The Principal Residence Exemption (PRE) is a crucial tax benefit in Canada that allows homeowners to avoid paying capital gains tax when selling their primary residence. For most Canadians, the home is one of the largest investments they’ll make, and the PRE serves as a powerful incentive for homeowners, ensuring they can benefit from the appreciation of their property without facing a significant tax burden upon sale.
This exemption offers substantial financial relief, making homeownership more attractive and attainable. Understanding how the PRE works, and what qualifies a property as a principal residence, is key to making the most of this tax advantage. By taking the proper steps and maintaining eligibility, homeowners can significantly reduce or eliminate the capital gains tax on their primary home, helping them retain more of their hard-earned equity.
What Qualifies as a Principal Residence?
Definition of a Principal Residence
A principal residence is defined as a home that the owner or their family members “ordinarily inhabit” throughout the year. In other words, it must be the place where the homeowner, their spouse, common-law partner, or children typically live for all or part of the year. This definition includes not only traditional homes, such as single-family houses, but also a wide range of property types.
Key Requirements for Qualification
Several requirements must be satisfied for a property to be considered a principal residence:
- Ownership: The property must be owned by the taxpayer or their family members. Rental properties that are not used as a primary home generally do not qualify unless specific conditions are met, such as partial personal use.
- Ordinary Use: The property must be lived in regularly during the year, though it does not need to be the only property the family owns. This applies even if the home is only used seasonally, such as a cottage or vacation home, provided it meets the other requirements.
- Land Size Limitations: The property cannot exceed 1.24 acres of land unless the excess is necessary for the homeowner’s use and enjoyment of the residence. Larger properties may be subject to partial exemptions.
- Habitability: The property must be habitable and must be used as a home, not as a business or rental property for the entire period of ownership.
Types of Properties That Can Qualify
In addition to single-family homes, several other types of properties can qualify as a principal residence under the PRE:
- Condos and Townhouses: Urban residences are eligible as long as they meet the primary residence criteria.
- Cottages: Seasonal homes, such as cottages, can also qualify if the family uses them regularly for living purposes.
- Mobile Homes: These are included, provided they meet the general conditions for a principal residence.
How the Principal Residence Exemption Works
How Capital Gains Are Calculated on Property Sales
When a property is sold, any profit made from the sale is considered a capital gain. The capital gain is calculated as the difference between the selling price of the property and its adjusted cost base (ACB), which includes the original purchase price plus any associated costs, such as major renovations or legal fees. Normally, 50% of the capital gains are subject to tax. However, if the property qualifies for the Principal Residence Exemption, the homeowner can reduce or eliminate this tax.
Exemption Calculation: How PRE Reduces Capital Gains Tax
The PRE allows homeowners to claim an exemption on the capital gains made from the sale of their principal residence for each year the property was designated as such. The formula for calculating the exemption is straightforward:
The “+1” in the formula accounts for the year of sale, ensuring that even if the property was not the principal residence for the entire period of ownership, the homeowner can still benefit from partial tax relief. For example, if the homeowner lived in the house for eight out of ten years of ownership, they would still get an exemption for nine years (8 + 1).
Step-by-Step Guide to Claiming the Exemption
Claiming the Principal Residence Exemption is relatively simple, but homeowners must follow specific steps to ensure they receive the full benefit:
- Declare the Sale on Your Tax Return: As of 2016, homeowners are required to report the sale of their principal residence on Schedule 3 of their income tax return. Failing to do so may result in penalties or disqualification from the exemption.
- Complete Form T2091 (IND): This form is used to designate the years during which the property was your principal residence. It’s essential to accurately report the number of years the property was used as your principal residence, as this will determine the size of the exemption.
- Include Any Supporting Documentation: Keep records of the purchase price, renovation costs, and sale details, as these will be needed to calculate the adjusted cost base and the exemption amount.
- Seek Professional Advice: Given the complexity of tax rules and the potential financial impact of claiming the exemption incorrectly, it’s often wise to consult a tax professional.
