Principal residence exemption allows a taxpayer to eliminate capital gains on the disposition (or deemed disposition) of his/her principal residence in Canada.
This post is meant for general information purposes. You can find below a summarised version of different tax rules applicable to you if you have sold your principal residence, converted your principal residence to income-generating property, or from an income-generating property to a principal residence. Principal residence rules might become complex depending on your personal tax situation, so it is recommended to contact your professional income tax service provider in Canada for proper tax advice.
Section 54 of the Income Tax Act (ITA) includes the definition of Principal Residence. Without going into depths, simply put, a Principal residence is (i) a housing unit, (ii) a leasehold interest in a housing unit, or (iii) a share of the capital stock of a cooperative housing corporation. Such a unit must be acquired with the sole purpose to inhabit it.
A detailed guide on the principal residence is issued by the Canada Revenue Agency (CRA) in Income Tax Folio S1-F3-C2, Principal Residence. For the purpose of this post, we are going to discuss some of the commonly asked questions.
What type of property can be qualified as Principal Residence in Canada?
Below types of properties that can qualify as Principal Residence:
- A housing unit – Can be an apartment, a house or a cottage
- A leasehold interest in a housing unit
- a share of the capital stock of a co-operative housing corporation
When to designate the property as Principal Residence?
You can designate the property as a principal residence in your individual income tax return (T1) in the year you disposed it of. You can do so by filing form T2091 (IND) in the same year. Form T2091. You will be needing the proceeds of dispositions and the adjusted cost basis of the sold property to include on this form.
You can only designate one property for one year as a Principal residence. Also, if one spouse has designated a property as a principal residence, another spouse cannot designate another property.
Change in Use:
When a taxpayer converts his/her Principal Residence into an income-producing property or vice versa, a change of use has occurred. Change of use is often ignored by some of the taxpayers unintentionally which can result in significant penalties. Some of the most common situations are discussed below. For more details on these, please contact your personal income tax preparer in Canada.
Converting a Principal Residence to an Income-producing property
When a taxpayer converts his/her principal residence into an income-producing property, a deemed disposition has occurred. Such a deemed disposition has occurred at the Fair Market Value on the date of conversion. The taxpayer can then claim principal residence exemption on this deemed disposition. Moving forward, the adjusted cost basis of this property is the FMV at which deemed disposition had happened.
Subsection 45(2) allows a taxpayer to elect as if a change of use has not happened. The taxpayer is required to send a letter to CRA making this election. A taxpayer can continue to elect the property as a principal residence for up to four years under subsection 45(2) election. In some cases, you can still file a late election if you forgot to use the taxpayer relief provisions. Subsection 45(2) election does not exempt a taxpayer from reporting income earned from the property, the taxpayer must report all the income and expenses from that property.
Converting an Income-producing property to a Principal Residence
Another common situation is where a taxpayer converts his/her rental property or income-producing property to a Principal Residence. Like the previous situation, a deemed disposition has happened at the fair market value of the property on the date change in use has occurred. The resulting capital gain from this deemed disposition is taxable. Subsection 45(3) election allows a taxpayer to defer recognition of this gain.
Sometimes there is a partial conversion of the principal residence to income-producing property or vice versa. In such a situation, a deemed disposition is at the fair market value of the property and pro-rated gain results based on the area of the property. However, such a conversion must be substantial and of permanent nature. A temporary change in use does not result in a deemed disposition.
Capital Cost Allowance and Principal Residence
If you claim capital cost allowance (CCA) on the principal residence it can have a serious effect on your principal residence exemption. If you are claiming CCA on the property, sometimes you cannot file a subsection 45(2) election. Further, a partial capital gain is taxed on such properties for the portion of the house on which CCA is claimed. It is always better to consult a professional tax preparer if you have rental income and tend to claim CCA on capital expenses.
Does renting the basement of the house affect principal residence exemption?
Canada Revenue Agency does not consider the deemed disposition rule if you rent your basement or a room in your house. However, such an income should be of secondary nature and the main purpose of the property is for the taxpayer to live there. Further, there should be no structural changes and CCA claimed on that property.
If you have recently sold or purchased a principal residence or converted a principal residence to income property or vice versa. We can help to file income tax returns along with required elections. If you are a non-resident of Canada and own a principal residence in Canada, rules are a little bit complex as compared to Canadian residents, we can help to file your income tax return for non-residents in Canada as well.
Maroof HS CPA Professional Corporation is a CPA firm located in the Greater Toronto Area providing comprehensive income tax services for individuals and corporations. Get in touch with us.