Readers are likely aware of the principal residence exemption under the Income Tax Act (“Act”), which normally exempts all or part of the gain from the sale of your home from income tax. For example, if you have lived in the home during all years during which you owned it (or all years but one), the rule will normally exempt the entire gain on the sale of the property. If you have lived in the residence for fewer years, typically only a part of the gain will be exempt.
A special rule in the Act allows to rent out your home for a specified period and still claim the exemption in respect of the rental period.
Basic Calculation for Exemption
In general terms, the exempt portion of the gain realized on the sale of your residence equals:
(Gain before exemption) x (1 + # years as your principal residence / number of years of ownership)
For example, say you owned a home in 10 consecutive calendar years and it was your principal residence during 9 of those years. The entire gain would be exempt, as the fraction in the brackets would equal 1. The same would be the case if it was your principal residence for all 10 years, as the exempt portion cannot be greater than the gain itself (i.e. the fraction above cannot be greater than one).
On the other hand, if it was your principal residence for 6 years, your exempt portion of the gain would be 7/10ths of the gain.
For the purposes of numerator of the above fraction, you only count years that the home was your principal residence in the years during which you were resident in Canada for income tax purposes.
For the purposes of the denominator, the number of years of ownership includes years in which you owned the property either solely or jointly with another person (such as your spouse). The property does not have to be located in Canada, so foreign property you own can qualify.
The purpose of the “1 +” part of the formula relates to the fact that you can designate only one home per year as your principal residence for that year (after 1981). Thus, if you sell a home and buy a new one in the same year “X”, you can only designate one of those as your principal residence for that year; but the “1 +” part ensures that the other property can still qualify for the exemption when you sell it, even though it was not designated as your principal residence for year X.
Designation of One Home Per Year
As noted, you can normally designate only one property as your principal residence in any particular year (assuming it meets the conditions discussed below). More specifically, after 1981, only one home per family unit can be designated in any one year. For these purposes, a family unit includes you, your spouse or common-law partner, and unmarried children under the age of 18. So, for example, the fact that your 19-year old son owns a home in a year does not affect your designation of a home that you own in the same year.
Meaning of Principal Residence
Normally, a residence qualifies in a year if you, your spouse (or common-law partner) or former spouse (or former common-law partner) or your child (which term has an extended definition) ordinarily inhabits the residence in the year. (The former spouse is allowed for these purposes since, under family law, your former spouse may be allowed possession of the home even though you own it.)
The courts and the Canada Revenue Agency (CRA) take a liberal interpretation of “ordinarily inhabits”, so, for example, if you stay at your cottage for 2 or 3 weeks a year it can qualify as your principal residence for that year.
The catch, as noted above, is that you can designate only one property per year per family unit as your principal residence. The designation need not be made each year; it is normally done when you sell the property and are required to report the gain, if any, on your tax return for the year of sale. Furthermore, if the entire gain on the sale is exempt owing to the principal residence exemption, the CRA does not require the designation with your tax return for the year.
Rental Property May Qualify
Although the general rule requires you to “ordinarily inhabit” the property for the year in which you designate it as your principal residence, a special rule applies where you live in your home and later rent it out, or where you rent out a property and later move in.
In either case, you can make an election and designate up to 4 years of the rental period as years in which the property is your principal residence. In the former case (live in first, then rent out), you make the election in your tax return for the year in which you move out and start to rent it. In the latter case, you can make the election in your return for the year in which you dispose of the property (or within 90 days of the CRA making a demand for the election, if that is earlier). The election also prevents the application of certain “change-in-use” rules, which would otherwise deem the property to be disposed of at fair market value at the time of change in use from personal-use to rental or rental to personal-use, as the case may be.
However, remember again the rule that you can designate only one property as your principal residence per year. Therefore, if you own another property in which you live (while you rent out the rental property), only one can qualify in any given year.
Example
You owned and lived in your home from 2005 to 2010, and then you moved out and rented out the home. This period covers 6 calendar years of “ordinarily inhabiting” the home. You rent it out until 2015, and then you sell the home. Years 2011 through 2015 constitute another 5 years of ownership.
Assuming you make the election, your home can qualify as your principal residence during 4 years in the 2011 through 2015 period (assuming you do not designate another property for those 4 years).
Using the above formula, your entire gain will be exempt:
- Exempt part = Gain x (1 + 10 years as principal residence / 11 years of ownership)
- = entire gain exempt
Lastly, you can claim more than 4 years of principal residence status for the property while you rent out the property, generally if you are required to move because of the relocation of your employment, and you move back into your home during your employment or by the end of year following the termination of your employment.