Factors That Can Affect the Principal Residence Exemption
Impact of Owning Multiple Properties
Many Canadians own more than one property, such as a vacation home or rental property. However, you can only designate one property as your principal residence per year. If you own multiple properties, you need to choose which one will be considered your principal residence for that year. Typically, you would designate the property that has appreciated the most, as this strategy will yield the highest tax savings.
Partial Exemption for Mixed-Use Properties
If a portion of your property is used for business or rental purposes, you may still qualify for the exemption, but only for the part of the home used as your principal residence. For example, if you rent out the basement of your house, the exemption would apply to the part of the home you personally inhabit. The capital gains on the rental portion of the home would still be subject to tax.
In some cases, homeowners may convert their entire home from personal use to income-generating use, or vice versa. In these situations, the CRA allows for an election under section 45(2) of the Income Tax Act, which can preserve the homeowner’s PRE eligibility for up to four additional years during the rental period, provided no capital cost allowance is claimed.
Moving and Its Effect on PRE
If you move out of your principal residence but retain ownership, the PRE can still be applied for the year of the move and up to four years afterward, provided you don’t designate another property as your principal residence during that time. This is particularly useful for homeowners who relocate temporarily but intend to return to their original home.
Renting Out Your Home
Renting out your home can complicate the PRE. If you rent out your entire property, you risk losing the principal residence designation for those years, leading to potential capital gains tax liability when you sell the home. As mentioned, electing under section 45(2) can help homeowners maintain their PRE eligibility for a limited time, but this option is not indefinite.
Using Part of the Home for Business
If you operate a business out of your home, such as using a dedicated room as a home office, the PRE can still apply to the portion of the house used for personal living. However, if you make structural changes to your home (e.g., converting part of it into a full-fledged commercial space), that part of the property may no longer qualify for the PRE, reducing the overall exemption.
The Role of Family Members in the Principal Residence Exemption
Claiming the Exemption as a Family Unit
For tax purposes, the CRA considers a family unit to be the homeowner, their spouse or common-law partner, and any children under 18. The family unit is allowed to designate only one property as their principal residence per year, regardless of how many properties they own. This means that if both spouses own separate properties, they must choose which one will be designated as the principal residence for that year.
Impact of Children on the PRE
Children living with their parents also affect the principal residence designation. If a child under 18 owns a property, the parent or guardian may designate that property as the family’s principal residence for that year, even if the parents own other properties. This can be a strategic advantage for families who want to maximize their exemption, particularly if the child’s property has seen substantial appreciation.
What Happens When Family Members Inherit a Property?
Inheritance can complicate the principal residence designation. If a family member inherits a property, they cannot automatically claim the PRE unless they meet the residency requirements. For example, if you inherit your parents’ home but already own your own, you cannot designate both properties as principal residences during the same year.
Scenarios When the Principal Residence Exemption May Not Apply
Selling a Property Before Owning It for a Full Year
One common scenario that can affect the PRE is selling a home before owning it for an entire year. While the property can still be designated as a principal residence, the number of years the exemption applies may be reduced, potentially leading to a partial capital gains tax. The CRA generally expects homeowners to hold their primary residence for a reasonable period, and flipping properties frequently may raise red flags, resulting in scrutiny or denial of the exemption.
Properties Used Primarily for Rental Income or Business Purposes
If a property has been used primarily to generate rental income or as a place of business, the PRE may not apply. For instance, if more than 50% of the home is used for rental purposes, only the portion used as a personal residence would be eligible for the exemption. Similarly, if the home was purchased with the intent to run a business, the CRA may deny the PRE unless the homeowner can prove it was also used as a personal residence.
Changing the Use of a Property
Changing the primary use of a home, such as converting it from a personal residence to an investment property or rental unit, can also affect the ability to claim the PRE. When a homeowner makes such a change, they trigger a deemed disposition, meaning the CRA treats it as though the home was sold and immediately repurchased at fair market value. This can result in capital gains tax for the period when the property was used as a personal residence.
