Wealth Strategies: Principal Residence Exemption Decision - Home or Cottage?

In Canada, since 1982, only one property can be designated as a principal residence per year per family unit (which includes a spouse or common-law partner and minor children). This is an important distinction when it comes to taxes, as the CRA states that under the principal residence exemption (PRE) rule, 100% of the capital gain on the sale of a primary residence is exempt from taxation. For many Canadians this can provide a substantial tax savings, as the prices of residential property have increased exponentially in recent decades.  For those who have only ever owned a single property, the tax savings and treatment are very simple. However, for those who may own multiple non-rental properties such as a home and cottage, a choice needs to be made as to which property to designate as their “primary residence” for tax purposes.

The first consideration, if you own multiple properties, is whether the property will qualify as a primary residence. According to the CRA, a primary residence is defined as a property that is owned and “ordinarily inhabited” by the individual and/or their spouse (including common-law partners). This generally means that the property is not designated as a rental property for the purpose of generating income. However, there are exceptions if the individual or family rents out the property for short-term use. A common example would be renting out the property for short periods of time through Airbnb. As the CRA does not state a specific number of days for which the property must be “ordinarily inhabited”, it is important to consider some of the information that the CRA may request if audited, which include:

• Utility bills in your name, with the property’s address noted.
• How many days the property was rented out (if applicable).
• How many days you spent living on the property.
• Your real estate transaction history.
• Amount of capital gains earned on the sale of the property.
• Rental income earned on the property.
• Sources of income outside of real estate.

We can see the importance of the designation of the primary residence in the case-study to follow. We will assume that Jane and John own a home in the city and a cottage that had different purchase dates. Jane and John are in the process of selling their home in the city and retiring to their cottage. Working with their advisor, they are looking to determine which property to treat as their principal residence under the PRE rule.

From 1986 until the end of 1994, Jane and John owned only the city house and, since the house was their only residence for those years, they can protect part of the gain on the house without affecting the PRE for the cottage. When we turn to the overlapping years since 1995 when they owned both the house and cottage, they will need to decide which property to allocate the PRE rule to. Because the Capital Gain on the house is larger, many would assume the PRE should be applied to the house; however, when we take into consideration the average capital gain for each property as seen below, using the PRE for the cottage would be more advantageous from a tax standpoint.  

There are some other considerations to take into account, including any unused RRSP contribution room or charitable donations that may help reduce owed taxes, as well as life insurance that may help cover any taxes owing on the future sale of the cottage. This example also assumes that the value of the cottage will not decline over time. These caveats illustrate why working with an advisor and considering all scenarios is important.

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DISCLAIMER: Opinions and estimates are written as of the date of this report and may change without notice.  This article is provided for your information only and is not to be considered investment advice. Readers should not act on this information without first consulting Milestone, their investment advisor, tax advisor, financial planner or lawyer. This communication is intended for Canadian residents only and does not constitute as an offer or solicitation by anyone in any jurisdiction in which such an offer is not allowed.