Geoff McLean & Associates - Victoria's Real Estate Experts
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Financial Planning
Charley Tsai LL.B., CFP, Financial Planning Advisory
A home is often the single largest purchase made by Canadians and an asset that can appreciate significantly over time. In many cases, a family may own more than one home. On the sale of any of these properties, there can be a significant tax liability on the increase in the value of the home, unless the principal residence exemption can be applied to eliminate or reduce the tax liability.
This article addresses a number of tax and estate planning questions, including “What is a principal residence?” and “Who qualifies to claim the principal residence exemption?”
A principal residence can include a house, condominium, cottage, mobile home, trailer, houseboat or shares in a co-operative building. In addition, the land on which the housing unit is situated is generally considered part of the principal residence, provided that this land is less than half a hectare (approximately 1.24 acres). In the case of farm property, the residential unit situated on the farm property along with the surrounding half hectare may be considered a principal residence.
Land in excess of half a hectare is generally not considered part of the principal residence unless it is necessary for the use and enjoyment of the housing unit. There are a few instances where the land in excess of half a hectare is considered necessary for the use and enjoyment of the housing unit. Examples of this include residential lots where local municipal zoning bylaws require that minimum residential lot sizes exceed half a hectare, or where the excess land is required to provide access to and from public roads.
To designate a property as a principal residence, an individual must own the property, either solely or jointly with one or more individuals. In addition, the owner, their spouse, their former spouse or their children must also ordinarily inhabit the residence during some part of the year. The definition of spouse under the Income Tax Act includes a common-law partner (same or opposite sex partner) who has cohabited with the owner in a conjugal relationship for a continuous period of no less than 12 months.
The capital gain arising from the sale of a home is the difference between the proceeds of sale and the adjusted cost base. The adjusted cost base is normally the purchase price plus the cost of any capital additions. This capital gain can be reduced if a capital gains election was applied to the home as of February 22, 1994 as part of the elimination of the $100,000 general capital gains exemption. Note that the time period to make a late capital gains election has now expired.
The gain can be further reduced or eliminated through the application of the principal residence exemption, which is discussed below. If the sale of a principal residence results in a loss, such loss cannot be claimed as a personal residence is considered personal use property.
A capital gain realized on the sale of a property can be reduced through the principal
residence exemption by applying the following formula:
1 + numbers of years designated as principal residence
—————————————————————– x capital gain = tax-exempt capital gain
Number of years the property is owned
Where a family owns only one home, that home is the family’s principal residence, and any gain arising from the subsequent sale of the home will be reduced to nil based on this formula. If more than one home is owned concurrently for any period after 1981 and each home qualifies as a principal residence, then the following should be considered in applying the principal residence exemption:
For example, Mrs. Jones acquired a home in the city in 1987 for $50,000. In 1992, she purchased a cottage for $70,000, which her family uses during the summer. The fair market values today (2010) for the home and the cottage are $225,000 and $180,000 respectively. Mrs. Jones is thinking of selling both properties this year. As the city home was the only residence owned by Mrs. Jones between 1987 and 1991, she must designate it as her principal residence for these five years. For the 15-year period between 1992 and 2006, Mrs. Jones can designate either the city home or the cottage as her principal residence each year.
The average annual increases are approximately 7,292 per year [($225,000 – $50,000) ÷ 24 years] for the city home and approximately $5,789 per year [($180,000 – $70,000) ÷ 19 years)] for the cottage. Mrs. Jones should therefore designate the city home as her principal residence for 18 out of the 19 years she owned both properties. She need not designate it for the entire 19-year period as the principal residence exemption formula requires the city home be designated principal residence for only 23 out of the 24 years to exempt all gains (due to the additional one year in the numerator of the formula). Mrs. Jones can therefore designate her cottage her principal residence for the remaining year. In this example, not only will the gain on the sale of the city home be exempt from tax, the principal residence exemption could reduce the taxes payable when she sells her cottage.
How is a home designated a principal residence?
A home is designated a principal residence using form T2091(IND) � Designation of a Property as a Principal Residence by an Individual (Other than a Personal Trust). This form is completed and filed with the tax return for the year in which the property was disposed. However, the seller does not need to complete this form unless there is still a capital gain on the disposition of the property after using the principal residence exemption formula.
Form T2091(IND) should also be used if Form 664 was filed previously to report a capital gain on property owned at the end of February 22, 1994. If the principal residence exemption formula is applied to eliminate the capital gain on the disposition of a property without filing the T2091 form, that property will be considered the principal residence for the years in question. This means that another property that was owned during the same period and had a higher average annual price appreciation may not be able to be designated as the principal residence for the same period. It also means that the additional one year in the numerator of the formula may not be available for the next property. It is therefore advisable to file a T2091 whenever a property is disposed of if more than one property is owned at the same time.
