July 10, 2017: This article has been corrected from an earlier version that misstated the formula for calculating the PRE. We regret the error.
The principal residence exemption (PRE) creates a high degree of planning flexibility.
Under the Income Tax Act, each family unit can designate one property per year as its principal residence. A family unit consists of the taxpayer, the spouse or common-law partner and any children under the age of 18. The PRE allows them to claim a capital gain exemption for some or all of the years they lived in the home. They must share the exemption.
The PRE applies to the building and up to one-half hectare (or 1.2 acres) of subjacent and adjacent land. If there’s more land, the owner must prove it’s required for the taxpayer’s use and enjoyment of the property.
The PRE can apply to any property that’s ordinarily inhabited by the person (and his or her family) during the year, provided it’s not primarily used to earn income. There’s no statutory definition of “ordinarily inhabited,” but the CRA has said residing in a property for “short periods of time” will qualify for the PRE.
So, many clients who own secondary properties can choose which property they claim for the PRE. In certain circumstances the PRE can also apply to property held within a trust.
History of the PRE
Prior to December 31, 1981, each taxpayer was entitled to a PRE. So, if a husband and wife owned a house and a cottage, each spouse could designate one of the properties as a principal residence and be eligible for the full PRE for each property.
This is no longer permitted: only one property per family unit can be designated a principal residence at any given time.
Calculating the PRE
The principal residence exemption is claimed at the time the property is sold or deemed to be sold. This is the formula used to calculate it*:
([1 + number of years designated]/number of years owned) x gain = exemption amount
If a taxable capital gain applies after the exemption is taken into account, Form T2091 – Designation of a Property as a Principal Residence by an Individual (Other than a Personal Trust) must be completed and filed with the taxpayer’s return in the year they disposed of the property or deemed it disposed.
The years referred to in the formula refer to calendar years after 1971. The “1” in the formula covers any partial years the property was owned.
PRE splitting example
Mr. Black owned a home in the city, purchased in 2004 for $300,000. He also owned a cottage, purchased in 2009 for $240,000. He sold both properties in 2013—the city home for $600,000 and the cottage for $400,000. What is the best use of his principal residence exemption?
Since the city home was his only property from 2004 to 2008, he uses the exemption on that property for these years. For 2009 to 2013, when Black owns two properties, he must determine which property to use the PRE on.
Let’s look at the capital gain he would trigger for each property over the years he owns it.
|Home in the city||Cottage|
|Proceeds of disposition||$600,000||$400,000|
|Gain per year||$300,000 / 10 years = $30,000||$160,000 / 5 years = $32,000|
The cottage has a larger capital gain on a per-year basis, so it may make sense to designate it as the principal residence for 2010 to 2013, inclusive. That’s four years, because the formula is 1+the years designated for the exemption.
This allows him to eliminate the capital gains tax on the sale of the cottage. He can then designate his city home his principal residence for the years 2004 through 2009, which would allow him to shelter $210,000 of the capital gain.
This is calculated as [(1+6)/10] x 300,000. As a result, his capital gain would be $90,000 and his taxable capital gain $45,000. This strategy would provide bigger tax savings than only designating his city home as his principal residence for all years.
Designating his city home the principal residence would have meant paying a capital gain on his cottage of $160,000—$80,000 of which would have been taxable. By splitting his principal residence exemption, he’s reduced his taxable capital gains by $35,000.
PRE and trusts
A personal trust can designate a property held within it as a personal residence and still be eligible for the PRE.
To be eligible for the exemption, the person using the property as the principal residence must be a specified beneficiary of the trust. And either he, his spouse or common-law partner, his former spouse or common-law partner, or child must ordinarily inhabit the property.
For the trust to designate the property a principal residence, no corporation or partnership could have been beneficially interested in the trust at any time during the year.
When the PRE is used by a trust, no specified beneficiary or member of his family can designate another property as a personal residence at any time during the calendar year the exemption is used.
For example, Mr. Black is a specified beneficiary of personal trust A that holds the property Mr. and Mrs. Black live in. Mrs. Black is a specified beneficiary of personal trust B that holds the family cottage. Trust A designates the PRE to the property in trust A, since Mr. and Mrs. Black live there. As a result, trust B cannot designate the cottage as a personal residence and be entitled to the PRE. A family unit cannot designate more than one property as a principal residence, even if the properties are held in separate trusts.
*A previous version of this story misstated the formula for calculating the PRE. Return to the corrected sentence.