Understanding The Principal Residence Exemption: A Cottage Case Study

Chris Hanley, CA, CPA, CFP® and Denika Heaton, BBA, JD, TEP
Mawer Tax and Estate Planning Specialists

In this case study, we’ll explore a common situation for cottage owners: how the principal residence exemption (“PRE”) can reduce income taxes for a family with multiple properties.

The PRE currently has no dollar limit, making it possible to shelter significant capital gains. As you’ll see, understanding how the PRE operates and carefully choosing how to use it can have a significant impact on the taxes you pay and your family’s overall wealth.

Please keep in mind the following scenario is intended to be general in nature as the rules are complex and each individual situation warrants a deeper review with a qualified tax advisor.

Meet the McDonald Family

Maureen and Mark McDonald are married retirees in their mid-60s who discovered their passion for world travel later in life. Now, they can be found frequently jet setting from their home in Calgary to far-flung destinations around the globe.

Their adult children, John and Michelle, have long since moved away from Calgary and established careers and families in Toronto and San Francisco.  

When the kids were younger, the McDonald family would drive nearly every weekend from Calgary to their cabin in Fernie to ski, hike, and spend quality time together. However, with John and Michelle’s busy lives far away and Maureen and Mark’s travel-filled calendar, it’s been quite a few years since any of them have spent much time there.

The rapidly aging property now requires increasingly expensive maintenance and is becoming more of a financial burden. After a tough family discussion, Mark and Maureen decide to sell the Fernie property. They plan to keep their home in Calgary, which they’re not likely to sell for the foreseeable future, and wish to use the sale money from their Fernie property for travel. Below is a summary of the tax attributes of the two properties:

What Qualifies as a Principal Residence?

First we must evaluate whether one or both of the McDonalds’ properties will qualify as a principal residence during the periods of ownership.

1. Property is a housing unit

The property being considered for the PRE must be considered a “housing unit,” which includes houses, condominiums, cottages, units in a duplex, and even a trailer or houseboat. It’s possible to have your property located outside of Canada qualify, as well.

2. Owned the property

It may seem obvious, but ownership of the property is required by the taxpayer for each year for which they wish to claim the PRE. This includes sole ownership, joint ownership with another person, as well as beneficial ownership. An example of beneficial ownership is where someone else is on title only, holding a property on behalf of the beneficial owner.

Note: Some ownership situations aren’t as straightforward. For example, property held in a family trust, or by U.S. citizens, or held jointly with adult children, or a property owned by an individual from before their current marriage or common-law relationship. Situations like these require further analysis and are outside the scope of this case study.

3. Ordinarily inhabited the property

Just as in step two, which requires reviewing a given property’s ownership history, step three requires a review of the property’s inhabitation history—and not just at the time of sale or the year of sale, but for each previous calendar year of ownership for which the taxpayer wishes to claim the PRE for that property. (We’ll take a closer look at how those calculations work a little further on in this section.)

First, what does “ordinarily inhabited” mean? It doesn’t refer to the property you live in the most during the year, but rather the one inhabited by you, your current or former spouse or common-law partner, or child, for some amount of time during the year. This requirement can be met even if only a very short time is spent at the property each year.

Note: A property that has been used to generate income, even if only partly used for that purpose (for example, renting a bedroom or basement, or operating a business), might not meet this requirement, and will require further analysis.

4. Nature of gain is capital

The disposition of the property (selling or formally giving it to someone) must be considered a capital gain for income tax purposes. Essentially, it must not be from a business of buying and selling real estate, nor intentional profit making.

Additionally, profits earned on the sale of residential property that have been held for short periods of time may be considered profits from “flipping” and ineligible for the PRE, subject to higher federal and provincial income taxes, and in some cases subject to municipal speculation taxes, unless an exception is met.

5. Land area is less than half a hectare

Generally, the amount of land that can be considered part of the principal residence is limited to half a hectare, or about 1.24 acres. However, some cottages will have a much larger lot size.

