1. What is a capital gain?
When you sell property, a capital gain is the profit resulting from the difference between the selling price and the amount you spent to buy it.
If you buy property for $50,000 (cost base) and later sell it for $150,000, then you’ve made a capital gain of $100,000.
Generally speaking, 50% of the capital gain is taxed after you sell a building, property, shares, or a residence.
To calculate your capital gain, you must also add all your “capital expenses” to the cost base. These generally refer to expenses that have a long-term benefit for the property, like if you built an addition to your house. The property’s cost base plus these expenses will give you your adjusted cost base (ACB).
The Canada Revenue Agency’s website can help you identify your capital expenses.
2. What is the capital gain exemption for the sale of a principal residence?
This measure was set up by the Canadian government to allow people to take the money they make from selling their home and reinvest it in the purchase of another home or in some other goal. The idea is for the exemption to lower their tax burden and help them build wealth.
Only a gain resulting from the sale of a principal residence, as defined by law, can be tax exempt in part or in full.
That’s why it’s important to analyze your situation before putting one of your properties up for sale. If you sell a residence that doesn’t qualify as a “principal residence,” as defined by the Income Tax Act, then 50% of your capital gain may be taxed. Do your research before deciding to sell property, because there are many details in tax law that could preclude you from the principal residence exemption.
3. What is a principal residence?
Several criteria must be met in order to designate a property as a principal residence when you sell it. Here are the main ones:
- Its nature: A chalet, an apartment in a building, a trailer, or a home abroad may all be designated as a principal residence as long as they meet all the criteria.
- Its use: According to the Income Tax Act, a principal residence must be “ordinarily inhabited,” meaning it’s inhabited, even for a short period, in the year by the taxpayer or their spouse, common-law partner, or child (adult or minor).
- Its designation: Since 2016, in order to take advantage of the principal residence exemption, you must have declared the sale or disposition in your annual tax returns the year the residence is sold. Each year, only one residence can be designated as your principal residence in your tax return. You also need to take into account your “family unit,” which includes yourself, your spouse or common-law partner, and your unmarried children under the age of 18. For example, you might not be able to claim the years that were used by your partner when they sold their first property.
- Its ownership: You must be the owner (or the co-owner) of the residence for which you’re asking for a capital gain exemption.
- The land’s area: A principal residence may be tax exempt if the area is 53,820 square feet (half an acre) or less. The capital gain of the excess land will be taxed at 50%.
Does your principal residence need to be the place where you get your mail?
Let’s debunk a widespread myth: a principal residence has nothing to do with your mailing address. It’s a tax designation that you make after selling the property and it has nothing to do with the address where you get your mail.
Can a house that you flip count as a principal residence?
Let’s say you buy a house, renovate it, live there for a short while, then sell it and start all over with a new house. The Income Tax Act considers this to be a commercial activity. The profits will be classified as business income and will be counted entirely towards your taxable income. So, these residences cannot take advantage of the capital gain exemption for principal residences.
Can a rental condo or cottage be exempt?
The answer is usually no. Rental property like a cottage or a condo are not considered as “ordinarily inhabited,” so they aren’t eligible for the capital gain exemption for principal residences.
However, if you’ve only rented out your cottage a few times over the years, this residence may be eligible for exemption for a few years. The same also applies if the residence was rented out to the taxpayer’s child and that child ordinarily inhabits it during the year. It varies case by case; that’s why it’s important to talk to an expert.
If I work from home, can I claim the exemption?
If you work from home and have a small office in your basement, there’s a strong likelihood that you can claim the exemption without any issue.
But if you work in a hair salon, for example, that you operate out of your basement and the business has its own, separate door, the situation is more complicated. It all depends, which is why it’s best to get advice from an expert.
What happens if there’s a change in use of my real-estate property?
A change in use refers to a situation where you no longer live in a principal residence and rent it out instead or, alternately, you start to live in a building that was previously being rented out.
Following this change, the person is deemed to have sold the building at fair market value and reacquired it immediately thereafter for the same amount. As per tax law, this change entails certain fiscal consequences. Talk to an expert, as some options could ease your tax burden.
4. How is the exemption calculated?
Here is the formula for calculating the portion of the capital gain from which you are exempt:
A x B / C
A: The capital gain resulting from selling the residence
B: 1 + the number of years the property was designated “principal residence” by the taxpayer
C: Number of years during which the taxpayer owned the property
The most important thing to remember is that the formula for calculating the exemptions grants a “bonus” year (see “B”). Therefore, to make sure the totality of the gain is exempt, you just need to designate the ownership years minus one year. Save the year you subtracted to exempt another property that you may sell one day.
If a property is sold one year after it can be designated as a “principal residence,” 100% of the gain can be exempt. Moreover, if many years pass before the disposition of a property and it cannot be designated as a principal residence anymore, only part of the gain will be taxable.
Here’s a concrete example
Let’s say you bought a house in 2001 and are still the owner in 2021.
You also have a cottage that you bought in 2004. In 2021, you decide to sell it.
In 2021, you own two houses. The first thing you should do is check if your house and your cottage meet the criteria for being designated principal residences for each year of ownership.
For the sake of this example, let’s say that both properties are eligible and can be designated as principal residences for all years of ownership.
That means your cottage is eligible for 18 years (2021 - 2004 inclusively = 18).
Let’s assume that you bought your cottage for $200,000 in 2004 and spent $25,000 on improvements and costs associated to its sale.
You just sold it for $500,000 in 2021.
Let’s calculate your capital gain:
- Purchase price: $200,000
- Improvements and costs associated to the sale: $25,000
- Adjusted cost base: $225,000
- Selling price: $500,000
- Capital gain: $500,000 - $225,000 = $275,000 (“A” in the formula)
- Designation of the property as a principal residence: 1 + 17 = 18 (“B” in the formula)
- Numbers of years as owner of the property: 18 (“C” in the formula)
- A x B / C gives you:
- 275,000 x 18 / 18
- $275,000 - $275,000 = $0
Let’s take a look at the situation for the other house you’ve owned since 2001. Say you bought it for $300,000 and it’s now worth $1M.
You just used up 17 years for your principal residence exemption.
If you sell it in 2023, for example, that means you owned it from 2001 to 2023, so 23 years.
- Purchase price: $300,000
- Improvements and costs associated with the sale: $0
- Adjusted cost base: $300,000
- Selling price: $1,000,000
- Capital gain: $1,000,000 - $300,000 = $700,000 (“A” in the formula)
- Designation of the property as a principal residence: 23 - 17 = 6 + 1 (“B” in the formula)
- Number of years as owner of the property: 23 (“C” in the formula)
- A x B / C gives you:
- $700,000 x 7 / 23
- $700,000 - $213,043.48 = $486,956.52
This shows that it’s important to do the math before designating a property as a principal residence. In the example above, it would have been better fiscally to spread out the years in which the cottage and the house were designated as the principal residence. When you sold the cottage, if you had decided to only report one designation year, part of the gain would have been exempt: (1 + 1) / 18 = 11%. In 2023, 100% of the capital gain on the house would have been exempt by reporting 22 designation years: (22 + 1) / 23 = 100%.
5. How do you determine which house should be your principal residence?
There’s no magic formula for figuring out which of your properties should be designated as your principal residence. If you’re hesitating between your more expensive residence and the one you’ve owned for a long time, there’s only one answer: do the math before selling either of them. A financial planner can help you with this and make sure nothing falls through the cracks. We’re here to answer your questions.