Selling your Home - Tax Implications
The sale of a "principal residence" is exempt from capital gains tax (known as the Principal Residence Exemption or PRE). If you sell your home and it's considered a "principal residence" throughout your ownership period, there's no "capital gains tax" that needs to be paid or remitted to the Canada Revenue Agency (CRA). However, there may be situations where the sale of your 'property' attracts 'capital gains' tax. This will be discussed shortly.
So - how does CRA define a "principal residence"?
A principal residence is defined as a house, apartment in a duplex, apartment building or condominium, cottage, houseboat, trailer or mobile home, or a share in a co-operative housing corporation.
To qualify as a principal residence certain criteria must be met:
- The taxpayer must own the housing unit, either jointly or solely.
- A family unit may only have one principal residence.
- The land upon which the housing unit sits cannot exceed one acre and any excess is not considered part of the principal residence unless the taxpayer can prove it is necessary for personal use and enjoyment.
- The unit must be ordinarily inhabited in the year by the taxpayer or by his/her spouse or common-law partner, former spouse or common-law partner, or child.
- The unit must be designated as the taxpayer's principal residence for the year.
In most instances, it should be easy to determine whether your home qualifies as a principal residence or not. However, there are situations that create uncertainty and if this should be the case, consider speaking to an informed accountant!
New rule announced by the federal government that applies for tax years that end after October 2, 2016:
The Canada Revenue Agency (CRA) will require a taxpayer to report the disposition of a property for which the principal residence exemption is claimed. The CRA currently does not require this reporting where a property is eligible for the full principal residence exemption. The change means that, when a taxpayer disposes of a principal residence, the taxpayer will be required to provide basic information in the taxpayer’s income tax return for that year in order to claim the exemption. In addition, the CRA will be explicitly authorized to accept late-filed principal residence designations. More details are available on the CRA’s website.
One such situation that may involve uncertainty as to whether a home qualifies as a principal residence is the rental of a property that you once treated as your principal residence. So, imagine you bought a home several years ago that met the definition of a 'principal residence'; fast forward to today - you decide to rent part or all of this 'property'. There may be tax consequences that arise as a result of this 'change in use' that must be reported to CRA. Fast forward to the eventual sale of your property - There may be a capital gain to report relating to those years where your property wasn't designated or treated as a principal residence.
Another such situation may involve a home based business - Imagine you operate a home based business from your principal residence. On your tax return, you claim various home based expenses, including depreciation (on the portion relating to your home office). This may trigger a negative tax consequence on the eventual sale of your 'principal residence'; this is why accountants will generally advise those operating home based businesses not to take any depreciation (CCA)!
Both these situations demonstrate exactly why having a knowledgeable accountant in these specific areas is valuable. He/she can advise you as to any tax consequences and possible solutions; of course, everything depends on your facts and circumstances!
Key takeaway - if you intend on renting out part or all of your 'property' or 'properties', or you intend on operating a home based business, speak to an accountant knowledgeable in these areas. You don't want to unknowingly jeopardize the use of the 'principal residence exemption'.
Let's explore these 'change in use' rules in more detail.
Renting All or Part of your ‘Property’ – Tax implications
As mentioned, when you sell your home or when you are considered to have sold it, usually, you don't have to pay tax on any gain from the sale provided your home was your 'principal residence' for every year you owned it. Also keep in mind that prior to a rule change in 2016, there was no requirement to report the sale on your tax return. As a result of the rule change, from 2016 onwards, the sale of your principal residence needs to be disclosed on your tax return.
If your home was not your principal residence for every year that you owned it, you may have to report the part of the capital gain on the property that relates to the years for which you did not designate the property as your principal residence. You designate your home as your principal residence when you sell or are considered to have sold all or part of it. You can designate your home as your principal residence for the years that you own and use it as your principal residence. However, you do not have to designate it each year.
To designate a property as the principal residence, it does not have to be the place where the taxpayer lives all the time. The property will qualify as a principal residence if the taxpayer, taxpayer's spouse or common-law partner, or any of the taxpayer's children lived in it at some time during the year. However, if it is rented out the situation may change.
