PRINCIPAL RESIDENCE EXEMPTION
If you are a Canadian resident, you are normally eligible for the principal residence exemption if you have a gain on the sale of your home.
The Income Tax Act provides that the portion of the gain that is exempt from tax is:
Gain x (1 + the number of years you designate the property as your principal residence) / number of years you owned the property.
Therefore, if the property was your principal residence for all years you owned it, or all years but one, the entire gain is exempt. (The exempt fraction of the gain cannot exceed 1/1, since at that point the full gain is exempt.)
The “1+” in the numerator allows for the fact that you can designate only one property per year as your principal residence. (Actually, your entire family – meaning you and your spouse and unmarried minor children – can designate only one property per year.) Thus, if you sell a home and buy another one in the same year, you can designate only one home as your principal residence for that year. The “1+” makes sure that you don’t lose your exemption on the other home in respect of that year.
Normally, you can designate the property as your principal residence in a year if you or your spouse or children “ordinarily inhabit” the property during the year. The courts and the CRA allow a low threshold to meet the “ordinarily inhabit” requirement. For example, if you stay in your cottage for a couple of weeks a year, that will normally meet the “ordinarily inhabit” requirement for the year. (Of course, if you designate the cottage for some years, you cannot have the principal residence exception apply to your city home for those years.)
When you sell your principal residence, you must now report the sale on Schedule 3, Capital Gains, which is filed with your T1 tax return for the year of sale. (Before 2016, the CRA did not require reporting for the sale of a principal residence if it was your principal residence for every year that you owned it.) If the home was not your principal residence for all years of ownership, you must also file Form T2091, Designation of a property as a principal residence by an individual.
Rental property for some years
There are special rules that apply where you live in your home and later rent it out, or conversely when you rent out a property and subsequently move into the home.
In either case, there is a “deemed disposition” rule in the Income Tax Act that deems you to have sold and repurchased the home at fair market value (possibly triggering capital gains that are taxed). However, you can elect out of that rule, meaning that there will be no deemed disposition. Furthermore, if you make the election, the property can qualify as your principal residence for up to four years while you rent it out, even if you do not ordinarily inhabit the property during those years (but subject to the usual rule that you can designate only one principal residence for any given year).
You bought a property and lived it in for 6 years. You moved out and rented out the property for 7 years. You then sold the property at a gain.
You can designate the property as your principal residence for the first 6 years. For the next 7 years, you can designate it for 4 years. As a result, you designate the property as your principal residence for a total of 10 years. This assumes you do not designate any other property as your principal residence for those 10 years.
Your exempt portion of the gain on the sale will be:
Gain x (1 + 10)/13, or 11/13ths of the gain.
Of the remaining gain, one-half will be a taxable capital gain which is included in your income.
Note: If you wish to use the election, you cannot claim capital cost allowance (tax depreciation) in respect of your home while it is rented out.