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“Principal Residence Exemption – vacation properties” ©2008 Investors Group Inc. (01/2008) MP1392

Principal Residence Exemption – Vacation Properties

The principal residence exemptionallows you to exempt from taxationsome or all of the capital gains thatyou realize when you sell a home thatqualifies as a “principal residence” –a potentially significant tax savings.

If during your lifetime, you and yourspouse together have only everowned one personal-use home at atime, you will usually be able toexempt all the capital gains on thosesequentially-owned homes. However,if you and your spouse ever ownedtwo personal-use homes during thesame period – e.g. your “city home”and your “vacation home”, then atleast some of the capital gains on oneof those homes will eventually besubject to taxation. When you sell thefirst home, you must decide whetheryou will designate it as your principalresidence and exempt the capitalgains on that first home, or whetheryou will pay the capital gains taxes onthat sale so that you will be able tofully exempt the gains on your sec-ond home when you eventually sellit. This decision could be one of themost significant financial decisionsyou will make.

Definition and RulesTax legislation defines a “principalresidence” as an accommodationowned by a taxpayer (either solely orjointly), and ordinarily inhabited bythe taxpayer, the taxpayer’s spouse orcommon-law partner, former spouseor common-law partner, or child.Whether a property was “ordinarilyinhabited” in a given year is deter-mined based on the facts of eachcase, but generally a property needonly be inhabited for a short periodof time in the year to meet the test.For example, you would be consid-ered to ordinarily inhabit your vaca-tion home even if you only used itduring your annual vacations, as longas the vacation home was not prima-rily an income-producing (rental)property to you.

There are many types of propertiesthat could qualify as a principal resi-dence including a house, an apart-ment, a cottage, a mobile home, atrailer, a houseboat, a farm, or a sharein a co-operative housing corporation.For farms, the principal residencegenerally will be deemed to include

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the first ½ hectare of land on whichthe property is situated, and in cer-tain cases can include surroundingland in excess of ½ hectare.

You can only designate one propertyas your “principal residence” for anygiven year, even if you own morethan one property that could qualify.Also, you must share that designa-tion with your spouse or common-law partner and your children underthe age of 18. (Prior to 1982, spousescould “double up” on the principalresidence exemption.)

You don’t have to designate any prop-erty as your principal residence untilyou sell a property and want to claimthe exemption. In order to designatethe property as your principal resi-dence you should attach FormT2091(IND), Designation of a Propertyas a Principal Residence by anIndividual (Other Than a PersonalTrust) to your income tax return forthat year. In situations when youwere deemed to have disposed of theresidence because you died, yourlegal representative must complete aT1255, Designation of a Property as a

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Principal Residence by the LegalRepresentative of a Deceased Individualand attach it to your terminal taxreturn. However, these forms mustonly be attached to your tax returnswhen you have a taxable capital gainto report. In Quebec, you must attachForm TP/274 even if the capital gainis entirely exempt.

If you own two homes during thesame period that could qualify for theprincipal residence exemption, thenat least some of the capital gains onone of those homes will be subject totaxation. When you decide to sell thefirst home, you must decide whetherthe principal residence exemptionshould be used on that home. Tomake that decision, you will need toestimate:

3 the number of years you will con-tinue to own and occupy the secondhome, and

3 the future capital gain on the second home.

Figure 1. shows the principal resi-dence exemption formula.

ExampleAnne and Henry are married, andthey own two homes that could qual-ify as “principal residences” for allyears of ownership – i.e. their “cityhome” and their “vacation home”.They purchased the city home 10 years ago and the vacation home5 years ago. Their marginal tax rate,now and in the future, is and will be 40%.

Anne and Henry are selling the vaca-tion home today, and will realize acapital gain of $100,000. They willnot be buying a replacement vacationhome, but will continue to own theircity home. They expect to continue tolive in the city home for a further 10years, and when they sell it in 10years time, they expect to realize acapital gain of $250,000.

They have two choices.

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Choice #1

They could designate the vacationhome as their principal residence for4 of the 5 years they owned it, mean-ing that when they sell the cityhome, they will at most be able todesignate it as their principal resi-dence for 16 of the 20 years they willhave owned it.

On the vacation home sale, theexempt portion of the capital gainwill = [$100,000 * (4 + 1)/5] =$100,000, meaning they will have atax bill of $0.

On the city home sale 10 years fromnow, the exempt portion of the capitalgain will = [$250,000 * (16 + 1)/20] =

$212,500, meaning they will have atax bill of ($250,000-$212,500) * 50%

* 40% = $7,500.

Figure 1.Principal Residence Exemption FormulaTo determine the amount of the capital gain that is exempt from taxation, use the following formula:

The taxable capital gain = (Realized gain – Exempt portion of capital gain) * 50%.

# of years as principal residence after 1971 + 1# of years of ownership after 1971

Exempt portion of capital gain = Realized gain x

Choice #2

They could designate the vacationhome as their principal residence for0 of the 5 years they owned it, mean-ing that when they sell the city home,they will be able to designate it astheir principal residence for all 20 ofthe years they will have owned it.

On the vacation home sale, they willhave a tax bill of $50,000 * 40% =

$20,000.

On the city home sale 10 years fromnow, the exempt portion of the capitalgain will = [$250,000 * (19 + 1)/20] =

$250,000, meaning they will have atax bill of $0.

In other words, it is a choice between

Pay $0 in taxes today and $7,500 intaxes 10 years from now,

or

Pay $20,000 in taxes today and $0 intaxes 10 years from now.

In this case, it makes sense to use theprincipal residence exemption on thevacation home for 4 years of owner-ship. But if they expected that theymight sell the city home sooner, or fora higher capital gain, it might havemade sense to “save” the exemptionto use it against the city home.

SummaryAs demonstrated, the principal residence exemption can result insignificant tax savings if appliedappropriately. For further informationand advice please contact yourInvestors Group consultant.

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