For tax purposes, every time you change the use of a property, there may be tax consequences that are triggered. You can be considered to have sold all or part of your property even though you did not actually sell it! This is called a deemed disposition and can arise if:
• You change all of your principal residence to a rental or business operation.
• You change part of your principal residence to a rental or business operation.
• You change your rental or business operation to a principal residence
Think about like this – Five years ago, you bought a detached home and it’s been your ‘principal residence’ ever since. Fast forward to today – You’ve made the decision to rent part or all of your home. You find a great tenant and start collecting rent for the next five years. You potentially have a ‘change in use’ when you first start renting; after all, you went from a ‘principal residence’ to a ‘rental property’. Ten years in (from when you bought the home), circumstance is such that you will no longer be renting any portion of your property. At this point (ten years in), there’s another potential ‘change in use’; this time from rental property back to ‘principal residence’. At no time during these past ten years have you sold the property; you still own it but CRA looks at these ‘changes in use’ as deemed dispositions.
Well – subject to a few exceptions that I’ll get to shortly, every time you change the use of a property, you are considered to have sold the property at its fair market value and to have immediately reacquired the property for the same amount and in certain situations, you have to report the resulting capital gain or loss in the year the change of use occurs.
If the property was your ‘principal residence’ for any year you owned it before you changed its use, you do not have to pay tax on any gain that relates to those years. You may only have to report the gain that relates to the years your home was not your ‘principal residence’.
So – what are these exceptions:
1) Changing all your principal residence to a rental or business property
When you change your principal residence to a rental or business property, you can make an election not to be considered as having started to use your principal residence as a rental or business property. This means you do not have to report any capital gain when you change its use. If you make this election:
• you have to report the net rental or business income you earn; and
• you cannot claim capital cost allowance (CCA) on the property.
While your election is in effect, you can designate the property as your principal residence for up to four years, even if you do not use your property as your principal residence. However, you can only do this if you do not designate any other property as your principal residence for this time.
You can extend the four year limit indefinitely provided certain requirements are met. I haven’t included these requirements.
To make this election, attach a letter signed by you to your income tax and benefit return of the year in which the change of use occurs. Describe the property and state that you want subsection 45(2) of the Income Tax Act to apply.
2) Changing part of your principal residence to a rental or business property
You are usually considered to have changed the use of part of your principal residence when you start to use that part for rental or business purposes. However, you are not considered to have changed its use if:
• your rental or business use of the property is relatively small in relation to its use as your principal residence;
• you do not make any structural changes to the property to make it more suitable for rental or business purposes; and
• you do not deduct any CCA on the part you are using for rental or business purposes.
If you meet all of the above conditions, the whole property may qualify as your principal residence, even though you are using part of it for rental or business purposes.
However, if you do not meet all of the above conditions, when you actually sell the property you have to:
• split the selling price between the part you used for your principal residence and the part you used for rental or business purposes. CRA will accept a split based on square metres or the number of rooms as long as the split is reasonable; and
• report any capital gain on the part you used for rental or business purposes. You do not have to report any capital gain for the part you used for your principal residence.
Note -You cannot file an election under subsection 45(2) of the Income Tax Act, if there is only a partial change in use of a property.
3) Changing your rental or business property to a principal residence
When you change your rental or business property to a principal residence, you can elect to postpone reporting the disposition of your property until you actually sell it. However, you cannot make this election if you, your spouse or common-law partner, or a trust under which you or your spouse or common law partner is a beneficiary has deducted CCA on the property for any tax year after 1984, and on or before the day you change its use.
This election only applies to a capital gain. If you claimed CCA on the property before 1985, you have to include any recapture of CCA in your business or rental income. Include the income in the year you changed the use of the property. If you need more information on the recapture of CCA or on a host of other rental related matters, see T4036, Rental Income guide.
Recapture happens if the selling price of the building is greater than the remaining undepreciated capital cost (UCC) at the time of sale. The difference between the original cost and the UCC will be added back to income. If the selling price is greater than the original cost of the building, then the difference between the selling price and the original cost will be a capital gain. When purchasing or selling a rental property, it is important to break down the purchase or sale price between buildings and land.
If you make this election, you can designate the property as your principal residence for up to four years before you actually occupy it as your principal residence.