If you can demonstrate that additional land is necessary for the use and enjoyment of your cottage, you may be able to include more than the standard amount as part of your principal residence. For instance, this could apply if the municipality's minimum lot size requirement at the time of purchase was greater than half a hectare.

Otherwise, the excess land will not qualify for the PRE and that portion will not be sheltered from income taxes.

How is the Exemption Calculated?

First, the capital gain on any property disposition is calculated whether that disposition is a result of a sale, gift, or upon death without a surviving spouse.

The principal residence exemption will then decrease or completely eliminate that gain using the following formula:

The “1” in the formula is key and provides for one extra year of exemption to account for instances where a home is sold and another one purchased in the same calendar year. As you can only designate that calendar year towards one and not both properties, the “one plus rule” would allow both homes to be tax-free.

Let’s now apply the formulas to the McDonald’s two properties. For the years 1985 through 1999, the only property which can be designated at PRE is the Calgary home, as that is the only property they owned. This will not affect the PRE for the Fernie property, if any.

For 2000 through 2024, they owned both properties, so they must choose whether to allocate those 25 years towards Calgary, Fernie, or some manner of split.

While the total accrued capital gain on the Calgary home is larger than on Fernie, it’s relevant that the Fernie property has a greater capital gain per year of ownership.

For each overlapping year (i.e., the years they owned both properties) that the Fernie property is designated instead of the Calgary home, the McDonalds will shelter more total capital gains ($40,000 vs. $30,000 per year).  

For purposes of the PRE, the total gain is apportioned on a straight-line basis over all of the years of ownership, even though the true market gains would have varied from year to year. You’ll also notice that the year of purchase and year of disposition are counted in the total number of years of ownership for the PRE.

Sheltering the gain

Due to the “one plus rule” noted above, they will only need to designate 24 out of the 25 years of ownership (2001 through 2024) to fully shelter the gain on Fernie. The calculation of their PRE for the Fernie cabin will be as follows:

The years 1985 through 2000 (16 total), as well as any years after 2024 that they continue to own the Calgary home will remain available to designate for the Calgary home when that property is disposed of in the future and a PRE designation is made. The PRE for 2001–2024 will have already been designated towards the Fernie property. This means there will be some taxes payable on the Calgary home when disposed of, since the PRE doesn’t permit an individual, spouse, or common-law family unit to designate the same years on more than one property.

When and How is the Exemption Claimed?

The PRE is claimed in your income tax return the same year as the disposition by completing specific forms prescribed by Canada Revenue Agency. This allows you flexibility as you don’t have to make a PRE designation until there has been a disposition, at which point the amount of capital gain is known.

All dispositions of a principal residence must be reported, even if the PRE will completely eliminate the capital gain, and even if there was no capital gain. If you overlooked reporting a disposition or making a principal residence designation in a prior tax return, speak to your qualified tax advisor about amending that return, as a late-filed designation may be possible. Penalties may apply for the late filed designation. 

Sold

The McDonald family successfully sold their Fernie cabin this summer and realized a capital gain of approximately $1M. They will work with their accountant to complete the necessary PRE reporting and designation in Mark and Maureen’s 2024 personal income tax returns and shelter the entire gain from tax.

Disclaimers:

This communication is an overview only and it does not constitute financial, business, legal, tax, investment, or other professional advice or services. It is not intended to be a complete statement of the law or an opinion on any matter. If you (or any of your family members) are a U.S. citizen, hold a U.S. green card, or are otherwise considered a U.S. resident for U.S income/estate tax purposes, the Canadian and/or U.S. tax implications could be substantially different from those outlined herein. No one should act upon the information in this communication as an alternative to legal, financial or tax advice from a qualified professional. No member of Mawer Investment Management Ltd. is liable for any errors or omissions in the content or transmission of this email or accepts any responsibility or liability for loss or damage arising from the receipt or use of this information.

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