Consider the Principal Residence Exemption for Your Secondary Residence
Michelle Tatham, CIM, CFP Personal Finance & Wealth Management
In some parts of the country they’re referred to as cottages. Others call them cabins or chalets. No matter the label, owners of recreational properties have been feeling especially fortunate recently to have another place for a change of scenery. With remote access now the norm, some have reconsidered where they live and work too. At the same time, high demand, limited inventory, and low interest rates have conspired to elevate prices.
Families should contemplate the eventual tax implications of selling a cottage or passing it on to the next generation. While there are many strategies to consider, this article focusses on use of the principal residence exemption (PRE).
The PRE Tax Advantage
One of the best tax advantages for Canadians is the PRE when a qualifying property is sold, eliminating some or all of the realized capital gain. A qualifying property can be a house, condominium, cottage, trailer, motor-home, or houseboat – an inhabitable property that is owned for personal use purposes and that does not generate any income. To qualify for the exemption, you need only designate the property as your principal residence. However, if a ‘family unit’ owns more than one qualifying property, only one property can be designated as the principal residence per year. The family unit includes your spouse or common-law partner and minor children, and pertains to properties owned after 1981 (for properties purchased prior to 1982, each spouse is entitled to a PRE up to the 1981 tax year).
WHAT CHANGED IN 2016?
The PRE has been around for decades and because it is well-known people pay little attention to reporting the sale of their homes or the realized capital gain. This needs to change, especially with reporting requirements that came into effect in 2016 and potential optimization of the PRE for families that own more than one home. For 2017 and subsequent years, if a property is sold and filers neglect to report the sale on their tax return or neglect to file the principal residence exemption, the entire taxable capital gain will be included in taxable income.
Can a Cottage Be a Principal Residence?
One of the most common misconceptions we encounter about the PRE and cottage ownership is that the PRE only applies to the property that is primarily lived in, often with a mistaken belief that the family must prove they live there, for example, by receiving mail at the property. However, when a family owns more than one residential property, any one of those properties can be designated as a principal residence, as long as the intent of the property is for personal use. This means, the property cannot be used for commercial purposes or produce income.
Optimizing the PRE
The value of the PRE to taxpayers increases with property values. But with a little bit of record keeping, multiple property owners can actually optimize use of the PRE and benefit from a little-known rule called the “one-plus rule” which provides one additional tax year of exemption to recognize that a taxpayer (and Canadian resident) can have two residences in one year if one is sold and another one is bought in the same year.
When you sell a property, you are required to report basic information on your tax return such as the year of acquisition, address, proceeds on disposition, and the adjusted cost base (or ACB). This data is needed to compute the capital gain, but more importantly the capital gain per year of ownership. To optimize the tax benefit of the PRE, it must be applied to the property that has the highest capital gain per year of ownership. Not just the biggest increase in fair market value. This is another mistake we often see and the reason we highly recommend that multiple property owners keep supporting documents for the ACB of each property, regardless of which property is the principal residence.
The ACB is normally the purchase price plus fees and commissions to buy the property, plus capital expenditures to improve the property. Therefore, while a major renovation may increase the fair market value of the property, it also raises the ACB of the property, which may result in a material reduction in capital gains.
To illustrate, let’s assume a married couple purchased a house in 1999 for $600,000 and a cottage in 2014 for $200,000. Over the years $150,000 was spent renovating the home and now the ACB of the home is $750,000. The couple plan to sell both properties in 2021 and buy a smaller home. Let’s assume the house is sold for net proceeds of $1.1 million and the cottage for $350,000. Most people would assume their house is the principal residence and as a result, would miss the opportunity to optimize the PRE in this case, potentially paying tax on an additional $10,598 of taxable capital gains.
In the example, the cottage has the highest capital gain per year of ownership. By designating the house as principal residence for 16 years (1999 to 2014) and the cottage as principal residence for 7 years (2015 to 2021) and using the one-plus rule, those additional taxable capital gains could be saved.