Selling a Home After Significant Renovations or Rebuild
If a homeowner undertakes substantial renovations or rebuilds a property before selling it, the CRA may view the sale as a business transaction rather than the sale of a principal residence. In these cases, the PRE may not apply, and the capital gain could be treated as business income, which is fully taxable. This typically happens when homeowners engage in property flipping or develop homes for profit.
Non-Resident Status
Homeowners who become non-residents of Canada may also face limitations on the PRE. If a property is sold after the owner leaves Canada, the CRA may not allow the exemption for the period of non-residency. However, in certain circumstances, a homeowner can maintain the PRE for up to four years after becoming a non-resident if they do not designate another principal residence during that period.
Common Misconceptions about the Principal Residence Exemption
Misconception 1: You Don’t Need to Report the Sale of Your Home
One of the most common misconceptions is that if you sell your principal residence, you don’t need to report the sale on your tax return. This was true in the past, but as of 2016, the CRA requires homeowners to report the sale of their principal residence on their tax return, even if no capital gains tax is owed. Failing to report the sale can result in penalties or the loss of the PRE.
Misconception 2: You Can Claim the Exemption on More Than One Property
Some homeowners mistakenly believe they can claim the PRE on more than one property at a time. For example, if you own both a house and a cottage, you must choose which one to designate as your principal residence for any given year. Claiming the exemption on multiple properties is not allowed, and attempting to do so can lead to tax penalties.
Misconception 3: You Can Flip Houses and Still Claim the PRE
Flipping houses, or purchasing a property with the intent to quickly resell it for a profit, does not qualify for the PRE. The CRA views property flipping as a business activity, meaning any profit from the sale is considered business income and is fully taxable. The PRE is intended for properties used as a long-term home, not for investment or speculative purposes.
Misconception 4: You Can Claim the PRE on a Property You’ve Never Lived In
Another common misunderstanding is that homeowners can claim the PRE on a property they own but have never lived in. To qualify as a principal residence, you or your family members must ordinarily inhabit the property. If you’ve never lived in the home, it cannot be designated as your principal residence, and any capital gains from the sale will be subject to tax.
Misconception 5: The PRE Automatically Applies to Inherited Property
While inheriting a property from a family member may seem straightforward, the PRE does not automatically apply. If the property was not the principal residence of the deceased or if the inheritor does not live in the property, it cannot be claimed under the PRE. Any appreciation in the property’s value after the inheritance is subject to capital gains tax unless it qualifies as the inheritor’s principal residence.
Misconception 6: You Can Rent Out Your Entire Home and Still Claim the PRE
Renting out your entire property removes its designation as a principal residence for the period it is rented. While partial rentals (such as renting a basement apartment) may still allow for partial exemption, renting out the whole home disqualifies it for the PRE unless a section 45(2) election is made, as previously discussed.
Real-Life Examples and Case Studies
Example 1: Family Downsizing from a Larger Home
The Thompson family lived in a large home for 15 years before deciding to downsize to a smaller, more manageable property. Over the years, the home’s value appreciated significantly, and when they sold the property, they made a substantial profit. Since they had lived in the home for the entire 15 years, it qualified as their principal residence for the full period of ownership.
The Thompsons were able to claim the full PRE on the sale of the home, meaning they paid no capital gains tax on the profit. By designating their home as their principal residence every year they owned it, they maximized their tax savings and retained more of the proceeds from the sale.
Example 2: Partial Exemption for a Rental Property
Samantha owned a house for 10 years but rented out the basement apartment for half of that time. She used the rest of the home as her personal residence. When she decided to sell the property, she had to account for the rental portion of the house.
The basement apartment did not qualify for the PRE, so Samantha was liable for capital gains tax on the portion of the home used as rental property. However, the main living area of the house, which she lived in full-time, qualified for the PRE, and she was able to claim the exemption on that portion. This allowed her to reduce her overall tax liability, even though the basement apartment didn’t qualify.
Example 3: Moving and Temporarily Renting a Property
John and his family lived in their home for 8 years before he was offered a job in another city. They decided to move but kept their original home and rented it out for 3 years while living in their new city. When John eventually sold the house, he was able to claim the PRE for the entire 8 years that he and his family lived in the home as their principal residence.
