For many Canadians, real estate is the single largest investment in their financial portfolios. Investors own homes, vacation properties and rental properties, and may have broader exposure to real estate markets through their investment portfolio. This first article of a two-part series will discuss some of the common tax considerations for Canadian resident individuals who own Canadian real estate, specifically the principal residence exemption and tax considerations for rental properties. Please note that this summary may not apply to non-residents, corporate investors, or real property located outside of Canada.
What is the principal residence exemption?
Individuals are generally required to pay capital gains tax when they sell real estate that has increased in value. If that real estate is considered a principal residence, however, the individual may be able to claim the principal residence exemption to reduce or eliminate this capital gains tax.
Your family, including your spouse or common-law partner and any unmarried minor children, can designate only one property to be your family’s principal residence for each year. For family units that own and occupy only one property at any given time, this is fairly straightforward. Proper planning is essential, however, if your family owns more than one property. Despite being called the “principal residence” exemption, nothing requires you to use it on your primary home. For some Canadian investors, it will make financial sense to use the exemption on a vacation home or a rental property instead.
Can a vacation property be considered a principal residence?
A vacation property can be your principal residence for a year if it meets three requirements. First, you must own the property personally. Second, you must designate it as your family’s only principal residence for that year. Finally, any one of you, your spouse, your common-law partner or your child must have “ordinarily inhabited” the vacation property in the year.
It may not be obvious, but even occasional use of a vacation property can be enough for you to “ordinarily inhabit” it, as long as the property’s primary use is personal. Canadian tax legislation does not require you to use the property for any particular length of time in order to meet this test. In many cases, even a few weeks of use in a year will meet this threshold, as long as you are using the property in a habitual or ordinary fashion. You should consult with your tax advisor to confirm whether your vacation home can be your principal residence.
Can rental properties have a principal residence exemption?
A rental property typically cannot be your principal residence, except for in rare cases such as where you lease the property to your child. You may be able to use the exemption, however, where the real estate has been used as a rental property during some years and as a principal residence during others.
When you begin to use a rental property for personal use, you are generally required to pay capital gains tax on any accrued gain immediately. If you convert the rental into your principal residence, though, you can choose not to trigger that gain by filing an election. Not only does this election avoid the immediate tax bill, it also enables you to treat the rental property as your principal residence for up to four preceding tax years, including years in which the property was rented. This can provide a significant benefit if your rental property has increased in value since it was acquired.
This result is only available if you are proactive with your planning. Most taxpayers deduct capital cost allowance (depreciation) against their rental income, but if you claim depreciation on a rental property, you are forever barred from using this special election on that property. If you have any plans to use your rental property for personal use in the future, you may wish to talk with your tax advisor about whether it makes sense to claim depreciation each year.
There are similar rules in the reverse situation, where a taxpayer decides to convert their home into a rental property. Ordinarily, individuals must recognize any accrued gains on their home up to the time they began using it for income-earning purposes. Once again, a taxpayer can file an election, which will defer this gain until the property is sold and allow the taxpayer to continue claiming the property as their principal residence for up to four years after it begins being used for rental purposes. These four years are in addition to any years in which the property was actually used as a residence by the taxpayer. As long as this election is in effect, however, the taxpayer will not be able to claim depreciation against their rental income. Once again, proactive planning with your tax advisor is crucial to maximize your benefit.
How much of your land can qualify for the principal residence exemption?
The principal residence exemption applies to both the building and the land under it, but there are limits to how much land can qualify for the exemption. The exemption can be used for the land directly beneath your residence and up to half of a hectare of surrounding land, if that land is reasonably necessary for the use and enjoyment of your residence. If your land area exceeds half of a hectare, you can still use the exemption on the excess amount, but only if you can prove that excess land is necessary to the use and enjoyment of the building. This is difficult to prove, but it could apply if, for example, a minimum lot size or subdivision restriction exists.
When should I use the exemption?
Only one property can be declared as your family’s principal residence each year. If you own more than one home, you must decide which one should get the exemption each year. This decision is made at the time you dispose of one of the properties.
The exemption reduces your capital gain on a percentage basis, based on how many years you claimed the property as your principal residence compared to how many years you owned it. If you were resident in Canada when you originally bought the property, you are treated as if it was your principal residence for one extra year. This is designed to give you credit for cases where you buy one home and sell another in the same year, since you can only claim one of those homes as your principal residence that year. For example, if you own a house for 10 years and designate it as your principal residence for six, your gain will be reduced by (6+1)/10 or 70%. If the gain was $100,000 over that 10-year period, you will only need to recognize $30,000 of the gain.
There are no easy answers for which property should get the exemption. If your goal is purely tax savings, you may wish to use your exemption on the property that you expect will have the largest average annual gain. That said, it is difficult to predict which property will have the highest average gain per year until you actually sell all of your properties. It may also make sense to use the exemption on a smaller gain in situations where you sell one property and plan to hold the rest for an extended period, because it can help to defer your eventual tax bill. For example, imagine a case where a couple plans to live in their home for the next 30 years, but buys a a condo for their child to use for four years while attending university. Even if the matrimonial home has a higher average annual gain than the condo, it may make sense to claim the exemption on the condo when they sell it in four years, to eliminate the immediate tax on that sale. They will not be able to use the exemption on their house for those years, but the tax on their house will not be triggered until they sell it in 30 years, anyways. The benefit of deferring their tax burden for 30 years could easily outweigh the loss of a few years of exemption on their house. Your best strategy is to have a proactive discussion with your tax advisor to make a plan that matches your life and financial goals.
Changes in 2016: reporting requirements and real estate held in a family trust
Prior to 2016, the CRA’s (Canada Revenue Agency) administrative policy did not require taxpayers to report the sale of a principal residence if the property was designated as the principal residence for every year it was owned. Such transactions must now be reported, even if the sale is tax-free. Do not overlook this compliance step or you could find yourself with unexpected tax consequences.
The federal government also restricted the ability for personal trusts to claim the principal residence exemption after 2016. Some trusts, like an alter ego trust or a spousal or joint-spousal trust, can still claim the exemption in isolated situations. Most family trusts, however, are not able to designate a property as a principal residence for tax years after 2016. If you have real property owned by a trust, you should discuss your plans with your tax advisor before selling the property.
The information provided in this article is a simplified general summary and is not intended to replace or serve as a substitute for professional advice. Professional tax advice should always be obtained when dealing with taxation issues as each individual’s situation is different. This information has been obtained from sources believed to be reliable but no representation or warranty, expressed or implied, is made as to their accuracy or completeness. This information is subject to change and ATB Securities Inc. (Member Investment Industry Regulatory Organization of Canada and Canadian Investor Protection Fund), ATB Investment Management Inc. and ATB Insurance Advisors Inc. reserves the right to change the information without prior notice, and does not undertake to provide updated information should a change occur. ATB Financial, ATB Investment Management Inc., ATB Securities Inc. and ATB Insurance Advisors Inc. do not accept any liability whatsoever for any losses arising from the use of this document or its contents.