Canadian Taxes A to Z (2018): "P" is for Principal Residence Exemption

Today, "P" for for Principal Residence Exemption. Sixteen letters down. Ten to go!

PRINCIPAL RESIDENCE EXEMPTION MIGHT BE BEST TAX BREAK OUT THERE

The principal residence exemption may be the best tax break going for Canadians who own a home. As I've mentioned earlier in the alphabet, you usually must pay tax on capital gains just like on income gains (though at a lower rate). However, any capital gain on your principal residence is tax free. With home values in Canada generally rising at much faster rates than investment values, this can be a very profitable exemption!

COUPLE CAN TOGETHER ONLY HAVE ONE PRINCIPAL RESIDENCE

Prior to 1981, each spouse in a couple could designate a principal residence for the purpose of the exemption. So one could choose the cottage, and one the city home, and no one would pay tax on capital gains on either of them. However, since that time couples can only have one joint principal residence.

A couple could pick the cottage as the principal residence if they wish to avoid tax when it comes time to sell it, but for the years of its designation they would lose the exemption on their city home. So designating the cottage would probably only make sense if it had experienced a larger capital gain during the relevant period than the city home.

For a couple with a tiny city condo and a palatial waterfront cottage, picking the cottage sale to be tax free would make sense. But for most people, the city home is going to have risen more in value because it was more expensive to begin with. Picking the cottage as the principal residence would help defer tax payments for a while if it is sold prior to disposition of the city home, but if you plan to sell the city home at any time in the future the taxing of its capital gain would eventually catch up with you.

The most important requirement of the principal residence exemption is that the home must have been your principal residence for the entire time you owned it, not just at the time you are selling it. Otherwise, you'll need to take a percentage of a capital gain exemption equivalent to how long the home was your principal residence as compared to the total amount of time you owned the home.

Recent tax changes now require you to explicit claim the principal residence exemption in your tax filing.

DEATH & REBIRTH OF HOME OFFICE DEDUCTION FOR PRINCIPAL RESIDENCE

Especially controversial in recent changes was a Canada Revenue Agency fall 2016 principal residence exemption filing guide that seemed to suggest if you were claiming business use of home expense deductions for any portion of your principal residence, then the principal residence capital gains exemption would be reduced by a corresponding percentage. This could have had the effect for valuable properties of costing taxpayers hundreds of thousands in payable capital gains taxes, in exchange for only tens of thousands (at best) of home office expense deductions. 

At the end of February 2017 without any fanfare the CRA updated its website to now read: 

If only a part of your home is used as your principal residence and you used the other part to earn or produce income, whether your entire home qualifies as a principal residence will depend on the circumstances.

It remains the CRA’s practice to consider that the entire property retains its nature as a principal residence, where all of the following conditions are met:

• the income-producing use is secondary to the main use of the property as a residence;
• there is no structural change to the property;
• and no capital cost allowance (CCA) is claimed on the property.

If your situation does not meet all three of the conditions above, you may have to split the selling price and the adjusted cost base between the part you used for your principal residence and the part you used for other purposes (for example, rental or business). 

Thus the home office deduction appears to have been saved! And claiming CCA on a home was always a bad idea anyway, even if legally permissible, because of the massive recapture that might be triggered at selling time. 

Gordon S. Campbell is a tax lawyer practicing throughout Canada who has argued tax cases as high as the Supreme Court of Canada. Learn more at acmlawfirm.ca/taxlaw.