We had an interesting discussion last night during a sailboat race. My friend was telling me about his neighbour who was about to sell his house and move into his rental property, and in the process make a big tax mistake.
It turns out there’s still a lot of misunderstanding about the principal residence exemption (PRE), which real estate sales are tax-free and how you can lose that exemption. Let’s clarify.
Here is the situation:
A fellow we’ll call Bob has owned and lived in his house for 20 years. He has also owned a rental property nearby for 10 years.
For round numbers, the house in which he lived was purchased for $100,000 and is currently worth $300,000, called the fair market value or FMV.
However, Bob built an external garage, fence and created a beautiful oasis in the backyard, spending $50,000. This means that his adjusted cost base (ACB) on the house is $150,000.
The rental property was purchased for $150,000, and the FMV is now $300,000. No capital improvements have been made, just regular maintenance.
Bob’s clever plan was to sell his residence, the gain on which will be tax-free, then move into the rental property.
Here’s where the misunderstanding begins… He believes that if he spends a few years living in the rental property, it will also become eligible for the principal residence exemption.
Wrong… Or at least partially wrong, and potentially very expensive, if the Canada Revenue rules are not followed.
When Bob moves into the rental property, this is called a “change of use” of the property, prompting a deemed disposition.
This means that for tax purposes, Bob is deemed to have sold the rental property at the FMV on the day he moves in. That would prompt tax to be paid on the 50% of the capital gain that is taxable, at Bob’s marginal tax rate.
In this case, the gross gain is $150,000, $75,000 of which is taxable. That $75,000 will show up on his tax return and, assuming he had regular income of $45,000, he would pay about 40% tax on the $75,000, or $30,000.
Compounding the ouch is the fact that he has no cash proceeds with which to pay the tax, as he has not sold to a third party.
Possible good news is that Bob can file an election to delay reporting the disposition until he actually sells the property, by attaching a letter to his tax return and requesting that subsection 45 (3) of the income tax act applies.
This delays actually paying the tax on the gain until cash proceeds are received. Part of the gain will also be eligible for the PRE.
This election is not available if capital cost allowance (CCA) has been claimed in the property. This is a method by which an owner uses assumed depreciation of the property to offset some of the rental income each year that would otherwise be taxable.
Back to the house that Bob actually occupied, we have to remember that in 2016 CRA also changed the rules for claiming the PRE. Until then, virtually no one even mentioned such a sale on their tax returns. Now, to quote our friends at CRA:
“You will complete Schedule 3 and file it with your T1 Income Tax and Benefit Return for the year you sell the property. If the property was your principal residence for every year that you owned it, you will make the principal residence designation in your Schedule 3. In this case, the year of acquisition, proceeds of disposition and the description of the property are the information that will have to be reported. Schedule 3 will be modified accordingly.
“Form T2091 (or Form T1255) will still be required for the designation in the case the property was not your principal residence for all of the years that you owned it.”
Keep that filing in mind, or you could even lose the principal residence exemption when it would have otherwise applied.
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Dollars and Sense is meant as an introduction to this topic and should not in any way be construed as a replacement for personalized professional advice.
Please consult legal, tax, insurance and investment experts for advice on your unique situation.
David Christianson, BA, CFP, R.F.P., TEP, CIMis recipient of the FP Canada™ Fellow (FCFP)Distinction, and repeatedly named a Top 50 Financial Advisor in Canada. He is a Portfolio Manager and Sr Vice President with Christianson Wealth Advisors at National Bank Financial Wealth Management, and author of the book Managing the Bull, A No-Nonsense Guide to Personal Finance.