Because John filed an election under section 45(2) of the Income Tax Act, he was also able to preserve the principal residence designation for the first 4 years it was rented out. This election allowed John to defer capital gains tax for those 4 years, but he was liable for tax on the gains accrued in the final year of rental. Thanks to the election, John minimized the amount of tax he had to pay on the sale.
Example 4: Owning Multiple Properties
The Jones family owned both a house and a vacation cottage. For most of the year, they lived in their primary home, but they spent summers at the cottage. When they decided to sell the cottage, they were faced with a decision: Should they designate the cottage or the main house as their principal residence?
The cottage had appreciated more over the years, so they decided to designate it as their principal residence for the years they owned it. This allowed them to claim the PRE on the sale of the cottage and avoid paying capital gains tax on the substantial appreciation. They did not claim the exemption for their main house during those years, which resulted in a taxable gain when they sold that property later on, but the savings from designating the cottage as their principal residence outweighed the tax owed on their primary home.
Example 5: Inheriting a Principal Residence
Maria inherited her late mother’s home, which had been her mother’s principal residence for over 30 years. After inheriting the property, Maria decided to sell it. For the period during which her mother lived in the home, the PRE applied, and no capital gains tax was owed on that portion of the home’s appreciation. However, since Maria did not live in the house after inheriting it, the appreciation that occurred after her mother’s death was subject to capital gains tax.
FAQs on Principal Residence Exemption (PRE)
1. What happens if I own more than one property?
If you own more than one property, you can only designate one property as your principal residence per year. This applies to both the homeowner and their family unit (spouse and children). The property that is likely to have the highest capital gain should generally be designated as the principal residence to maximize tax savings.
2. Can I still claim the PRE if I rent out part of my home?
Yes, you can claim the PRE on the portion of the home you use as your principal residence, but the part of the property used for rental income will not qualify for the exemption. You will need to calculate the capital gains tax based on the portion of the property used for rental purposes. However, if you rent out a small portion, such as a basement apartment, the rest of the home may still qualify for the exemption.
3. Can I claim the PRE on inherited property?
You can only claim the PRE on inherited property if it qualifies as your principal residence. If you live in the property after inheriting it, you may designate it as your principal residence for the period of ownership. However, any appreciation in value that occurred before you inherited the property may be subject to capital gains tax if the property was not the principal residence of the deceased.
4. What if I move and rent out my home temporarily?
If you move out of your home and rent it out temporarily, you may still claim the PRE for up to four years after leaving the property, provided you do not designate another property as your principal residence during that time. To maintain eligibility, you must file an election under section 45(2) of the Income Tax Act, which allows you to defer capital gains tax on the property for the period of rental.
5. Do I have to report the sale of my principal residence?
Yes, as of 2016, the CRA requires homeowners to report the sale of their principal residence on their tax return, even if the entire gain is exempt from tax. The sale must be reported on Schedule 3 of your income tax return, and you may need to complete Form T2091 to designate the property as your principal residence. Failure to report the sale can result in penalties and loss of the exemption.
6. Can I claim the PRE on a property owned by my child?
If a property is owned by a minor child (under 18 years old), a parent or guardian may designate that property as the family’s principal residence for a given year. This can be an effective way to claim the exemption on a property used by the child, provided the property meets the CRA’s criteria for a principal residence.
7. How does the size of the property affect the exemption?
The Principal Residence Exemption generally applies to properties of up to 1.24 acres of land. If your property exceeds this size, the CRA may limit the exemption to the portion of the land necessary for the use and enjoyment of the principal residence. Any excess land may not qualify for the exemption, and capital gains tax may apply to that portion.
8. What happens if I flip houses?
If you buy and sell homes frequently, the CRA may view your activity as business income rather than capital gains, in which case the PRE would not apply. House flipping is considered a business activity, and the profits are fully taxable as business income. The PRE is reserved for properties genuinely used as a personal residence, not for investment or speculative purposes.