This is but one example of the value added assistance we can provide to clients beyond our core investment advisory services, in a world with increasing complexities.
DISCLAIMER
The information contained herein is for informational and reference purposes only and shall not be construed to constitute any form of investment advice. Nothing contained herein shall constitute an offer, solicitation, recommendation or endorsement to buy or sell any security or other financial instrument. Investment accounts and funds managed by Generation PMCA Corp. may or may not continue to hold any of the securities mentioned. Generation PMCA Corp., its affiliates and/or their respective officers, directors, employees or shareholders may from time to time acquire, hold or sell securities mentioned.
The information contained herein may change at any time and we have no obligation to update the information contained herein and may make investment decisions that are inconsistent with the views expressed in this presentation. It should not be assumed that any of the securities transactions or holdings mentioned were or will prove to be profitable, or that the investment decisions we make in the future will be profitable or will equal the investment performance of the securities mentioned. Past performance is no guarantee of future results and future returns are not guaranteed.
The information contained herein does not take into consideration the investment objectives, financial situation or specific needs of any particular person. Generation PMCA Corp. has not taken any steps to ensure that any securities or investment strategies mentioned are suitable for any particular investor. The information contained herein must not be used, or relied upon, for the purposes of any investment decisions, in substitution for the exercise of independent judgment. The information contained herein has been drawn from sources which we believe to be reliable; however, its accuracy or completeness is not guaranteed. We make no representation or warranties as to the accuracy, completeness or timeliness of the information, text, graphics or other items contained herein. We expressly disclaim all liability for errors or omissions in, or the misuse or misinterpretation of, any information contained herein.
All products and services provided by Generation PMCA Corp. are subject to the respective agreements and applicable terms governing their use. The investment products and services referred to herein are only available to investors in certain jurisdictions where they may be legally offered and to certain investors who are qualified according to the laws of the applicable jurisdiction. Nothing herein shall constitute an offer or solicitation to anyone in any jurisdiction where such an offer or solicitation is not authorized or to any person to whom it is unlawful to make such a solicitation.
In some parts of the country they’re referred to as cottages. Others call them cabins or chalets. No matter the label, owners of recreational properties have been feeling especially fortunate recently to have another place for a change of scenery. With remote access now the norm, some have reconsidered where they live and work too. At the same time, high demand, limited inventory, and low interest rates have conspired to elevate prices.
Families should contemplate the eventual tax implications of selling a cottage or passing it on to the next generation. While there are many strategies to consider, this article focusses on use of the principal residence exemption (PRE).
The PRE Tax Advantage
One of the best tax advantages for Canadians is the PRE when a qualifying property is sold, eliminating some or all of the realized capital gain. A qualifying property can be a house, condominium, cottage, trailer, motor-home, or houseboat – an inhabitable property that is owned for personal use purposes and that does not generate any income. To qualify for the exemption, you need only designate the property as your principal residence. However, if a ‘family unit’ owns more than one qualifying property, only one property can be designated as the principal residence per year. The family unit includes your spouse or common-law partner and minor children, and pertains to properties owned after 1981 (for properties purchased prior to 1982, each spouse is entitled to a PRE up to the 1981 tax year).
WHAT CHANGED IN 2016?
The PRE has been around for decades and because it is well-known people pay little attention to reporting the sale of their homes or the realized capital gain. This needs to change, especially with reporting requirements that came into effect in 2016 and potential optimization of the PRE for families that own more than one home. For 2017 and subsequent years, if a property is sold and filers neglect to report the sale on their tax return or neglect to file the principal residence exemption, the entire taxable capital gain will be included in taxable income.
Can a Cottage Be a Principal Residence?
One of the most common misconceptions we encounter about the PRE and cottage ownership is that the PRE only applies to the property that is primarily lived in, often with a mistaken belief that the family must prove they live there, for example, by receiving mail at the property. However, when a family owns more than one residential property, any one of those properties can be designated as a principal residence, as long as the intent of the property is for personal use. This means, the property cannot be used for commercial purposes or produce income.
