As Canadians enter the second year of changes to rules that require taxpayers to report the “disposition” of a principal residence, lawyers and accountants warn there are some hidden land mines that could blow up previous estate planning efforts. If clients fail to report or account for the sale of a principal residence, they may be exposed to capital gains taxes under recent changes to the principal residence exemption (PRE) regime.

“Everyone has to report the disposition of a principal residence,” says Kim Drever, partner, accountant and regional leader in the taxation services group at MNP LLP in Grande Prairie, Alta. She notes that a “disposition” can arise in several instances beyond the simple sale of a home.

For example, when taxpayers die, they are deemed to have disposed of their assets. Divorces and the transfer of property can also be problematic when it comes to who claims the PRE. As well, any trust that was set up for a client a few years ago to leave the house to a spouse could be offside under the new PRE regime.

Under the changes, individuals who are not Canadian residents at the time they acquired their home cannot claim an exemption for the years they did not reside in the home.

The government also tinkered with eligibility criteria involving trusts as it relates to a principal residence. As well, Canadians must now inform the Canada Review Agency (CRA) when they sell a principal residence. They must designate which years during ownership that the house constituted the principal residence. Only one principal residence can be designated at a time.

The CRA is “going to be paying a lot more attention to whether people are properly maintaining their principal residence exemption,” says Jamie Golombek, managing director, tax and estate planning at Canadian Imperial Bank of Commerce‘s wealth strategies group in Toronto. He adds that ” frequent flippers” could be reassessed easily and have the gains included as business income.

Many Canadians own rental or cottage properties – one report suggests 20% own rental real estate – which means that more attention has to be paid to which house your client wants to claim as the PRE.

For example, Golombek says, if a client has two homes and decides to sell one and incurs a gain, but also has a second property that has more upside potential – say, in Toronto or Vancouver – the client might want to claim that property as his or her principal residence and pay gains on the home that was sold.

Taxpayers also need to take more care when tracking things such as renovation expenses. The cost of upgrades, such as a new roof or kitchen, can be added to a home’s adjusted cost base, which lowers capital gains. “If you own more than one residence, you have to do a really good job tracking what you paid for it and all the costs of renovations,” says Drever.

Karen Slezak, partner and leader of estates and trusts within Crowe Soberman LLP’s tax group in Toronto, warns that one area that’s particularly tricky involves the use of spousal and alter ego trusts. Depending on how a trust is worded, the PRE could be negated.

Before the changes, “we had a pretty liberal rule” and most trusts qualified, Slezak says. Now, however, the trust in question must be a “qualifying spousal trust.” That means all the income from the trust must be paid or payable to the spouse during his or her lifetime, and the spouse must be the only person having the right to use that property during his or her lifetime.

The problem, Slezak says, is that a trust often is structured in such a way that if a spouse remarries or co-habits, the spouse must vacate the property and it goes to the kids. That puts the trust outside the new PRE rules, she says, and your children could face stiff capital gains taxes later on.

As well, Drever points out that something as innocuous as granting someone an option to purchase the property can put it offside of the new rules. Another challenge arises if your client lives in the residence for some years, but rents it out in other years. The appreciation during the years it’s rented out is taxable, with some limited exceptions, and that information must be tracked.

Divorce can also create headaches, especially if the couple had multiple properties. If they sold a principal residence while they were together and later split up, with one taking possession of the other property, tax issues could arise.

Although the spouse taking possession of the home would be entitled to a new PRE from the time the couple split, if the home had been owned during the marriage and a PRE had already been claimed for some of those years, then a later sale could trigger capital gains tax. Drever says that’s why any separation or divorce agreement should take the PRE into consideration.

The penalty for failing to account for and report the PRE is “pretty harsh,” Slezak says. The CRA can reject the claim, and tax any gains. The CRA has three more years to review the taxpayer’s return.

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