The Principal Residence Exemption in Canada

The Principal Residence Exemption (PRE) is a Canadian tax provision that can reduce or eliminate the capital gains tax on the sale of a person’s home. When you sell a property for more than you paid for it, the profit is a capital gain, and a portion is normally taxable. The primary purpose of the PRE is to allow homeowners to sell their main residence without this tax consequence, acknowledging that a home is a personal asset, not just a financial one.

Qualifying for the Exemption

Property Eligibility

For a property to be eligible for the PRE, it must be a “housing unit,” which can include a house, condo, cottage, apartment, mobile home, or houseboat. The property must be “ordinarily inhabited” at some point during the year by the taxpayer, their spouse, or their children. There is no strict duration for this requirement, so even a short period of occupancy can be sufficient, allowing seasonal properties like cottages to qualify.

If a child lives in a home owned by a parent, the property can still meet the ordinarily inhabited rule for the parent to claim the exemption.

If a residential property is owned for less than 365 days before being sold, any profit is considered business income and is fully taxable. This anti-flipping rule makes the profit ineligible for the PRE. Exceptions are available for certain life events, including death, separation, serious illness, a change of employer, or an involuntary event like a fire.

Land Size

The exemption includes the land the home sits on, but it is limited to one-half hectare (about 1.24 acres). If the land is larger than this, the value of the excess land may be subject to capital gains tax. The portion of the sale price for the excess land must be calculated separately.

An exception exists if the taxpayer can prove the additional land was necessary for the use and enjoyment of the home. This could apply if a municipal bylaw required a larger minimum lot size at the time of purchase. The burden of proof is on the taxpayer to demonstrate that the excess land was essential, not just desirable.

Ownership

To qualify for the exemption, the taxpayer must own the property for each year it is designated as a principal residence. Ownership can be held alone, jointly with another person, or through certain types of trusts.

Designating a Principal Residence

Define “Family Unit”

The PRE rules apply to a “family unit,” which includes an individual, their spouse or common-law partner, and their unmarried children under 18. For any given year, a family unit can only designate one property as their principal residence. For example, a married couple owning a city home and a cottage cannot designate both properties for the same year; the family must choose one.

The Annual Designation Rule

The designation of a property as a principal residence is made on a year-by-year basis when the property is sold. This allows a taxpayer who owns multiple qualifying properties, like a house and a cottage, to make a strategic choice. To maximize the tax benefit, they can designate the property with the higher average capital gain per year of ownership as the principal residence for those years.

Calculating the Exemption Amount

The PRE Formula

The portion of a capital gain sheltered from tax is determined by a formula: Exemption = Capital Gain x [(1 + Number of years designated) / (Number of years owned)]. This formula prorates the exemption based on how many years the property was designated as a principal residence relative to the total years of ownership. If a property was designated for every year it was owned, this formula eliminates the entire capital gain.

Breakdown of Components

The “Capital Gain” is the property’s selling price minus its Adjusted Cost Base (ACB) and any expenses from the sale. The ACB is the original purchase price plus acquisition costs and capital improvements like major renovations, but not routine maintenance. The “Number of years designated” is the number of years the property is claimed as the principal residence, while the “Number of years owned” is the total period from purchase to sale.

The “Plus One” Rule

The “+1” in the formula is the “plus one” rule, which accommodates selling one principal residence and buying another in the same year. It allows both the old and new homes to be treated as a principal residence in the year of the move, preventing a portion of the gain from becoming taxable. For sales after October 3, 2016, this rule only applies if the taxpayer was a Canadian resident in the year the new property was acquired.

Reporting the Sale on Your Tax Return

Reporting Requirement

Since 2016, you must report the sale of a principal residence on your income tax return, even if the entire capital gain is eliminated by the exemption. Failing to report the sale can result in a penalty, which is the lesser of $8,000 or $100 for each complete month from the original due date to the date you request the change. The Canada Revenue Agency (CRA) can reassess a non-reported sale from any past year, so if you forget to report a sale, you should contact the CRA to amend that year’s return.

Completing Schedule 3

The details of the sale are reported on Schedule 3, Capital Gains (or Losses), of the T1 Income Tax and Benefit Return. On this schedule, you must provide the proceeds of disposition, the adjusted cost base, and the resulting capital gain. If the property was your principal residence for every year you owned it, you can make the designation directly on Schedule 3.

Using Form T2091

In addition to Schedule 3, you must also complete Form T2091(IND), Designation of a Property as a Principal Residence by an Individual. This form is required for all principal residence sales. On Form T2091, you will formally designate the property and specify the years for which it is being claimed as your principal residence.

Rules for a Change in Use

Deemed Disposition

When a property’s use changes from a principal residence to a rental property, it is treated as a “deemed disposition.” This means you are considered to have sold the property at its fair market value (FMV) on the date of the change and immediately reacquired it at the same price. This event can trigger a capital gain that must be reported. The gain up to the point of the change may be sheltered by the PRE, but any future appreciation will be a gain on an income-producing property.

The Section 45(2) Election

To defer the capital gain from a deemed disposition, you can file a Section 45(2) election. This allows you to avoid reporting a capital gain at the time of the change in use. To make this election, you must attach a signed letter to your tax return for the year of the change.

A condition of this election is that you cannot claim Capital Cost Allowance (CCA), a form of depreciation, on the property. The election lets you designate the property as your principal residence for up to four additional years, as long as you remain a Canadian resident and do not designate another property.

Partial Change in Use

A partial change in use happens when part of your home is converted for income, like renting out a basement suite. You are deemed to have disposed of that portion of the property. The sale price and cost base must be split between the personal and income-producing portions, often based on square footage.

The CRA may not apply the deemed disposition rule if the income-producing use is secondary to the main use as a residence, no structural changes are made, and no CCA is claimed. Significant structural changes will cause the deemed disposition rules to apply.