For many Canadians, their home is their most valued asset. It is often considered the most significant purchase, and might provide the greatest return relative to risk. This return is enhanced by the fact that Canadians are not required to pay tax on increases in the value of a principal residence.
The Income Tax Act (ITA) states that when an individual disposes of his or her principal residence, any increase in value of the home is exempt from capital gains tax. To receive the exemption, certain conditions must apply. They include the following:
- The home was “ordinarily inhabited” by the taxpayer, his or her spouse or common-law partner, former spouse or common-law partner or child.
- No other property was designated a principal residence by any member of the taxpayer’s family unit. A family unit includes the taxpayer, his or her spouse or common-law partner and children (other than those who are married, in a common-law partnership or 18 years of age or older).
These rules are fairly straightforward when a family owns one home. But what if the family owns more than one home? What if the family owns a city home in Toronto and a cottage in Muskoka? What if the cottage appreciates in value more than the city home? Can the principal residence exemption be claimed on the cottage instead of the home in Toronto? How does one designate a property as a principal residence? Does the amount of time spent at each property play a role? Consider the following example.
Nathan is recently widowed with two kids, Sandra (age 33) and Kyle (age 27). Nathan owns two homes – a condominium in Halifax that he purchased in 1995 and a cottage on the lake in Canso, which he purchased in 2000. He spends most of each year in the Halifax condominium and the summer months at the Canso cottage. It is Nathan’s intention to leave both properties to his kids at the time of his death. If, at the time of death, Nathan’s cottage has increased in value more than his city home, can his cottage be designated his principal residence thereby sheltering it from tax?
When two or more homes are owned, the principal residence exemption can be claimed on any home provided the designated home was occupied at some point during the years it was designated, no other property was designated as the taxpayer’s principal residence for those years and the property was not used primarily to produce rental or business income. In other words, assuming both homes are held until his death, Nathan’s executor can designate his cottage as his principal residence, sheltering a larger portion of growth from tax. The fact that Nathan and his family occupied the cottage only periodically each summer does not impact this claim – even if a property is inhabited for only a short period of time each year, this is sufficient for the property to be declared a principal residence for those years.
The decision to claim one property versus another as a principal residence is not required each year – a declaration is not made until the properties are sold. CRA form T2091 (IND), Designation of a Property as a Principal Residence by an Individual (Other Than a Personal Trust), is the form used for this purpose. Form T1255, Designation of a Property as a Principal Residence by the Legal Representative of a Deceased Individual, is used in the case of death. Despite the availability of these forms, CRA practice is not to require them unless the property your client is claiming as their residence is not designated as such for each year it is owned. In other words, assuming the cottage has increased in value more than the Halifax condo at the time of sale or at death, Nathan’s cottage can be designated his principal residence for each year he owned it. The above-mentioned forms would not be required for the cottage and it would be fully exempt from tax.
It is common for clients to want to control the distribution of their assets at death. Some choose to extend control after death through the use of testamentary trusts. Testamentary trusts can be effective estate planning tools as they allow clients to control the handling of their assets long after they’re gone. This can be particularly beneficial for blended families where an asset is to provide for a beneficiary while alive and be passed to a different beneficiary – one chosen by the deceased as opposed to the beneficiary – after death of the first beneficiary. Can real estate be held in a testamentary trust? Can the principal residence exemption be used to offset a gain on distribution of a home by the trust? If your client were granted a lifetime interest in a home with the property passing to a different beneficiary on your client’s death, would the principal residence exemption be available to offset a gain on the home? Let’s consider Nathan’s situation again.
Several years after his wife’s death, Nathan met Jane. Jane, also a widower, had one son, Ale, age 25. Before long, a relationship ensued and Nathan and Jane were married. They lived together in Nathan’s condominium in Halifax. Jane did not have a home that she owned. Shortly after retiring, Nathan sold his condominium and he and Jane moved into the cottage on the lake. Since the value of the cottage had appreciated more than the condominium, Nathan claimed the condominium as his principal residence for only the years he owned it before buying the cottage. Because his cottage had a greater appreciation in value, he decided to save the exemption for it. While reviewing his estate plan, Nathan considered that he would love to provide the cottage as a residence for Jane while she is alive, but would ultimately want the property to pass to his kids, Sandra and Kyle, on Jane’s death. In speaking with his financial advisor, it was suggested that he could set up a testamentary trust to achieve this. In fact, he was advised that he could transfer the cottage to the trust and the property would not be considered disposed until transferred to his kids at the time of Jane’s death. Seeing that the trust would hold the property during Jane’s lifetime, Nathan inquired as to whether the principal residence exemption would be available to shelter the cottage from tax when she died.
The ITA states that a personal trust, which would include a testamentary trust, can claim the principal residence exemption for a home held by the trust where the home was occupied by a “specified beneficiary”. A specified beneficiary is generally one that is entitled to income or capital of the trust and ordinarily inhabits the home. The CRA has indicated that a person who has the right to reside rent-free in a housing unit held by the trust (eg. a lifetime interest) could satisfy these conditions. Because Jane would occupy the home as her principal residence, she should qualify as a specified beneficiary. This would allow the trust to claim the principal residence exemption, fully exempting the cottage from tax on transfer to Nathan’s kids.
Although Sandra and Kyle would also be beneficially interested in the trust (eg. they would ultimately receive the cottage on Jane’s death), they would not be considered specified beneficiaries for purposes of the exemption provided they do not ordinarily inhabit the cottage. In fact, if Sandra and Kyle have their own residences and intend to claim the principal residence exemption on it, they should be careful not to be specified beneficiaries of the trust – doing so could impact the claim on their own homes.
CRA form T1079, Designation of a Property As a Principal Residence By A Personal Trust, is used to claim the principal residence exemption for a trust.
When discussing real estate with your clients, be sure to consider the flexibility of the principal residence exemption. These discussions can go a long way in preserving the wealth of their families.