Cottage or home: which should be a principal residence?

For Canadians with multiple properties and soaring house prices, selling one or more can be a blessing and a curse. On the one hand, you can benefit from strong market conditions; on the other, you have a tough tax decision to make. If you can only have one principal residence exempt from capital gains tax, which house should it be?

Principal residence defined

For tax purposes, a principal residence is a property that you or your spouse¹ own and is ordinarily inhabited by you, your spouse, former spouse or (minor or adult) child,² in a year. It can be owned by you or your spouse alone, jointly, or by an eligible trust, and it’s designated as a principal residence. This usually includes the associated land, up to one-half of a hectare, although more land can be included if you can show it was necessary for the enjoyment of the home. Finally, a principal residence can be any of these housing units:

• a house, cottage, condominium
• an apartment in an apartment building or duplex
• a trailer, mobile home, or houseboat
• a share of the capital stock of a co-operative housing corporation (coop)
• a leasehold interest in a housing unit

There are several terms that need clarification:

• Ordinarily inhabit—The main reason for owning the property must not be to gain or produce income. Occasional rental income is okay; inhabiting for short periods throughout the year is also acceptable.
• Eligible trust—Certain types of trusts can designate a property as a principal residence:
  • an alter ego trust, joint partner trust, spousal trust, and other lifetime benefit trusts for the settlor’s own exclusive benefit
  • a qualified disability trust where the electing beneficiary is a resident of Canada; the specified beneficiary of the trust; and a spouse, former spouse, or child of the trust’s settlor
  • a trust for a specified beneficiary, under 18 years of age and resident in Canada, that arose because of the death of the beneficiary’s mother or father, and the deceased parent is the settlor of the trust.
• Designate as a principal residence—This is done on the individual’s or trust’s tax return for the tax year that the property is disposed. Use form T2091 for individuals and T1079 for trusts. It’s also possible to designate a property located outside of Canada as a principal residence if the conditions above are met.

Principal residence exemption

The principal residence exemption (PRE) can exempt up to 100% of the capital gain on a principal residence from tax. To determine the amount of PRE available to offset the capital gain, this formula is used:

The total capital gain is the home’s value at disposition less its adjusted cost base (post-1981 acquisition price and costs + capital improvements). Receipts for improvements during ownership should be kept if the Canada Revenue Agency (CRA) requests them. The “1 +” in the numerator is only available to Canadian residents and allows for two principal residences to claim the PRE in the year one is sold and a new one is subsequently purchased. Finally, the denominator is the total number of years the property is owned. This allows for the possibility of a partial PRE, when two or more properties are owned concurrently that could be eligible.

Starting in 1982, only one property could be designated as a principal residence per year per family unit, which includes a spouse or children under 18. For children under 18, this includes parents and unmarried siblings under 18.

Property flipping—word of caution

For most Canadians who own real estate, it’s important to understand that these assets are considered capital property. This means that the gains or losses you realize when you sell these assets are classified as capital gains or losses. In addition, if you meet the conditions, you can use the PRE to reduce or eliminate the associated tax.

If you sell your real estate having owned it for less than 365 days—including the rights to purchase a property before its official sale—the residential property flipping rule may apply. In this case, your gain will be classified as fully taxable business income and doesn’t qualify for the PRE. Alternatively, if you realize a loss, you won’t be able to use it to offset any other income or gains. There are a number of exceptions to this rule that, if met, would allow the gain or loss to be categorized as a capital gain or loss. A couple of examples include the owner’s death or a breakdown of their marriage or common-law relationship. Finally, even if an exception applies, or the property was held for 365 days or more, it remains a question of fact whether a gain on a residential property sale will be taxed as business income or a capital gain.

If the residential property flipping rule doesn’t apply to you and you only own one principal residence, using the PRE to save tax on a disposition is an easy decision. But what if you own more than one property that qualifies as a principal residence and you’re considering selling one or both, which of the two should get the PRE?

Case study

Parvin and Preeti are both 60 years old and retiring. They’ve sold their city house and are moving into their cottage. The city house has a substantial profit and they’re wondering if they should use the PRE to shelter the gain from tax or save it for the cottage. Here’s a breakdown of the two properties:

At first glance, the PRE should be used to shelter the gain on the house from tax because the total gain is bigger ($870,000 vs $625,000), but they need to know what the average capital gain is per year. This is where it gets interesting. Note that Parvin and Preeti owned only one property—the city house—from 1990 until the end of 1998. In this instance, if we apply the PRE formula, we can protect part of the gain on the city house without impacting the PRE for the cottage:

By doing so, we can compare the total price appreciation for both properties for the time they were owned concurrently. Now, we notice that the capital gain on the city house is $628,333 ($870,000 – $241,667), and $625,000 for the cottage. In other words, the average gain per year is $23,272 and $23,148 respectively. Applying the PRE to either property generates approximately the same tax savings.

Food for thought

Parvin and Preeti took stock of their overall situation along with their advisor and considered some of their options.

A bird in the hand is worth two in the bush—Consider the future growth of the cottage. Is its value expected to increase at a rate that would change its average capital gain? If this is likely to happen, saving the PRE for the cottage may be beneficial; otherwise, using the PRE on the city house now to reap the tax benefits now would be preferred.

RRSP contributions—If Parvin and Preeti have unused RRSP contribution room, they could expose enough of the gain on their city house to tax and use an RRSP contribution and the resulting deduction to defer that tax, saving part of the PRE for the cottage. If they sell the cottage after December 31 of the year they turn 71, they’ll no longer be able to contribute to an RRSP, even if they have unused contribution room.

Charitable donations—If they have philanthropic aspirations, they should consider making a donation that would create a large enough tax credit to offset the gain’s associated taxes.

Life insurance—Life insurance can be used to provide funds to the estate to cover the anticipated tax liability on the cottage for the years that the PRE can’t be used because it was used on the city house. A joint last-to-die policy will pay out when the second of them dies. This is when the tax liability would come due and the spousal rollover wouldn’t be available.

PRE—a complex but useful tax strategy

The PRE is a valuable, yet complicated tax exemption, especially in the current real estate market. When selling one or more eligible properties that are owned simultaneously, allocating the PRE can be a challenging decision. Start by crunching the numbers to understand where the PRE will provide the greatest tax savings. Then, consider your entire financial picture to see if other deductions and credits can reduce taxes. Life insurance can cover any future tax liabilities at death for years the PRE wasn’t available. All of this can help maximize your wealth today and in the future.

1 All references to spouse include common-law partners as defined in the ITA. 2 A child for the purposes of the ordinarily inhabited rule includes both minor and adult children. This means the owner of a principal residence can still claim the PRE, even if they didn’t occupy the home. If their spouse or children (minor or adult) did, the ordinarily inhabited rule can be met. An example of this can include a parent that retains ownership of their principal residence and moves into a nursing home while their adult child occupies their principal residence.