The family home is the largest purchase - and the most significant investment - that will be made in the lifetimes of most Canadians. Understanding the way the CCRA - formerly Revenue Canada - views the ‘principal residence’ in terms of tax treatment can therefore be a most important consideration in estate planning.

What is a Principal Residence?

A principal residence is defined as a housing unit — any house, condominium, mobile home, trailer or houseboat — together with the land the housing unit is situated on provided the land is less than 1.25 acres. Only in certain cases where it is deemed necessary to the use and enjoyment of the housing unit will land of greater size be considered as part of a principal residence, and even then a capital gain tax liability may apply to the portion of land in excess of 1.25 acres. The owner, the owner’s spouse or ex-spouse or children of the owner must inhabit a principal residence for some part of the year. If a portion of the housing unit is rented to provide income or set aside for a home business, the status of the unit as a principal residence is not altered as long as its main purpose is for residence.

The principal residence exemption is only available to Canadian residents. An individual who ceases to be a Canadian resident loses the tax-exempt status on property disposed of at any time after one year of becoming a non-resident. Before 1982, each member of a family, both spouses and children could designate a separate dwelling as their principal residence; since 1982 the law allows for only one principal residence per year per family.

Capital Gains & Principal Residence Exemption

Capital gains are calculated as the difference between the sale price and the Adjusted Cost Base of the dwelling, that is - the purchase price plus the value of any additions made subsequent to the purchase. If the property was purchased before Dec. 31st 1971, then the fair market value (i.e. FMV) of the property at that date applies (a professional appraiser can research past sales to determine this).

The capital gain applying to the sale of a property today may be reduced if the capital gains election was taken in 1994 as part of the elimination of the $100,000 general capital gains exemption. In that case the ACB indicated on the tax receipt of that year can be used and only the capital gain from 1994 onward would be subject to the tax calculation.

The formula used to calculate the capital gain on disposition of a principal residence is as follows:

A - (AxB/C), where:

• A is the capital gain,

• B is the number of years ending after the acquisition for which the property was designated as a principal residence, plus 1,

• C is the number of years ending after the same taxation year during which the taxpayer owned the property (jointly or otherwise).

Thus it is evident that when a housing unit that has been designated as a principal residence is sold, any capital gains that may have been realized over the period of time that the dwelling in question was designated as a principal residence are exempt from taxation.

Before 1982 it was possible for various members of a family - including minor children - to each designate a different principal residence for tax purposes. However since 1982, the tax rules allow for only one dwelling to be so designated at any one time. In cases where a family or individual own more than one home - a city house and a cottage for example - the law allows that either home be designated as the principal residence for the purposes of the capital gains tax exemption (regardless of which property you actually spent more time living in). In order to realize the greatest tax savings, the home with the greatest annual increase in value would be the one designated as principal residence.

As an example:

Mr. & Mrs. Smith purchased their 1st house in 1968 for $50,000. An independent realtor’s appraisal estimated the FMV of the house at the end of 1971 to be $85,000 and at the end of 1981 as $190,000. In 1972 the Smiths purchased a cottage for $25,000 and now, 31 years later, have sold both the house and cottage for $230,000 and $150,000 respectfully. In considering how to apply their principal residence designation the Smiths consider the following:

The capital gain on the 1st house is $145,000 ($230,000 - $85,000) and $125,000 ($150,000 - $25,000) on the cottage. Designating the city dwelling as principal residence exempts all capital gains from tax on that dwelling, and applying the formula ( A = A-(A x B/C) to the cottage where B = years of dual principal residence eligibility (1981 incl. - 1972) + 1 results in a calculated taxable capital gain on the cottage of $80,645. If the cottage had appreciated more than the city home, it would be advisable to designate the cottage as principal residence for the period of ownership after 1981.

Principal Residence in Trust

If a housing unit is transferred to a trust, that unit may be designated as the principal residence of a beneficiary provided that the beneficiary or spouse, former spouse or child of the beneficiary inhabits the house. This means that the estate trustee, as legal owner of the residence, may claim the principal residence exemption and the trust will not be taxed on any capital gains realized on the disposition of the residence. The definition of a principal residence for trust purposes is the same as for an individual. Only one housing unit per family may be designated as a principal residence in any year after 1981. Families can’t add to the residence deduction by putting separate properties in multiple trusts, nor can any other property be claimed as principal residence in any year in which a trust property has been so designated. If the estate trustee distributes the residence to a beneficiary there is deemed to be no capital gain, as the asset is considered to be disposed of at the trust’s cost. When the property is subsequently sold, the beneficiary may then claim the principal residence exemption for those years the property was in trust as long as the beneficiary, the beneficiary’s spouse or the beneficiary’s children inhabited the residence during those years.

Deduction of Mortgage Interest on a Principal Residence

It may be possible to deduct from your taxes the interest on a mortgage on a principal residence. This usually involves paying off an existing mortgage, then negotiating a new mortgage to invest the funds borrowed. Interest on the new mortgage can then be deducted from taxes. There are certain restrictions on the types of investments allowed by the CCRA (Canada Revenue) under the general anti-avoidance rule so one is advised to get professional tax advice before pursuing this strategy.

Principal Residence and Joint Ownership

Assets that are held in Joint Tenancy With Rights of Survivorship are deemed NOT to constitute part of the estate and therefore are not subject to probate taxes. This is accomplished by the fact that a JTWROS effectively grants to 2 or more persons both the legal (ownership by virtue of title) and beneficial (entitlement to the use and benefit of) ownership of assets. If the transfer is to a spouse, it will be considered done at the original adjusted cost base of the asset and no capital gains tax will be applied. If the transfer is to a party other than spouse, the law considers it a disposition at fair market value and any realized capital gains will be taxed. In the case of a principal residence in joint ownership with a non-spouse (adult child for example), capital gains may be taxable on the child’s portion of the home if the child did not inhabit the home. As well, the portion of a principal residency transferred to such an account is subject to the actions of the creditors of the joint tenant.

Note : The above article is intended to be general in nature. For further information about tax and estate matters relating to principal residence, individuals are advised to consult an estate planning professional.