On October 3, 2016, the Department of Finance introduced significant changes to the principal residence exemption ("PRE") rules in order to "improve tax fairness by closing loopholes surrounding the capital gains exemption" as they relate to the sale of your home. The changes were aimed primarily at foreign investors of Canadian real estate, but they also catch many Canadian residents who, in the past, have been able to access the PRE and avoid paying capital gains tax on the sale of their principal residences. In this article, we will review what these changes mean for you. Before we get into the nitty gritty of the changes, let us first review the rules.
Key Rules and Requirements:
In order to take advantage of the PRE, certain requirements must be met:
- The home must be ordinarily occupied for personal use by you, your spouse or former spouse, or a child at some time during the year.
- The home must be "capital property". If the home was renovated and "flipped" a short time after it was acquired, there is a risk it might not be considered capital property but rather the inventory of a business.
- To claim the PRE on a large lot (over ½ hectare - about 1¼ acres), you must be able to establish that the excess land is necessary for the "use and enjoyment" of your home.
- Restrictions also apply if part or all of your home is rented out or is not used by a family member, or if you have not been a resident in Canada throughout the period of ownership (other than in the year of purchase).
- As a general rule, a family can claim the PRE on only one home at a time. Claiming a second home is more of a problem. To stop you from trying to claim a separate exemption for another home by putting it in the name of a child, the rules restrict children from claiming the exemption unless they have reached age 18 in the year or are married.
- Where specific conditions are met, non-Canadian properties may also qualify for the PRE.
- It is possible for a trust to claim the PRE, provided that a corporation is not a beneficiary and the trust designates a beneficiary (or their spouse, common-law partner, or child) of the trust who ordinarily inhabits the property (referred to as a "specified beneficiary").
How it works:
Most people think of the PRE as a black and white matter - either you qualify to sell tax free or you do not. Actually, this is not the case. When you sell your home, you must calculate the gain on your residence just like any other capital gain, then PRE itself reduces your gain.
Moreover, eligibility for the exemption is on a year-by-year basis, which might come as a surprise. The more years you qualify relative to your total period of ownership, the more your gain gets reduced. To be more precise, here is the basic formula that normally applies:
Despite only allowing one property to be claimed, the rules allow a full exemption on two residences in a particular tax year, i.e. where one residence is sold and another is purchased in the same year. That is why the above formula adds "1" to the number of years the property was a principal residence (the "plus one rule").
As you can see from the above formula, to get the tax reduction, you must designate the home as a principal residence on a year-by-year basis. If your gain is completely covered by the principal residence exemption, under the previous rules, the CRA did not require you to file the designation form with your tax return. This has changed.
New Rules
Ownership by a Trust:
Under the new rules, additional requirements were introduced where a trust owns a principal residence (for the years that begin after 2016). Essentially, only the following types of trusts are able to designate a principal residence (where the trust has a "specified beneficiary" who is a resident of Canada during the year(s) for which the PRE is being claimed):
- an alter ego trust, spousal or common-law partner trust, joint spousal or common-law partner trust, or a similar trust for the exclusive benefit of the settlor of the trust during his/her lifetime;
- a testamentary trust created under a Will that is a qualifying disability trust for which the beneficiary is a spouse, common law partner, former spouse, former common law partner, or child; or
- a trust for the benefit of a minor child of deceased parents.
If you have a trust that owns a principal residence and does not meet the above conditions, you can take advantage of transitional rules that will allow the trust to crystallize the PRE in respect of any accrued capital gain relating to the property up to December 31, 2016. Essentially the trust will be deemed to have disposed of the property on December 31, 2016 (the trust can shelter the gain under the PRE up until that date) and to have reacquired the property at a cost equal to the fair market value on January 1, 2017. However, you may want to reconsider keeping the property in the trust for years after 2017 since it will no longer be sheltered (whereas it can be sheltered if owned directly by a beneficiary).
The new rules allow a trust that does not qualify for the PRE to make a tax-deferred distribution of the property to the beneficiary who had ordinarily occupied the property (assuming the beneficiary has a capital entitlement to the trust) and, for the purposes of accessing the PRE, the beneficiary will be able to designate the property as his or her principal residence for those years it was owned by the trust.
If the beneficiary who had ordinarily occupied the property does not have a capital entitlement to the trust such that the property cannot be distributed out to him or her, it may still be possible for the beneficiary to take advantage of the PRE after 2016 if there is another way for the beneficiary to become the beneficial owner of the property. For example, the property could be distributed to a capital beneficiary of the trust at fair market value (but this means that tax will be owing in the trust to the extent of any increase in value of the property from January 1, 2017, to the date of the distribution). The capital beneficiary in turn gifts the property to the first-mentioned beneficiary (who ordinarily occupies the property), who will then be able to designate the property as his or her principal residence for the tax years after the gift is made.
Trusts are often used to hold a principal residence as part of a succession and/or estate plan and as such, the planning described above might not be appropriate in a number of situations; for example, where the beneficiary is not equipped to control material wealth or where the property was originally intended to be transferred to other beneficiaries. If you kept the principal residence in a trust, any planning intended to sidestep or mitigate the impact of the new rules should be carefully reviewed by you and your advisors to ensure your original planning goals are still being achieved. Further, in considering such planning, you should be mindful of any applicable land transfer tax and structure the distribution from the trust to ensure such tax is avoided or mitigated.
Changes to the Plus One Rule:
Effective October 3, 2016, the plus one rule will not apply where an individual is not a resident in Canada during the year of acquisition. Under the previous rules, you could benefit from the PRE for the year that you purchased a residence in Canada, even though you were not a Canadian resident in the year of acquisition. This is no longer the case; however, a non-resident may be able to avoid this result by gifting funds to his or her resident spouse or child to acquire the property.
Requirement to Report a Sale & Extension of the Reassessment Period:
If your entire gain is covered by the PRE, we had noted that under the previous rules you were not required to file the designation form with your tax return to report the disposition of the principal residence. However, under the new rules, you are now required to report the sale of your principal residence and make the designation; this applies for all dispositions that occur on or after January 1, 2016. If you fail to do so, you will not be entitled to the PRE. In certain circumstances, the CRA will accept a late designation of your principal residence, but you could be subject to a penalty of up to $8,000.
Under the previous rules, the CRA could only reassess you within the normal reassessment period, which was generally three years after the date of the original notice of assessment (unless certain exceptions are applied). The new rules clarify that the CRA has the ability to reassess you for an unlimited period beyond the normal reassessment period (as it relates to your principal residence) if you failed to report the disposition of your principal residence, even if such failure to report was purely innocent.
Summary:
The two main take-aways from these new changes are:
- There is no longer any flexibility through the use of a family trust for owning a principal residence (usually popular with the purchase of a cottage property); and
- Do not assume that a sale of your home will no longer trigger any tax compliance on your part. If you sold your home on or after January 1, 2016, you must report the sale and make the proper designation or the PRE will not be allowed.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.
