100,000, meaning they will have a tax bill of $0. On the city home sale 10 years from now, the exempt portion of the capital gain will =[$250,000 * (16 + 1)/20] = $212,500, meaning they will have a tax bill of ($250,000-$212,500) * 50% * 40% = $7,500.
Choice #2:
They could designate the vacation home as their principal residence for 0 of the 5 years they owned it, meaning that when they sell the city home, they will be able to designate it as their principal residence for all 20 of the years they have owned it. For the vacation home sale, they will have a tax bill of $50,000 × 40% = $20,000. On the city home sale 10 years from now, the exempt portion of the capital gain will =[$250,000 * (19 + 1)/20] =$250,000, meaning they will have a tax bill of $0.In other words, it is a choice between paying $0 in taxes today and $7,500 in taxes 10 years from now, or paying $20,000 in taxes today and $0 in taxes 10 years from now.
In this case, it makes sense to use the principal residence exemption on the vacation home for 4 years of ownership. But if they expected they might sell the city home sooner or for a higher capital gain, it might have made sense to “save” the exemption to apply it to the city home.
Summary
As demonstrated, the principal residence exemption can yield significant tax savings when applied appropriately. For further information and advice, please contact your Investors Group consultant.
Written by Mohamad M. Sawwaf, CRP, CPCA
Financial Consultant and Division Director
IGM Financial Inc.
You may reach out to him at Mohamad.Sawwaf@investorsgroup.com.
Please note: this article is not a substitute for legal advice. This article provides general information that you may find helpful. You may wish to consult with a qualified professional financial or legal advisor, as appropriate.