- January 16, 2017
- Posted by: Harpreet
- Category: Tax Tips
The new trap of 2016 – Principal Residence Rules
Changes to Principal Residence Exemption and what to consider as you file your 2016 personal tax return.
It’s that time of the year again – yes, its tax season! You can file your 2016 personal income tax return as early as February 20, 2017. Some early-birds will take advantage of this date as they are expecting refunds or perhaps would like to get the taxes out of their way. Others will wait until the last few days of April to bring the information to their accountant.
The federal budget released in March 2016 proposed several taxation changes and you will notice the impact of these changes when you file your 2016 personal income tax return. Furthermore, in October 2016, the finance minister announced changes to the Principal Residence Exemption (herein referred to as “PRE”) rules. These new rules were introduced to combat soaring real estate market and to crackdown on real estate irregularities. The biggest change that Canadians will likely feel is the new disclosures on the sale of their principal residence, which is mandatory effective January 1, 2016. The CRA now requires the actual designation of the principal residence on your personal income tax return in the year of the sale.
The PRE provides the taxpayer with an exemption from tax on the capital gain realized when a property is sold. Generally, the exemption applies for each year the property is designated as your principal residence. A PRE can be claimed for a family home, cottage, ski chalet, farm, Florida condo and/or Canadian or foreign property.
A taxpayer and spouse may only designate one principal residence each for each tax years after 1981. For years prior to 1982, individual taxpayers could designate one principal residence each. Hence, if a couple had owned a primary home and a ski chalet for decades, the PRE was available on both homes prior to 1982.
Since the PRE is generally the biggest tax break for an individual in their lifetime, the impact of not taking this change seriously can be disastrous. The penalty for not reporting the sale of the principal residence starting in 2016 can be as much as $8,000 and given that this is under intense CRA scrutiny, it is vital to explore some complexities that arise due to the additional disclosures.
Some complexities may include:
- Size of property – The CRA limits the principal residence exemption to ½ hectare of property. However, excess land may be claimed if it is necessary for use and enjoyment of the housing unit. What does the CRA consider as necessary? If a portion of the property is considered excess land – which part is the excess (swamps, backwoods)? How would you allocate a value to the excess land if it cannot be sold individually from the property?
- Ordinarily inhabited – To designate a property as a principal residence, it does not have to be the place where the taxpayer lives all the time. The property will qualify as a principal residence if the taxpayer, taxpayer’s spouse or common-law partner, or any of the taxpayer’s children have lived in the property at some time during the year. A property under construction is not considered ordinarily inhabited. Therefore, for the time that the property is under construction, a capital gain may arise.
- Determining the cost of the property – Imagine the paperwork you have to keep, including the receipts for the construction, renovation and improvements to be able to determine the costs of the property. CRA may allow a reasonable estimate if the receipts are not available, however, this is dependent on the case a case basis!
- Property flippers – A property cannot be a principal residence if you are in the business of buying and selling property on a consistent basis (referred to as a property flipping). Prior to 2016, some builders, real estate agents and taxpayers were flipping properties, while inhabiting the property for a short period of time. They were then claiming the PRE and hence making the sale completely non-taxable. With the new disclosures, the CRA will be able to review the property sales and hence crackdown on those claiming the exemption incorrectly. However, what is the normal period for holding onto a property, without it being considered “flipping?” What if you generally like to upgrade or change your principal residence after a few years or are exploring different geographical areas? What is a reasonable period?
- Partial use – what happens if you rent out your basement or a room? How does the CRA view this situation? Generally, if you rent a room or office and do not claim capital cost allowance on your home, you should be able to claim the PRE. However, where the rental portion is considered “more substantial”, i.e. single family home to duplex, there may be issues. Does the fact that your basement has a separate entrance and is rented, indicate the house is income producing and thus this portion may be taxable when you sell?
- Change of use – What happens if you change a property from your principal residence to income producing and/or vice versa. This situation is very common, however, very often ignored. When you live in a property and later start to rent it, you are deemed disposed of the property and re-acquired at the fair value on the date of conversion. There are elections that you can make to essentially defer the gain until you sell the property. However, you must be able to substantiate the fair value of the house at the date of change – perhaps having a report of similar houses that sold in the area at the time. Similar rules apply when a property is changed from income producing to principal residence. What would the CRA consider reasonable support for the fair value on the date of change?
In summary, there are several unanswered questions and not enough precedence or guidance to find the solutions. The CRA will likely provide additional clarity in the years ahead, but for the time being, it is imperative to work with a professional that understands these changes and the implications on your particular situation. A simple change which was meant to crack down on real estate irregularities, has opened up a new can of worms. As Mortimer Zuckerman once said, “Don’t open up a can of worms, without knowing how to get the worms back inside.”
This article is for information purposes only. Tax rules regarding PRE can get complicated and hence we highly recommended you speak to a professional to discuss your particular situation or contact us.