Top 10 questions we are asked: The Principal Residence Exemption

1. What is the principal residence exemption?

The principal residence exemption generally allows you to sell your home, i.e., your principal residence, without paying tax on any increase in the home's value. In most situations, when these assets increase in value, the resulting capital gain is partially taxable. The principal residence exemption allows you to shelter the capital gain on your home.

2. What is a capital gain and how much is the capital gain tax?

A capital gain is the resulting profit from the sale of an asset for more than you purchased it. There isn't really a separate capital gain tax, nor a capital gain tax rate. Rather, when property is sold resulting in a capital gain, a portion of that gain is included in your income. This is called the capital gain inclusion rate.

When a portion of a capital gain is included in your income, it is taxed accordingly at your tax rate. This is determined by your total income from all sources and can vary considerably from one person to the next. That is, although the capital gain inclusion rate may be the same, the resulting tax rate and tax payable will vary from one person to the next.

3. What were the changes to the way capital gains are taxed?

Until recently, the capital gain inclusion rate was 50%. As explained in #2 above, this does not mean that the gain is taxed at a rate of 50%. Rather, it means that 50% of the gain is included in your income and taxed accordingly. As of June 25, 2024, the capital gain inclusion rate has changed, and is now as follows:

• One-half (50%) of the first $250,000 in capital gains you earn during the year, plus
• two-thirds (66.67%) of any further capital gains.

As we can see, for large capital gains above $250,000, this change results in a higher tax bill. With many homes across the country having increased significantly in value in recent years, the principal residence exemption is now even more valuable.

4. What is a principal residence?

There are a few conditions that must be satisfied for a property to be designated as your principal residence. For example, you must own it, either alone or with someone else. You and/or your spouse or common-law partner must also “ordinarily inhabit” it – so, you must live in it for at least some of the year. Beyond that, the definition encompasses a lot of different types of housing units. Your principal residence may be a house, apartment or unit, cottage, mobile home, trailer, houseboat, leasehold interest in a housing unit, or share of the capital stock of a housing corporation.

If the total area of the property that contains your home is less than one-half hectare, the land automatically counts as part of the principal residence. However, larger properties must prove the housing unit needs the excess land to “properly fulfill its function as a residence.”

5. How do I designate my home as a principal residence?

There’s no need to designate your home as a principal residence until you sell it. At that point, you must file both Schedule 3, Capital Gains (or Losses) and Form T2091IND, Designation of a Property as a Principal Residence by an Individual (Other Than a Personal Trust). If you don’t do this reporting, you cannot apply the principal residence exemption and you’ll have to pay tax on the capital gain that results from the sale.

If you didn’t fill out these forms in the year you sold your home, you can request an amendment to that year’s income tax return. The Canada Revenue Agency (CRA) may allow a late designation, although it is not guaranteed, and a penalty may apply.

6. Can I claim the principal residence exemption more than once?

Yes. You can only claim one principal residence per calendar year, but there is no limit to the number of times you can claim the principal residence exemption in your lifetime – after all, people change homes throughout their lives. That said, property flipping (see #9 below) is explicitly excluded and does not qualify for the principal exemption. Attempts to claim the principal residence exemption more than once within a small number of years may attract scrutiny from the Canada Revenue Agency (CRA).

It's also important to note that if you are married or in a common law relationship, there can be only one principal residence between the spouses or partners. You cannot, for example, claim the principal residence exemption on your house and your spouse or partner claim the exemption on the cottage. That isn't allowed. Similarly, if you are single, you can only designate one property as your principal residence. So, if you own multiple properties, any property other than your principal residence will be subject to capital gains tax when you sell it.

7. What if my home was my principal residence for only some of the time I've owned it?

If your home doesn’t qualify as a principal residence for every year you've owned it, you can still benefit from a partial principal residence exemption. For example, you may own and live in a home (your principal residence) for a period of time, but then decide to live elsewhere for a few years while renting out your place to someone else. In this scenario, the years when you are not living in your home do not qualify for the principal residence exemption. You may, however, still claim a partial exemption.

Principal residence exemption formula

The formula to calculate the capital gains inclusion rate for property that was your primary residence for only part of the time you owned it is as follows:

Capital Gain x (Eligible Number of Years as Principal Residence + 1) / Number of Years Owned

Although you can only have one principal residence in any given year, the “plus one” is in the formula to accommodate the principal residence exemption on both properties in the event that you sell one house and buy another within the same year.

8. How do I calculate capital gain if I rent out a room or operate a business from my house?

If you use a portion of your home to earn or produce income, you can still benefit from a partial principal residence exemption. For example, you may rent one of the bedrooms, and operate a daycare in the rec room. In this scenario, although you still live in the home, some of the space in your home does not qualify for the principal residence exemption because you’re using it for other purposes. You may still claim a partial exemption, which is calculated in one of two ways:

Square Metres Not Used as a Principal Residence / Total Square Metres of Home

or

Number of Rooms Not Used as a Principal Residence / Total Number of Rooms in Home

When you sell the home, this percentage will be used to calculate the capital gain (and resulting tax) on the part of your home that isn’t a principal residence.

9. How does property flipping work with the principal residence exemption?

Property flipping goes against the spirit of the principal residence exemption. The intended purpose of the principal residence exemption is to allow Canadians to enjoy the appreciated value of the home they live in without building up a tax liability. On the other hand, frequently buying, renovating, and selling properties to make a profit is more like operating a business, in the eyes of the Canada Revenue Agency.

As of January 1, 2023, there are new rules if you own a housing unit (including a rental property) for fewer than 365 consecutive days. In most cases, any rise in value will not qualify for the capital gains exemption and, moreover, will be taxable as business income rather than a capital gain. There are exceptions to this rule, for example moving due to a relationship breakdown, a serious disability, illness, a threat to personal safety as in the case of domestic violence, or relocation for work or school. But even then, it becomes “a question of fact” subject to the Canada Revenue Agency whether the profits are taxable as a capital gain or as business income.

It's important to make decisions informed by good tax advice if you’re contemplating property flipping.

10. How does the principal residence exemption work after death?

In general, when someone dies, a “deemed disposition” treats all their property as if they had sold it just before death. Regarding your principal residence, what happens next depends on your relationship status and how the house is owned.

If the home Is owned jointly with a spouse or common-law partner, the home can transfer to that person with no tax consequence. Furthermore, assuming the home remains the survivor’s principal residence, it will qualify for the principal residence exemption when sold or when the survivor passes away. In this case, there is no requirement to make a principal residence designation upon the death of the first spouse or partner.

For single individuals, the deemed disposition upon death includes the principal residence. The principal residence exemption is still available, and to ensure proper reporting, the executor of the estate must generally complete Schedule 3, Capital Gains (or Losses) and Form T1255 and file them with the deceased’s final tax return. If the home is left to other beneficiaries, such as your children, any further gain from that point onward is taxable in their hands, unless they make the home their principal residence.

How we can help

Whenever you’re making decisions that affect your financial life, including how to apply the principal residence exemption, it’s a good idea to ask an advisor for guidance and a tax professional.