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Beware capital gains tax exemption myths for a principal residence


Kim Moody: Exemption is one of the most misunderstood tax provisions in the Income Tax Act

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Once upon a time, capital gains were not taxable in Canada. But the federal government instituted a tax on capital gains when major tax reform was introduced on Jan. 1, 1972, yet only 50 per cent of the resulting capital gain was included in income.

The inclusion rate for capital gains has changed over the years: increasing in the late 1980s to two-thirds, further increasing to three-quarters in the early 1990s and then going back down to 50 per cent in the early 2000s, where it has been ever since.

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In order to encourage home ownership, and not tax Canadians on their most important financial asset, the principal residence exemption was also introduced in 1972. It essentially exempts from taxation any capital gains realized on the disposition of a housing unit and its contiguous land to the extent that property qualifies as the taxpayer’s principal residence.

There has been some minor tinkering with the exemption since then, but the architecture has pretty much stayed the same. Nevertheless, it is one of the most misunderstood tax provisions in Canada’s Income Tax Act and is the subject of much mythology.

Let me tell you an old story to illustrate. In the late 1980s, some friends of my parents were buying and selling homes in Alberta (given the slow recovery of home prices from the disastrous implementation of the National Energy Program earlier in the decade). They would move into their new homes for very short periods of time (sometimes only days), list the home they were currently living in and then sell.

Over a three-year period, they moved into and sold 11 different homes. Turns out, they believed the profit on each home was tax free because of the principal residence exemption. Back then, the Canada Revenue Agency (or Revenue Canada as it was then known) had an administrative policy that any gains on the disposition of a principal residence were not required to be reported on a taxpayer’s tax return. Accordingly, the friends never reported any of the 11 dispositions.

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Were their gains really tax free? Let’s analyze this since the definition of a “principal residence” in the act is surprisingly complex. Some of the more important elements are:

* It must be owned by you and “ordinarily inhabited” by you, your spouse/common-law partner or other relatives in certain circumstances. There is no shortage of myths as to what ordinarily inhabited means, but it doesn’t mean one day. Given the friends’ short periods of time living on the property and the reasons for acquisition, it is doubtful they ordinarily inhabited any of the homes they lived in.

* Even if they did, however, the property disposed of must be a “capital property” and not “inventory,” which means it must be acquired for a long-term hold and not purchased to flip. This is why flippers are not eligible to claim the principal residence exemption — the property they dispose of is not capital property. Were the friends’ properties capital properties or inventory? In my opinion, such properties were clearly inventory and, therefore, not eligible for the principal residence exemption.

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As an aside, the government earlier this year went ahead and implemented a very silly flipping tax, which will treat any gains on the disposition of a property held for less than a year (subject to some certain “life event” exceptions) as fully taxable and not a capital gain. This duplicative and nonsensical new provision needs to be repealed.

* Ever since 1981, a married/common-law couple must share eligibility to the principal residence exemption. Prior to such date, each taxpayer could claim a principal residence exemption. This was not an issue in the friends’ case.

* The land contiguous to the housing unit must not exceed half a hectare unless it is necessary for the use and enjoyment of the property. And, no, lifestyle cases such as long driveways, tennis courts, etc., do not make such excess land necessary for the use and enjoyment of the property. Typically, but not always, the courts look at what is the minimum subdivision lot size in the municipality, with such minimum subdivision lot sizes being called “necessary.” Again, this was not an issue in the friends’ case since they were buying and selling city homes that had lot sizes much less than half a hectare.

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To summarize, the friends’ dispositions and resulting profits on the 11 dispositions were likely not eligible for the principal residence exemption because of the simple fact that each property they disposed of was inventory and not capital property.

Because the CRA did not require dispositions where the principal residence exemption was claimed to be reported, it was not easy for them to become aware of the tax position taken by my family’s friends. This finally changed in 2016 when the CRA’s administrative position was altered to make it mandatory for dispositions of principal residences and the exemption to be reported. About time. Given that, the friends would likely not be able to get away with claiming the principal residence exemption 11 times without scrutiny today.

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There is no ceiling on the amount of principal residence claim. If you’re eligible, then the quantum of the exemption could be $1 or it could be $10 million, obviously depending on the actual amount of the gain on the disposition of the property.

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Is that fair? Did Canada’s parliamentarians ever envision multi-million-dollar gains in Vancouver and Toronto being exempt from taxation? Should there be a ceiling? Not easy questions to answer.

But don’t become my parents’ friends and rely on tax myths. Instead, ensure that any gains on the disposition of your home are indeed on a “home sweet tax-free home.”

Kim Moody, FCPA, FCA, TEP, is the founder of Moodys Tax/Moodys Private Client, a former chair of the Canadian Tax Foundation, former chair of the Society of Estate Practitioners (Canada) and has held many other leadership positions in the Canadian tax community. He can be reached at kgcm@kimgcmoody.com and his LinkedIn profile is www.linkedin.com/in/kimmoody.


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