The principal residence exemption is generally only available to Canadian residents. An individual who ceases to be a Canadian resident can not claim the principal residence exemption on a property for any year subsequent to the year of becoming a non-resident.
Thus because of the bonus year in the formula, a portion of the gain from the sale of the principal residence will be taxable if the individual is not a resident of Canada for two or more calendar years.
A trust is a relationship between the trustee and the beneficiary. The trustee holds legal ownership of the property for the benefit of the beneficiary. The beneficiary is the beneficial owner of the property. If a trustee disposes of a property that forms part of the trust’s assets and the property was inhabited by a beneficiary of the trust, a beneficiary’s spouse or a beneficiary’s children, then the trustee may be able to use the personal residence exemption to exempt or reduce any resulting capital gains. For every year that the trustee designates such property a principal residence, the beneficiary and members of their family unit are unable to designate another property their principal residence.
If a trustee distributes a property to a beneficiary in satisfaction of the beneficiary’s capital interest, the trustee is deemed, subject to certain exceptions, to distribute the property at the trust’s cost base, and the receiving beneficiary acquires the property at the same cost. In this case the trustee should not claim the principal residence exemption since there is no benefit in doing so. When the property is subsequently sold, the beneficiary may claim the principal residence exemption for those years that the trustee owned the property if the beneficiary, the beneficiary’s spouse or the beneficiary’s children lived on the property while the trustee owned the property.
Individuals often borrow to invest by mortgaging their principal residence. If the borrowed money is used directly to earn business or investment income, the interest paid on the mortgage may be deductible. An individual who comes into a large sum of money and wishes to invest may first want to consider paying down their mortgage. They can then remortgage the home and use the borrowed funds to invest. This way, interest paid on the mortgage may be deductible. The mortgage interest will not be deductible if the individual invests the sum directly without first paying down the mortgage. The reason is that the actual and direct use of the borrowed money will determine whether the interest paid may be deductible.
Provincial family law legislation generally provides for a division of family assets between spouses on the breakdown of their marriage. However certain items such as gifts and inheritances received during marriage generally do not form part of the family assets and may therefore not be subject to division upon a subsequent marriage breakdown. This exclusion from family assets may be lost if monies received from a gift or inheritance are used to pay down the mortgage on a matrimonial home. If you are a spouse receiving an inheritance and this is a concern, you should obtain independent legal advice from a qualified family law lawyer as every province has its own unique rules.
Estate Planning Considerations – Joint Ownership with a Non-Spouse
A question frequently asked by surviving spouses who wish to avoid probate fees or simplify the administration of an estate is whether or not they should register title to their principal residence in joint names with their children. While it may be possible to avoid probate fees in some circumstances by adding an adult child as a joint tenant with the right of survivorship, there can be other unintended consequences. As a result of two decisions in the Supreme Court of Canada in 2007, when an individual transfers assets such as a principal residence into joint ownership with adult children, there may be a number of potential outcomes from a legal and tax perspective.
The homeowner may wish to transfer a percentage of the legal and beneficial ownership of the home into joint names with adult children. This would result in a taxable disposition of the portion of the home transferred at the time of transfer (though it would be exempt from tax due to its principal residence status). On the death of the parent, their remaining share would pass to the surviving joint tenant(s) by right of survivorship without attracting probate fees.
If however the parent only wishes to transfer the right of survivorship and not the beneficial ownership of the proportionate share to their adult children, then there would be no disposition at the time of transfer, but the property would be transferred to the surviving joint tenant(s) by right of survivorship on the parent’s death without attracting probate fees. There would be a disposition for tax purposes at the date of death, but again, the principal residence exemption would apply.
Note: The above information is based on the current and proposed tax law in effect as of the date of this article. The article is for information purposes only and should not be construed as offering tax advice. Individuals should consult with their personal tax advisors before taking any action based upon the information contained in this article.
It is therefore important that a parent who transfers title to joint names makes their intentions clear and documents these intentions to avoid confusion as to the nature of the transfer that has occurred. In the event that the parent wishes to gift a share in the beneficial ownership at the time they add the joint tenant, the adult child will be deemed to have acquired an interest in the parent’s principal residence, to the extent of the portion transferred. On a subsequent sale, the child may be liable to pay tax on their share of any resulting gains since the principal residence exemption will not be available to the child unless they lived in the home. The child’s interest in the home may also be exposed to marital or creditor claims. It may be possible to avoid such adverse consequences by merely transferring a right of survivorship in their principal residence and not the beneficial title to their children. Furthermore, there could be legal and other costs (such as land transfer fees) involved in changing legal ownership of a property.
This article provided by Roman Hahn at RBC Investments.
