Most countries provide tax breaks for individuals, either to offset costs or to incentivize certain behaviours. For most Canadians, the biggest personal tax break provided by the Income Tax Act is the principal residence exemption. The principal residence exemption is a deduction that can reduce the capital gain from the sale or a residential unit to zero. This tax break is meant to promote home ownership and to assist individuals in building wealth.
The principal residence exemption formula determines how much of the gain realized on the sale of a home can be deducted. Not all residential units meet the definition of principal residence. This article will first set out the definition of principal residence and then discuss the formula used by the CRA to determine what portion of a gain is exempt from taxation.
Generally, a principal residence is defined as a housing unit that is owned by an individual and that individual ordinarily inhabited the unit in the year (or the unit was ordinarily inhabited in that year by that individual’s current or former spouse, current or former common-law partner, or child). However, there are rules that can result, for any particular tax year, in a housing unit NOT being an individual’s principal residence. The most relevant limitation is that the individual fails to report the property as his or her principal residence for that year. No other property can be reported as a principal residence in the same year as another property. Some relief is provided where the taxpayer or the taxpayer’s spouse or common-law partner has to move for work.
There are special rules for trusts that are not discussed here.
The principal residence exemption formula takes into account four variables. The first is the gain on the sale of a housing unit. The second variable provides two alternatives depending on whether or not the taxpayer was a resident of Canada in the year that the property was acquired. The third is the number of years that the property was owned by the individual. And, the fourth is a variable that corrects for the difference in capital gains inclusion rates over the year and is only a concern for persons who bought the property before February 23, 1994. In short, the formula pro-rates the gain on the property from the date of acquisition to the date of disposition, and allows a taxpayer to deduct a portion of that gain based on the number of years that the property was the principal residence of the individual.
Where a taxpayer is not a resident of Canada during the year in which the property was acquired, then only the years that the property was the taxpayer’s principal residence AND the taxpayer was a resident of Canada qualify for the pro-ration. This limits the availability of the principal residence exemption to Canadian residents and denies the exemption to non-residents. Remember, that as with all things tax, the concern here is tax residence and not residence for immigration purposes.
NOTE: Articles are for general information only and do not constitute tax advice nor can they be relied upon. Call Faris CPA for assistance.