The Canada Revenue Agency has increased its vigilance of real estate transactions during the past several years, aiming to increase compliance on the part of those who sell properties without reporting the gain or profit, and not paying the resulting tax.
As a result, during the two years ended in June 2017, the CRA levied more than 1,000 penalties related to real-estate transactions, totalling $23.1 million. The highest individual penalty was nearly $2.5 million. Most of these were in Ontario and British Columbia, markets that the CRA had targeted because they have been the most active and expensive, and popular among foreign investors.
While the authorities are mostly investigating property flips (quick purchases and resales), sales by non-residents, and those who fail to pay sales tax on the purchase of a newly constructed (or substantially renovated) building, it also is keeping a closer eye on principal residence sales.
The basic rules governing the taxation of a principal residence sale have not changed, so your home indeed remains your castle, as the familiar expression goes. As has been the case for many years, the gain on the sale of a principal residence is not subject to capital gains tax.
However, beginning with the 2016 taxation year, home sellers are required to report the basic details of the sale of a principal residence when they file their income tax returns. Assuming the home qualifies as a principal residence, the gain is not to be reported as income.
The CRA (and Revenue Quebec) have always trolled for unpaid tax by monitoring real-estate transactions, including high-value home sales. However, until 2016 a tax-exempt home sale did not have to be reported, under the general philosophy of the self-assessment or honour system.
Changing a property’s designation
While most principal residence exemption claims are cut-and-dried situations, homeowners are permitted to designate other qualifying properties -- as long as only one property for a particular year is identified and ultimately claimed as such. You do not actually make a designation until the time comes to report a sale of a principal residence on your tax return.
A typical situation might be where you own both a city house and a country cottage, either of which qualify as a principal residence because you or an immediate family member, in the words of the Income Tax Act, "ordinarily inhabited" it. If you are contemplating selling both in the foreseeable future, it makes sense to determine which sale will generate the largest gain and designate it as the principal residence.
Such computations can become quite complicated if you avail yourself of a provision which permits you to assign the designation to one home or the other in individual taxation years. The reason for doing so might simply be based on renting out a home for a particular year. However, if you inhabited both properties during the periods of ownership, in theory you can cherry-pick the years to designate one or the other, thus tailoring your principal residence claim to your tax advantage. This article explains how in more detail.
However, doing so might attract unwanted scrutiny, forcing you to provide compelling evidence of each property’s value at various points in time, based on historical real estate values for comparable properties in their respective areas.
A more straightforward scenario might be more acceptable to the tax man. For example, you might allocate the principal residence designation to your city home up until you acquired a valuable country property, and then fully exempt the gain from the eventual sale of the latter under the exemption. (This assumes, of course, that the capital gain from the sale of the cottage would be greater than if you had sold the city house.) If at that point in time you still owned the city home, you could then exempt the portions of the gains in value on it during both pre-cottage and post-cottage years.
While the rules state that you can only designate one property for a full taxation year, for a year in which a property is bought or sold, both old and new properties can be deemed a principal residence for the entire year. Or if you sell your cottage and keep the city home, then both homes can be claimed under the exemption for the whole year.
Cottage challenges
A cottage can be eligible for the principal residence exemption under the ordinarily-inhabited rule, even if it is seasonal or otherwise not occupied for the entire year. However, use of the exemption can become challenging, typically if:
If a property is owned principally for the purposes of earning rental income, then it won’t qualify for the exemption, although it may still qualify if the tenant is an immediate family member. However, when a property’s use is changed from personal to rental, it is considered to be a deemed disposition, and tax would have to be paid on the on-paper gain.
“Renting out a home causes a change in use that can result in a deemed disposition, although tax on this paper gain may be avoided through use of the principal residence exemption,” says Diane Tsonos, an attorney and tax partner with Richter in Montreal.
If you switch a rental property to personal use, it also results in a deemed disposition, Tsonos says, but in this case (as the property would not be a principal residence), tax on the paper gain would generally be payable. “There are elections to defer the resulting tax, although these are not available if depreciation on the property has been claimed during the rental period.”
Property larger than half a hectare
Circumventing the half-hectare rule can be a more complicated undertaking. Normally only the land within one-half of a hectare surrounding the house is considered by the CRA to be part of a principal residence, and thus sheltered from capital-gains tax. But there is a key exception: additional adjacent land may be included to the extent the vendor can prove this land was necessary for the residence’s use and enjoyment. (“Enjoyment” does not include recreational use.) A prime factor in including extra land under the exemption is municipal lot-size regulations, such as minimum dimensions or area, or a subdivision or severance restriction. Arguments in favour of going beyond the half-hectare limit also might include access (the driveway traverses this land) or privacy (proximity to neighbouring lots).
Elements that support the use-and-enjoyment factor can only apply to years in which they applied. For example, if minimum lot size is the principal reason for exceeding the half-hectare limit, and the lot-size regulation was only in place for the past 10 years, the exemption on the full property would only apply to the value gain during those 10 years. Any gain prior to that would be subject to the half-hectare rule, barring any other factors.
Wrinkles for long-term owners
Until Dec. 31, 1981, both spouses (or a parent and a child) could each have a property designated as a principal residence. So the gains in value of two homes owned prior to 1982 can be sheltered under two separate exemptions. After that point in time, you would have to select one home or the other for tax protection, as per the existing rules.
Note, too that only gains accrued since the beginning of 1972 are to be reported, as capital gains tax did not exist before then.
As well, you may have claimed up to $100,000 of the gains on a property under a special election in 1994. In some cases, this could result in basing the capital gain from the eventual sale of that property on an adjusted cost base set at the end of 1994.
