The Canada revenue Agency’s (CRA) revised principal residence exemption (PRE) reporting rules, introduced three years ago, are changing the way Canadians think about a tax benefit that homeowners tend to take for granted, tax experts say.
Now that the CRA has more information about each property sold, many Canadians recognize that they need to understand the rules governing the PRE better in order to avoid paying tax on the sale of their home.
“People realize they have to fill out this paperwork now when they sell [their property] to claim the PRE,” says Debbie Pearl-Weinberg, executive director of tax and estate planning in Toronto-based Canadian Imperial Bank of Commerce’s financial planning and advice group. “We’re seeing [more] questions on what constitutes a principal residence: ‘Does the property qualify; what if a portion is rented out; what about change of use?’ Things like that.”
Says Mariska Loeppky, director of tax and estate planning with Investors Group Inc. in Winnipeg: “There are lots of people who will rent out their home for a while and not give a second thought to it, but that’s a taxable event.”
The CRA issued in July an updated Income Tax Folio S1-F3-C2, Principal Residence to help Canadians navigate the rules governing the PRE. The document includes information about the revised reporting requirements and key technical changes made to the PRE rules over the past few years, as well as a comprehensive explanation of how the rules work.
In October 2016, the federal government announced that beginning with the 2016 tax year, taxpayers must report basic information, such as proceeds of sale, description of property and date of acquisition, at the time the principal residence is sold in order to claim the full PRE. Previously, homeowners didn’t have to report the sale of a property if they were designating it as their principal residence for every tax year they owned it.
Under the revised reporting rules, taxpayers provide information about the sale on Schedule 3 of their tax return, and by filing Form T2091, Designation of a Property as a Principal Residence by an Individual. Late filing the form comes with a penalty of $100 per month, to a maximum of $8,000 – although the CRA did indicate, when it introduced the revised rules, that it would exercise leniency in applying the penalties. “That discretion is probably going to end at some point,” Loeppky says.
The CRA now has the right to reassess a tax return, beyond the normal three-year reassessment window, if a taxpayer fails to report the sale of a home. “That’s really a big step,” Pearl-Weinberg says, because it thwarts taxpayers who may hope the CRA won’t “discover [the sale] within the normal reassessment period.”
For many homeowners, the revised reporting rules will not hinder their ability to access the PRE, says Wilmot George, vice president of tax, retirement and estate planning with Toronto-based CI Investments Inc. The basic rules haven’t changed: if a Canadian resident (and/or the Canadian resident’s family unit) owns an eligible home – and “ordinarily inhabits” it – he or she will be able to designate the property as his or her principal residence and not pay tax on the capital gain realized on the sale.
“The message isn’t that you’re not entitled to the PRE, for the large majority of Canadians,” George says. Rather, if the property is eligible for the PRE, the message is “be sure to report it.”
The government’s motivation for tightening the reporting rules is to increase compliance in the real estate sector in general. With the price of real estate skyrocketing in recent years, Ottawa is concerned that Canadians are accessing the PRE inappropriately. In the 2019 budget, the federal government proposed giving the CRA $50 million over five years, and $10 million ongoing, to fund a task force with a mandate to ensure people are paying their fair share of taxes in relation to real estate transactions.
The government is concerned about situations in which taxpayers are repeatedly purchasing, renovating and reselling properties for profit – a.k.a. “flipping” – and claiming the PRE when they are not eligible.
“If there’s a habit of buying and selling in relatively short periods, then that might speak to the generation of business income as opposed to capital gains,” George says. Among other factors, the CRA will look at how long the property was owned, the owner’s recent transactions and whether renovations were made to determine whether profits from the sale would be considered taxable business income, George says.
The revised reporting rules also will help the CRA ensure taxpayers claim the PRE for only one property per tax year. If an individual owns multiple eligible properties – say, a city home and a vacation home – he or she can claim the PRE for one property for some years and for the other property in other years, but not for both properties in same tax year.
Individuals who own multiple eligible properties now must be more careful when deciding whether to claim the PRE at the time they sell their first home or to “save” the PRE for a second home. A formula is used to determine what percentage of the capital gain on the sale of a home the individual can shelter with the PRE.
“It can be a very complicated comparative analysis,” Pearl-Weinberg says. “You have to look at what the consequences would be right now [and] what percentage of the gain would be covered right now versus what might happen in the future.”
Loeppky advises that homeowners keep all receipts documenting the cost of the home and all improvements to it – for all properties owned. When the time comes to sell a home for which the PRE will not be claimed, the cost of the improvements can be added to the property’s adjusted cost base, lowering the capital gain that will have to be reported for that home.
“You don’t know which house will have a bigger gain,” Loeppky says. Sometimes taxpayers won’t keep receipts for their city home, but do so for their vacation home, thinking that the PRE will cover the gain in their city home – only to discover that their vacation home has incurred more of a gain. “You want to put yourself in the position of maximizing the use of the PRE when it comes time to sell,” Loeppky says.
The considerations become even more complex for a rental property when the PRE is concerned.
If a taxpayer owns a property for the sole purpose of renting it out, he or she will pay taxes on the income earned annually and, when the property is eventually sold, the capital gains on the proceeds of the sale would be taxable at the capital gains inclusion rate of 50%.
On the other hand, if a taxpayer lives in a principal residence, but rents out part of the property, the PRE still could be available if certain conditions are met, including that no structural changes are made to the property for rental purposes, and the rental use is ancillary to the property’s main use as a primary residence.
Much will depend on the facts of each case. “If you have [modified] your principal residence in some significant way, then you may have an issue as to whether you can claim the PRE,” says Doug Carroll, practice lead for tax, estate and financial planning with St. Catharines, Ont.-based Meridian Credit Union. “For people who are renting out a room, [claiming the PRE] may not be a problem if [the rental use] is not a major part of the reason that they own the house.”
Sometimes a person will own a primary residence, but wants to turn it into a rental property. Conversely, an individual may own a rental property, but wants to turn it into their primary residence. Both of these scenarios would be regarded as a “change of use” by the CRA, and be treated as a deemed disposition.
In either scenario, the taxpayer can elect to opt out of the deemed disposition, thus extending the number of years that the property can be designated a principal residence by up to four years (subject to certain conditions). These “change of use” special elections may give taxpayers more flexibility in determining when and for which property they can claim a PRE.
A proposal included in Budget 2019 would allow taxpayers to elect not to incur a deemed disposition when there has been a change in use to just a part of a property. This change to the tax rules is not yet law, and is not reflected in the updated tax folio for principal residences.