Brighton and Hove is a city in East Sussex, in South East England, which is known as the most populous seaside resort in England with 273,400 residents at the time of the last census in 2011. One of those residents was Hilaire Purbrick, who used to live in a seven-foot cave. Mr. Purbrick was forced out of his “residence” by the city council, who cited the lack of a fire exit as the reason he had to move.
If Mr. Purbrick were in Canada, he’d be out of luck if he were to sell the cave to another nature lover with the hope of claiming the principal-residence exemption (PRE) to shelter the place from tax. Our tax law has strict rules around what properties can qualify for that exemption (check out my article from last week).
To be sure, the taxman is not taking lightly the attempts of many homeowners to claim the PRE. Since 2015, the Canada Revenue Agency (CRA) has found an additional $635.7-million in taxes and penalties from the audit of real estate transactions over that time, and the CRA is looking at about 10,000 transactions a year that involve the PRE.
Each family unit (which includes you, your spouse or common-law partner and any children under the age of 18) is allowed to designate one property as their principal residence for each calendar year. So, if you own more than one property at the same time, you could end up paying tax on one or both of the properties eventually, if they’ve gone up in value.
Form T2091 is used to let the taxman know which property you want to designate as your principal residence for which years. In the past, there was no requirement to actually file this form if your intention was to designate a property as your principal residence for every year you owned it. This changed in 2016.
Today, you have to report a disposition (or partial disposition) of a principal residence on Schedule 3 of your tax return and must file Form T2091 if you’re claiming the PRE on a property.
Consider Fred and Wilma. They bought a city home in 1990 for $300,000 and a cottage in 1993 for $250,000. They plan to sell the cottage this summer. Today, the cottage is worth $625,000, so they expect to realize a capital gain of $375,000 ($625,000 less $250,000) when they sell it. The city home is worth $720,000 today.
The question: When they sell the cottage this year, can it be a tax-free sale? In short, the answer is yes. You see, both the city home and cottage can qualify as a principal residence because, in this case, they are both “capital properties” and they have “ordinarily inhabited” both places (see my article from last week). The problem? Fred and Wilma can choose to shelter the cottage from tax but doing this will restrict their ability to sell the city home completely tax-free.
Check out the math. You can designate one property as your principal residence for each calendar year. Fred and Wilma could designate the cottage as their principal residence for the years 1993 to 2018 inclusive, and this would allow them to fully shelter that property from tax. In this case, the exemption will be 26 years (if they designate that property from 1993 to 2018 inclusive) out of 26 years that they’ve owned the cottage. So, 26 years out of 26 years, or 100 per cent, of the gain on the cottage will be exempt from tax.
Notice, however, that the years 1993 through 2018 are now spoken for. Those years are not available to shelter the city home from tax if they sell that property later. So, if they were to sell the city home in 2018, too, they could designate it as their principal residence for the years 1990 (when they bought it) through 1992, a total of just three years out of the 29 years they’ve owned it. So, the exemption on the city home would be 3 years out of 29 years, or 10.3 per cent of the gain on that home. Got it?
One last point: Our tax law allows you to add one more year to the years you choose to designate a property. So, Fred and Wilma only have to designate the cottage for 25 years of the 26 years they’ve owned it and can still shelter the full gain from tax. This “one-plus” rule allows you to own two properties that may overlap by one year and still shelter both properties fully.
Tim Cestnick, FCPA, FCA, CPA(IL), CFP, TEP, is an author, and co-founder and CEO of Our Family Office Inc. He can be reached at firstname.lastname@example.org.