9. Can I claim the PRE on a second home or vacation property?
You can claim the PRE on a vacation property, such as a cottage, if it is designated as your principal residence for a given year and meets the ordinary inhabitation requirements. However, you cannot claim the PRE on both your primary home and a vacation property in the same year. Careful planning is necessary to maximize your tax savings by designating the property that has appreciated the most.
10. How does separation or divorce impact the PRE?
In the case of separation or divorce, both spouses can designate their own principal residence, provided they each occupy separate homes and meet the CRA’s requirements. For example, if one spouse moves out and acquires a new home, they can designate that new home as their principal residence, while the other spouse can maintain the original home as their principal residence.
Actionable Tips for Maximizing the Principal Residence Exemption
1. Keep Detailed Records
Maintaining thorough records of your property’s purchase price, major improvements (like renovations), and sale details is essential for accurately calculating the capital gains and applying the PRE. Make sure to retain all receipts, legal documents, and any evidence of the home being your principal residence, such as utility bills and tax assessments.
2. Plan When Owning Multiple Properties
If you own more than one property, consider how long you plan to hold each property and how much it will appreciate over time. Designating the property that is likely to appreciate the most as your principal residence will maximize your tax savings. Keep in mind that you can only designate one property per year, so be strategic when deciding which property to sell and when.
3. Use Section 45(2) Election for Rental or Business Use
If you convert your principal residence to a rental property or use part of it for business, you can file an election under section 45(2) to defer the capital gains tax for up to four years. This allows you to maintain the PRE for those years, provided you do not claim capital cost allowance (CCA) on the property. This election can help minimize your tax burden, especially if you plan to return to the property after a short rental period.
4. Avoid Frequent Property Sales
Selling multiple homes in a short period can attract the CRA’s attention and lead to the property being classified as a business transaction, making it ineligible for the PRE. To avoid this, refrain from frequently buying and selling homes, particularly if your intention is to profit from the sale. The CRA expects homeowners to live in their principal residence for a reasonable period before claiming the exemption.
5. Ensure the Property Is Used as a Personal Residence
To qualify for the PRE, the property must be used as your personal residence, either year-round or seasonally. Ensure that the property is not primarily used as a rental or business property, as this can disqualify you from claiming the full exemption. You should live in the property regularly, and any income-generating activities should be secondary to its use as your home.
6. Consider the Impact of Renovations and Rebuilds
While significant renovations can increase the value of your home, they can also draw the CRA’s attention if the property is sold shortly after being improved. The CRA may view the sale as a business activity rather than the sale of a principal residence. To avoid this, hold the property for a reasonable amount of time after completing renovations to ensure it continues to qualify for the PRE.
7. Consult a Tax Professional
The rules surrounding the Principal Residence Exemption can be complex, particularly when dealing with multiple properties, rental situations, or significant renovations. Consulting a tax professional can help ensure that you are maximizing your exemption and complying with all relevant regulations. A professional can also help you plan your property transactions to minimize tax liability.
8. Make Use of the “Plus One” Rule
When calculating the exemption, the CRA allows you to add one extra year to the number of years you designate the property as your principal residence. This can be particularly beneficial if you move out before selling or if you own more than one property during the period of ownership. The extra year can help reduce the taxable portion of any capital gains.
9. File the Appropriate Forms
When selling your principal residence, ensure that you properly report the sale to the CRA by completing Schedule 3 on your tax return and Form T2091 (IND) if necessary. Proper documentation will help you avoid penalties and ensure that you are correctly claiming the exemption. Failing to report the sale can result in significant penalties and the potential loss of the exemption.
10. Avoid Claiming Capital Cost Allowance (CCA)
If you rent out part of your principal residence, avoid claiming Capital Cost Allowance (CCA) on that portion of the property. Claiming CCA disqualifies the property from the PRE for the period it is rented, which can lead to a larger capital gains tax liability when the property is sold. By not claiming CCA, you preserve your ability to claim the exemption on the rental portion of the home.
By following these actionable tips and staying informed about the rules surrounding the Principal Residence Exemption, homeowners can maximize their tax savings and avoid unnecessary complications when selling their homes.
