Tax Alert - Changes to the Principal Residence Exemption Announced

October 2016

There has been growing concern lately that certain taxpayers, particularly non-residents of Canada, may have been avoiding tax on Canadian real property gains by misusing the rules that allow a gain on a principal residence to be exempt from Canadian income tax. On October 3, 2016, Finance Minister Morneau announced several income tax measures meant to target this misuse.

However, one of these measures will apply to all Canadian taxpayers who sell a home after December 31, 2015. As explained more fully below, the Canada Revenue Agency (CRA) is dropping its long-standing policy of not requiring that a disposition of a principal residence be reported if there was no gain remaining after applying the principal residence exemption rules. This will mean that, starting in 2016, all dispositions of real property by individuals will need to be reported, even where the gain is fully sheltered by the principal residence exemption. Minister Morneau also introduced measures to place limits on the types of taxpayers who will be eligible to claim the principal residence exemption going forward.

The principal residence exemption

While many Canadians regard the gain on selling their home as “tax-free”, it is the workings of the principal residence exemption that achieves this result. In simple terms, the principal residence exemption is a special exemption that will reduce or eliminate the capital gain realized on the disposition of real property which constitutes a “principal residence”, thereby reducing income tax. In this regard, a principal residence is generally any residential property (such as a house) owned by an individual and “ordinarily occupied” by that individual, their spouse or common-law partner, their former spouse or common-law partner, or their child, at any time in the year. The individual may own the property jointly with another person and, under certain circumstances, the property may also be owned by a personal trust. Specific rules in respect of claiming the exemption may also apply where there has been a change in use of a property, such as where a principal residence converts to a rental property (or vice versa).

Note that while a taxpayer can designate a residential property as their principal residence for each year that they, their spouse (or common-law partner), and/or their minor child “ordinarily inhabited” the property, since 1982 only one property can be designated by this family unit as a principal residence in respect of a given taxation year.

Reporting the sale of a principal residence

Previously, the CRA did not require any reporting related to the sale of a principal residence, unless a capital gain was being reported. Typically, a taxpayer was simply required to retain the necessary information in the event that the CRA would request to see it.

Starting in 2016 (i.e. for dispositions of a principal residence that occur on or after January 1, 2016), in order to qualify for the exemption, the CRA will now require that a sale of a principal residence be reported on Schedule 3, Capital Gains, of the taxpayer’s T1 return. To facilitate this new reporting requirement, the CRA has indicated that for the 2016 T1 return, Schedule 3 will be revised to permit a designation of a property that was disposed of to be a principal residence. In particular, the schedule will be modified to require the disclosure of the year of acquisition, the proceeds of disposition, and a description of the property being designated as a principal residence.Note that deemed dispositions of a principal residence will also be required to be reported on the T1 return, including dispositions arising as a result of a change in use.

Previously, the CRA only required that a taxpayer file the Form T2091, Designation of a Property as a Principal Residence by an Individual (Other Than a Personal Trust), to designate a property as a principal residence when there was a capital gain to report (i.e. in situations where the property was not the taxpayer’s principal residence for all of the years they owned it). It appears that the CRA will continue its policy of not requiring Form T2091 to be filed when the gain on the disposition of the home is fully offset by the principal residence exemption. In addition, the requirement to file Form T1079, Designation of a Property as a Principal Residence by a Personal Trust, where a trust designates a property as a principal residence, also remains unchanged.

These new reporting requirements mean that, going forward, the principal residence exemption will only be allowed where the sale and designation of the principal residence is reported on the taxpayer’s income tax return. This represents a substantial change in administrative policy, which could have harsh consequences for a taxpayer who is not aware that the reporting requirements with respect to the disposition of a principal residence have changed. In order to provide relief in situations where the designation is not reported, the proposed measures also include legislation to extend the CRA’s ability to accept a late-filed designation in respect a principal residence. However, a penalty may apply. This penalty will be equal to the lesser of $8,000, or $100 for each complete month from the original due date of the relevant T1 return to the date that the request to the CRA to accept a late-filed designation is made. Note that, as a transitional measure, the CRA has indicated that it will limit the assessment of penalties for a late-filing of a principal residence designation in respect of dispositions occurring in the 2016 taxation year to only the most “excessive” cases. The CRA did not define what it would consider to be an “excessive” case.

In addition, the proposed measures include provisions which would extend the ability of the CRA to assess taxpayers beyond the normal reassessment period in respect of a disposition of real estate where the taxpayer failed to report the disposition on their tax return for the year in which the disposition occurs.

Other changes to eligibility for the principal residence exemption

In order to ensure that the principal residence exemption is made available only where appropriate, the government proposed a number of measures that would close tax loopholes which previously have allowed foreign owners and immigrants to Canada to claim the principal residence exemption in respect of real estate investments in Canada.

One such loophole was the use of the “one-plus” rule to shelter capital gains on a residence purchased by a foreign investor. The “one-plus” rule, as it pertains to the principal residence exemption, accounts for the year in which a taxpayer disposes of their former principal residence and acquires a new one. Since only one property can be designated as a principal residence for any given taxation year, the “one-plus” rule allows a taxpayer to reduce their capital gain to nil on the disposition of each of these properties, despite having owned both properties during the course of the same taxation year. However, the same rule that is meant to facilitate fairness in the taxation system for some taxpayers was creating an advantage for others whereby a foreign investor, or an immigrant who moved to Canada in a year after the year in which the Canadian property was acquired, could utilize the “one-plus” rule to reduce or eliminate their capital gain on the disposition of a “principal residence”. This was possible by allowing a year during which the property was owned by a non-resident to be an eligible year when calculating the principal residence exemption. The new rules propose to deal with this issue by limiting the application of the “one-plus” rule only to a taxpayer who is resident in Canada during the year in which they acquire the property. This measure will apply to dispositions occurring on or after October 3, 2016.

Additionally, new measures were introduced to curtail the use of trusts by non-residents to acquire property and subsequently claim the principal residence exemption. This is achieved by restricting certain trusts from being eligible to designate a property as a principal residence for years after 2016. For dispositions that occur in taxation years beginning after 2016, only a spousal or common-law partner trust, an alter ego trust (or a similar trust established for the exclusive benefit of the settlor during their lifetime), a qualifying disability trust, or a trust for the benefit of a minor child of deceased parents will be allowed to designate a property as a principal residence for years after 2016 for the purpose of the exemption. This will have the effect of ensuring that any gains accruing after 2016 on real property held by non-qualifying trusts will be taxable, and not sheltered by the principal residence exemption.

Furthermore, other new rules will require that the trust’s beneficiary who (or whose family member) occupies the residence for the year be resident in Canada in the year, and also be a family member of the individual who creates the trust.

For more information about these changes, please contact your BDO advisor.
 


The information in this publication is current as of  October 6, 2016.

This publication has been carefully prepared, but it has been written in general terms and should be seen as broad guidance only. The publication cannot be relied upon to cover specific situations and you should not act, or refrain from acting, upon the information contained therein without obtaining specific professional advice. Please contact BDO Canada LLP to discuss these matters in the context of your particular circumstances. BDO Canada LLP, its partners, employees and agents do not accept or assume any liability or duty of care for any loss arising from any action taken or not taken by anyone in reliance on the information in this publication or for any decision based on it.

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