For most people, the gain in value on their principal residence is completely tax-free. This is the case when someone lives in one home and there is no ‘change in use’ (turning your home from a principal residence into a rental, or vice versa).
It also applies when someone moves from one home to another (both principal residence) – the gain in value for both is tax-free.
But what happens when someone moves from their principal residence and rather than selling it – they rent it out? Or the opposite – when someone moves back into their home after having rented it out for a number of years?
Designation as Principal Residence
When a home is converted from a principal residence into a rental property (or vice versa) this is considered a ‘change in use’ by CRA and results in a ‘deemed disposition’. For more information on these topics click here.
When a property’s use is changed from a principal residence to a rental property, an election can be filed to avoid the deemed disposition on the property.
Related: Lessons from a First Time Landlord
A similar election can be made when a rental property becomes a principal residence.
The 4 Year Rule
A property owner can designate the property as their principal residence up to 4 years in which it isn’t normally inhabited.
The 4 year maximum doesn’t apply if all of the following conditions are met:
- The property wasn’t lived in due to a relocation of employment
- The employer isn’t a related party
- The property becomes a principal residence during employment or after termination of employment
Calculating the Principal Residence Exemption
The formula for calculating the principal residence exemption is:
(1 + # of years home was principal residence / # of years owned) x gain
For example: John has owned his home for 15 years (he bought it in 1999). In 2009 he converted it into a rental property. Since becoming a rental property, it has increased in value by $50,000 (any gain before becoming a rental is tax-free).
The exemption is: (1 + 10 years/15 years) x $50,000 = $36,667. This means the capital gain is $13,333 ($50,000 – $36,667) and half ($13,333 x 50% = $6,667) is taxable.
When a family owns more than one principal residence, it would likely make sense for them to designate each property for at least one year to take advantage of the “1+” part of the formula.
This rule doesn’t apply to non-residents of Canada or for any property held prior to 1982.
How to Handle a Move Due to Work
In some cases an individual might be unsure how long their relocation for work may last, whether they will buy another property at their new place of employment or if they will even return to the original property they left.
Filing the election can give the individual up to 4 years that the property can be designated.
If the person decides they won’t return or will buy another property in the new place of employment, the election (to avoid the deemed disposition) can be withdrawn. In this case the original property can be designated as the principal residence for enough years to offset the maximum amount of gains possible. In many cases this is 100%.
The only downside to an election is that you can’t claim Capital Cost Allowance (CCA).
The election gives the individual the option of keeping the tax-free status on the original property while he/she decides what to do in the future.
Where to Find More Information
To get more information from CRA relating to the principal residence exemption, click here.
Conclusion: the principal residence exemption allows someone to maintain the tax-free status of their original property for up to 4 years that it isn’t lived in (ie. becomes a rental property).
Note that the above discussion doesn’t include rental income – which has to be claimed in the years it was earned.