How Your Home Sweet Home Can Help Shelter You From Tax
You’ve got to love home ownership. I remember buying my first home. The real estate agent asked me how much I could afford,
The truth is, home ownership remains one of the pillars of financial security. A key benefit of owning a principal residence is the ability for each family to sell their principal residence free of income tax when certain conditions are met. Last week I talked about the principal residence exemption (PRE) which can shelter the gains on a property from tax. Today, I want to finish that discussion.
What if you use your principal residence partly as a residence, and partly to earn business or rental income? Can you shelter any gain on the sale of that property from income tax using the PRE? This is a common scenario where, for example, you have an office in your home, or where you're using the home as a place to carry on your business (such as a daycare or some other business), or where you rent out part of the residence.
The good news? Canada Revenue will allow you to call the entire property your principal residence (and therefore fully shelter from income tax any gain on sale where you otherwise qualify) where you meet three tests: (1) the partial use of the residence for income-producing purposes is ancillary to the main use as a residence, (2) there is no structural change to the property, and (3) capital cost allowance (depreciation for tax purposes) has not been claimed on any part of the residence.
Now, if you don't meet these tests, you'll likely be able to partially shelter from tax any gain on the sale of the property, but Canada Revenue will expect some reasonable allocation of the sale proceeds between the principal residence portion of the home and the income-producing portion (generally based on square feet used to earn income). Only the portion of the home qualifying as a principal residence can be sheltered from tax using the PRE.
Keep the following ideas in mind when looking to shelter a property from tax using the PRE:
Vacation homes can qualify. If you have a cottage or other vacation property that is not primarily a rental property, you can generally shelter it from tax using the PRE. In the year you sell a property, you'll have to decide which property to designate. It generally makes sense to use the PRE to shelter the property with the largest capital gain per year of ownership. But you'd be wise to visit a tax pro for advice on this before making a decision.
Foreign properties can qualify. A family unit can designate just one property as their principal residence each year of ownership, but that property doesn't have to be located in Canada. Keep in mind, the PRE may shelter the property from Canadian income taxes, but it won't shelter it from taxes in the foreign jurisdiction, which you'll have to consider.
Consider utilizing a child's PRE. If you're thinking of purchasing a second property - perhaps a cottage, consider putting the property in the name of an adult child, or purchasing the property in a trust for that child. This can allow use of your child's PRE, effectively multiplying the number of exemptions being used in the family. Talk to a professional about the other pros and cons here.
Split properties on marriage breakdown. If you're separated or divorced, you and your ex-spouse will each be entitled to your own PRE. It makes sense, then, to each take one property when splitting the assets. Together, you'll be able to shelter from tax the gains on more than one property. The taxman loses in this scenario.
Beware of changing use of a property. You may trigger a taxable capital gain when converting an income-producing property to a principal residence because you'll be deemed to have sold the property at fair market value, and to have reacquired it at that same value. So, get tax advice first.
Tim Cestnick is managing director at WaterStreet Family Wealth Counsel and author of 101 Tax Secrets for Canadians.