The Principal Residence Exemption: Words of Comfort

At parties, I sometimes become the priest.

I don’t want this role. I certainly don’t seek it out. But it’s happened enough now that I’ve noticed a pattern.

You ask me what I do (tax lawyer). It turns out you are burdened with guilt (tax guilt). And so, you confess to me your sins (tax sins), for which you humbly request absolution.

Most often, these sins relate to a single topic: the principal residence exemption. And so, in the hope that I might provide comfort (and enjoy future parties like a normal human), let me take you through what you need to know about the exemption and (perhaps) do not—including some tips to obtain the entire exemption where it might otherwise be unavailable.

Year by year

First, qualification for the exemption is determined year by year. One year you might qualify; the next, not.

The exemption is a formula: (A+1)/B multiplied by the gain (which is, put oversimply, the home’s sale price less its original purchase price).

A is the number of years the property qualifies for the exemption.

B is the number of years you own it.

(The plus 1 makes it so that you can sell a home and buy a new one and have the exemption cover both in the year.)

Own a property for 10 years and qualify for 10 years (or 9) and you’re fully covered. Otherwise, you might have some tax to pay.

Live there

Next, you have to live there (usually).

If you never lived in the property, for obvious reasons, you are out. It’s not your principal residence.

If you lived in the property at one point, but no longer, the circumstances are muddier.

Under certain circumstances the exemption can continue, but it’s not so simple (as some partygoers believe) as declaring it to the universe. If you used to live in a property but don’t anymore, talk to your accountant or tax lawyer. You may be able to elect into a four year extension to the principal residence exemption. Beyond that time limit however (or once you leave, without the election) you are out of luck.

Housing unit

This next requirement is, in my experience, commonly ignored.

If a property has more than one “housing unit”—a self-contained unit with a bedroom, bathroom and kitchen—then one of these units is excluded from the exemption.

The CRA’s position (not entirely in accordance with case law) is that some of the value of the underlying land must also be excluded, based on the ratio of the size of the excluded unit as against the area of the entire house.

For example: excluded unit is 1,000 sqft; entire house is 4,000 sqft; therefore the value of the unit plus the value of 25% of the underlying land is also excluded.

In my view, this is not correct, and I have successfully put together positions for clients for a more reasonable exclusion ratio.

Half a hectare

This issue is most common for farms.

Clients in these circumstances often come to me after their accountant explains to them that the limit for the principal residence exemption is half a hectare, or approximately 1.25 acres. They want to know if there is any way that they can obtain the entire exemption, in spite of this limitation.

Fortunately, there is. Specifically, the additional land is excluded from the scope of the exemption unless it is “necessary … to the use and enjoyment of the housing unit as a residence”.

“Use and enjoyment” here has a specific meaning. It does not mean “I need this land for my lifestyle”, for example. (“I horseback ride,” spoken with a cocktail in hand and a pinky raised, will not be sufficient.) In practice, courts have read this requirement down to one simple thing: the property cannot be subdivided.

The nuances of this are beyond the scope of this note. This is most typically satisfied by prohibitive zoning requirements. The CRA is clear that a mere ALR designation is not sufficient (properties in the ALR can, in theory, be subdivided). However, depending on the surrounding circumstances, ALR designation can assist, and I’ve had circumstances where clients have successfully claimed greater than half a hectare for their principal residence.

Income producing use

The final issue I’ll raise comes when a property is used to produce income.

In these cases, the CRA’s position is that, absent any election or deeming rule, once a part of a property is used to produce income, that part of the property is excluded from the principal residence exemption unless the income-producing use is “ancillary” to the main use of the property as a residence (with further requirements not addressed here).

In the CRA’s view, “ancillary” means subordinate or secondary to the main use of the property as a residence. Examples they give are renting single rooms in a home, having a home office in connection with a business, or operating a daycare.

That’s the CRA’s position. Case law provides more nuance. For example, under the CRA’s position, all land used to earn income from farming would be excluded. However, there are numerous cases where the court permitted an exemption on the entire property despite farming use—a fact difficult to reconcile with the CRA’s position.

Party on

So, now you know. Let me party in peace.

If you have any further questions about the principal residence exemption (or tax questions in general), you can feel free to reach out to us. The author can be contacted directly at jonathan@rkwlaw.ca or 604.425.1123.