We often catch ourselves drooling at our American cousins’ ability to write off their home mortgages. On the other hand, we enjoy a tax-free capital gains treatment better than theirs. The general rule is that a person’s home (“principal residence” in tax terms) is tax-free. This means any appreciation that you hope accrues over the years is all yours! In practical application , there is a myriad of tax rules that define and target this benefit. These include:
- You must be a Canadian resident. If you leave the country for a number of years but rent out your former family home, those years will not count as tax-free when you ultimately sell the property or return home. On the other hand, if you maintain your Canadian resident tax status even though you live outside Canada, the tax-free status can apply to a principal residence you inhabit in some foreign land.
- Only one principal residence can be claimed by a couple, subsequent to 1981. Prior to that, each spouse could claim their own principal residence, thus clearing the way to shelter a second, recreational property in the family.
- You or your family must have ordinarily inhabited the property.
- There are limits to the size of a property which can be claimed. Normally properties must be under 1/2 hectare unless you can establish that the excess was necessary for use and enjoyment, OR the size was a required residential lot size under local zoning by-laws at the time of purchase.
Renting Out Your Home
If you rent out part of the house, e.g. a basement suite, tax law allows you to retain the tax-free status, as long as you do not claim tax depreciation on any part of the property.
CRA has been taking the position that, if the rental proportion of your home is significant, then that proportion of your gain on disposal may not avail of the tax-free principal residence advantage. While no such arithmetic proportion has been set in law, CRA has been seen to challenge the 40% range.
These rules normally are straight forward for most people. However, if you move into or out of the house in exchange with renters, then matters may get more complicated… or they may not! The “four year rental” election allows you to consider the house as your home even though renters are living in it for as long as four years. If they stay longer, those extra years will not count as principal residence years. Furthermore, if you bring in renters (due to a job transfer), then the four year restriction is waived and the principal residence election carries on throughout your entire job transfer period.
If you buy another place to live in while the renters occupy the original home, then you really do have some potential tax issues. Upon the sale of either of the properties, you must “do some figuring” and make a declaration to Revenue Canada, wherein you elect which property is designated your principal residence year-by-year. For the property sold, a give-away “1 +” is added to the years designated and that number is simply divided by the number of years owned. The resulting fraction determines how much of the gain on the property is tax-free and how much is taxable at 1/2.
(1 + # years designated as your principal residence) / (# years owned)
When you move in or out, there is an alternative election which deems a taxable event to have occurred immediately. The fair market value of the property upon the so-called “change-in-use” is determined. This becomes your future deemed cost if you have converted to a rental unit. If you kicked out the renters to move in yourself, this fair value is compared to your original cost to determine the gain or loss since you bought, and a taxable event occurs that year.
The capital gains exemption provision brought in by the Conservatives in 1985 also extended to taxable real estate. When the provision was phased out in 1992 (for real estate) and 1994 (for everything else), there were complicated calculations to figure out the tax-free portion of appreciation on divided-use properties. Those calculations need to be retained for the ultimate sale of the property.
Cottage or Vacation Properties
If your second real estate property is a family-use cottage (a “personal use property” in tax terms), you too have some tax complications-in-waiting. Personal use property is the victim of prejudicial one-way tax law. Capital gains are subject to tax but capital losses don’t count for anything. If you have gains, each of you could tie up the home and the cottage in principal residence elections up to and including 1981. However, after that, one of the properties will face taxable appreciation and it is up to you to decide which. Again, nothing needs to be done until one of the properties is sold. In this situation, you will need to calculate which property has the higher gain per year and make designations accordingly. You are well advised to seek professional assistance in this area.
If your cottage was another “home-improvement project”, then various expenditures over the years qualify as an increase to your cost, thereby lowering your taxable gain in the future. Thus, it would be wise to keep a little journal of these costs over the years
Matters of Estate require consideration if you plan to pass on a family cottage to your beneficiaries. First of all, there may be a large capital gains tax liability on the property. This tax bill needn’t trigger until both you and your spouse pass away. If your children wish to keep the property but there isn’t a lot of cash elsewise in the estate, they may have difficulty paying the capital gains tax. This situation happened with a famous sports franchise in the U.S. One possible solution is to life insure sufficiently to cover the taxes. The downside here is that life insurance premiums will be expensive the older you are. Do you bear that cost? Do your children bear it?
You can cut short the tax liability by selling or gifting the property to the children while you are alive. The future appreciation will accrue in their name(s) and defer tax issues until their death. However, loss of control may create practical difficulties while you remain alive. Also, risk of marital discord within your children’s marriages may create other unexpected problems later on.
If you have more than one child, there may be some family politics concerning who inherits the property. One may like it more than others. Some may live far away and not have easy access. Some may have greater financial needs. Remember also, the capital gains tax liability on the property that comes home to roost upon your death is a liability of your estate, not of the beneficiary. So, if you will the property specifically to one child and the other assets to another child, the cash assets to the one child will be reduced by the tax bill incurred on the other child’s cottage property. This won’t go over well, so you need to make some accommodations in your will.