To make this election, attach to your income tax return a letter signed by you. Describe the property and state that you want subsection 45(3) of the Income Tax Act to apply. You have to make this election by whichever of the following dates is earlier:
• 90 days after the date we ask you to make the election; or
• the date you are required to file your income tax and benefit return for the year in which you actually sell the property.
A few parting comments – First, you’ll notice that the ‘deemed disposition’ rules mentioned above refer to a ‘rental or business operation’. To determine whether your rental income is from property or from business, consider the number and kinds of services you provide for your tenants.
In most cases, you are earning income from property if you rent space and provide basic services only. Basic services include heat, light, parking, and laundry facilities. If you provide additional services to tenants, such as cleaning, security, and meals, you may be carrying on a business. The more services you provide, the greater the chance that your rental operation is a business. The distinction matters because there are different taxation rules depending on whether you have rental income or business income.
Key takeaway - The best advice that I can offer as a real estate agent (and former corporate tax accountant) is to seek the advice of a knowledgeable accountant in this area. You’ll be advised of any tax consequences and potential solutions. They can assist you in deciding whether to claim CCA or not and whether it's advisable to file the election under 45(2) of the Income Tax Act.
How to determine whether the Sale of a Rental property gives rise to a Capital gain vs. Ordinary income
It's important to remember that capital gains are taxed differently (and more favourably) than ordinary income. So - for the 'house flippers' among you or for those who have one or more rental properties, keep reading. The Income Tax Act does not specifically set out whether or not a gain or loss is capital in nature.The taxpayer is responsible for reporting the gain as income or capital gain. This report may then be challenged by the Canada Customs and Revenue Agency with the onus of proof on the taxpayer.
Over the years, determining whether something is a capital gain or not has been determined based on a number of factors such as the intention of the taxpayer, relationship to the taxpayer's business, frequency of transactions, length of time held, nature of the transaction and objects of the corporation. Following are several factors that help determine how to characterize the income generated from the sale of rental property:
What was the taxpayer's intention at the time the property was purchased?
When a property is purchased for investment, any resale profit could still be considered taxable as ordinary income, if the apparent intent was to resell for a profit at a future time. The Tax Court will consider such things as reasons for the sale, compelling necessity, change in circumstance and external factors.
Relationship to the Taxpayer's Business:
The Tax Court will undoubtedly classify profits as taxable under ordinary business income when a taxpayer uses expertise acquired in regular business activity to generate a profit on the purchase/sale of similar or related commodities. The court also looks at the time and attention the taxpayer spent on the transaction. Real Estate transactions of contractors, renovators, brokers, sales people, and appraisers have typically fallen under close scrutiny.
Frequency of Transactions:
Revenue Canada will assess how often the taxpayer engages in the sale of capital property. Usually, frequency of such occurrences suggests the carrying on of a business for profit. Assessment as ordinary business income will be the result. However, even an isolated transaction can be so judged, given the right set of circumstances.
Nature of Transaction and Assets:
Taxability as income may be indicated if the asset cannot normally be used either personally or for investments purposes. Mortgages are often judged under this test. If the mortgages are purchased at substantial discounts or have a short maturity date, the mortgagee may be viewed as being in a business that realizes profit from the transaction, thus invoking business income as opposed to capital gain.
Objects of the Corporation:
The Tax Court will look at the articles of incorporation to determine if a transaction falls under the objects of the corporation, and if it is part of usual business. However, the absence of this provision may not be deemed conclusive by the Court. Proving that a specific sale fell beyond the normal course of affairs of the company is difficult and once again the burden of proof rests with the taxpayer.
SPECIAL NOTE
Real Estate Transactions:
Profits would likely be taxed as regular business income if a taxpayer buys and sells real estate on a regular basis. However, if the taxpayer can prove that these dispositions were a planned and necessary part of a total investment program, then there may be a case for capital gains treatment of the profit. In the case of farmlands, if the taxpayer purchased or inherited the land and lived on it for a period of time, a disposition of the property will most likely be regarded as a capital gain.
Key takeaway - If you're interested in or currently 'flipping properties' OR you have one or more rental properties generating a revenue stream, let your accountant know your circumstances. Making informed decisions is key!