Optimizing the PRE
The value of the PRE to taxpayers increases with property values. But with a little bit of record keeping, multiple property owners can actually optimize use of the PRE and benefit from a little-known rule called the “one-plus rule” which provides one additional tax year of exemption to recognize that a taxpayer (and Canadian resident) can have two residences in one year if one is sold and another one is bought in the same year.
When you sell a property, you are required to report basic information on your tax return such as the year of acquisition, address, proceeds on disposition, and the adjusted cost base (or ACB). This data is needed to compute the capital gain, but more importantly the capital gain per year of ownership. To optimize the tax benefit of the PRE, it must be applied to the property that has the highest capital gain per year of ownership. Not just the biggest increase in fair market value. This is another mistake we often see and the reason we highly recommend that multiple property owners keep supporting documents for the ACB of each property, regardless of which property is the principal residence.
The ACB is normally the purchase price plus fees and commissions to buy the property, plus capital expenditures to improve the property. Therefore, while a major renovation may increase the fair market value of the property, it also raises the ACB of the property, which may result in a material reduction in capital gains.
To illustrate, let’s assume a married couple purchased a house in 1999 for $600,000 and a cottage in 2014 for $200,000. Over the years $150,000 was spent renovating the home and now the ACB of the home is $750,000. The couple plan to sell both properties in 2021 and buy a smaller home. Let’s assume the house is sold for net proceeds of $1.1 million and the cottage for $350,000. Most people would assume their house is the principal residence and as a result, would miss the opportunity to optimize the PRE in this case, potentially paying tax on an additional $10,598 of taxable capital gains.
In the example, the cottage has the highest capital gain per year of ownership. By designating the house as principal residence for 16 years (1999 to 2014) and the cottage as principal residence for 7 years (2015 to 2021) and using the one-plus rule, those additional taxable capital gains could be saved.
This is but one example of the value added assistance we can provide to clients beyond our core investment advisory services, in a world with increasing complexities.
DISCLAIMER
The information contained herein is for informational and reference purposes only and shall not be construed to constitute any form of investment advice. Nothing contained herein shall constitute an offer, solicitation, recommendation or endorsement to buy or sell any security or other financial instrument. Investment accounts and funds managed by Generation PMCA Corp. may or may not continue to hold any of the securities mentioned. Generation PMCA Corp., its affiliates and/or their respective officers, directors, employees or shareholders may from time to time acquire, hold or sell securities mentioned.
The information contained herein may change at any time and we have no obligation to update the information contained herein and may make investment decisions that are inconsistent with the views expressed in this presentation. It should not be assumed that any of the securities transactions or holdings mentioned were or will prove to be profitable, or that the investment decisions we make in the future will be profitable or will equal the investment performance of the securities mentioned. Past performance is no guarantee of future results and future returns are not guaranteed.
The information contained herein does not take into consideration the investment objectives, financial situation or specific needs of any particular person. Generation PMCA Corp. has not taken any steps to ensure that any securities or investment strategies mentioned are suitable for any particular investor. The information contained herein must not be used, or relied upon, for the purposes of any investment decisions, in substitution for the exercise of independent judgment. The information contained herein has been drawn from sources which we believe to be reliable; however, its accuracy or completeness is not guaranteed. We make no representation or warranties as to the accuracy, completeness or timeliness of the information, text, graphics or other items contained herein. We expressly disclaim all liability for errors or omissions in, or the misuse or misinterpretation of, any information contained herein.
All products and services provided by Generation PMCA Corp. are subject to the respective agreements and applicable terms governing their use. The investment products and services referred to herein are only available to investors in certain jurisdictions where they may be legally offered and to certain investors who are qualified according to the laws of the applicable jurisdiction. Nothing herein shall constitute an offer or solicitation to anyone in any jurisdiction where such an offer or solicitation is not authorized or to any person to whom it is unlawful to make such a solicitation.
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