How to choose and why it matters
The Principal Residence Exemption allows Canadian taxpayers to avoid paying capital gains tax on the sale of a principal residence.
To be considered the Principal Residence, a residential property must be ‘regularly occupied’ by the owner at some point during the year. If someone owns two residences and moves between one and the other, it is possible that either one of them could qualify as a Principal Residence. In that case, the person can choose to designate either property as the principal residence for that year. Normally a taxpayer will designate whichever residence gains the most in value, so as to shelter as much income as possible.
For 10 years Evan owns both a house and a getaway cottage. Every year he spends two weeks at the cottage while occupying his house the rest of the time. Because he occupies both he house and the cottage at various times during the year – even though he spends far more time at his house than at his cottage — he has the option to designate either property as his principal residence.
Which should be the Principal Residence?
One year, the area where his cottage is located experiences a development boom, and his cottage’s fair market value rises steeply – more steeply than the value of the house he usually occupies. The following year he decides to sell the cottage and earns a large capital gain of $250,000. He estimates that his house gained only $100,000 in the 10 years during which he owned both.
The gain on the cottage exceeds what he expects to gain on the house during the same period, so he chooses to designate the cottage to have been his principal residence. Thus he does not have to report the $250,000 as a capital gain on his tax return*.
Consequences for the house
However, when he eventually sells his house, he will have to pay tax on the gain attributed to the period during which the house was not his principal residence. If he owns the house for a total of 25 years, he will have to declare 10/25ths of the gain on the house on his income tax return. This represents the gain attributable to the 10 years during which the cottage, rather than the house, was designated as his Principal Residence.
* Remember that even though the capital gain on your Principal Residence is exempt from tax, all sales of principal residences must be reported on form T2091.