Disclaimer: The following information is intended as general information and not to be read as legal advice. Please seek legal advice from qualified legal professionals.
During the estate planning process, people often wonder how to structure their ownership in their principal residence to provide the most benefit to their beneficiaries with the least amount of tax obligations. Although tax considerations are important in estate planning, legal implications and practicality should also bear considerable weight. Landmark Law understands the importance of balancing these various factors and how challenging they may be throughout your estate planning process. This article will explore the basic tax consequences of your principal residence during your estate planning journey.
What is the Principal Residence Exemption [the “PRE”]?
Generally, when someone sells their property for an amount greater than what they purchased, that person will be responsible for taxes on the appreciated value. This tax on the appreciation of property value is also known as capital gains tax (currently, at a 50% inclusion rate which means only 50% of the capital gains are taxable). However, this rule has some exceptions, and one of those exceptions is the principal residence exemption. This exemption means that when you sell your principal residence for more than you paid, you are exempt from the capital gains tax on such a sale.
What constitutes a principal residence?
First, before a real property is considered a principal residence, there are a few qualifiers:
i. The real property must constitute “capital property” rather than “business property” (inventory). This is determined by looking at your intentions through objective evidence. Case laws and CRA’s interpretation Bulletins should be regularly referred to.
ii. The real property must constitute “personal use” capital property. Defined in s. 54 of the ITA as capital property that is used primarily (generally 50% or more of the time) for personal use or enjoyment by you or a person related to you. However, as stipulated in s. 40(2)(g)(iii) of the Income Tax Act (the “ITA”), it is important to note that any loss on personal-use property cannot be claimed as capital loss which may be used to offset your capital gains tax obligations. Similarly, s. 257 of the ITA deems losses to be nil.
iii. The real property must meet the definition of “Principal Residence”. Also defined in s. 54 of the ITA where it requires that the real property meet these requirements:
a. Be a housing unit.
b. You own it either solely or through shared ownership with another.
c. If beneficially owned (entitlement to use and benefit from the property irrespective of legal ownership), you must be an individual (not a corporation).
d. Be ordinarily inhabited (live in it regularly) by you, your former spouse, common-law partner, or child.
e. The land where the real property is situated must be less than ½ hectare in size.
iv. If you own multiple real properties that may be considered residences, you may only designate one residence per year. The real property must be designated as the principal residence for each desired year claimed.
v. You must be a Canadian resident duringthe particular year you designate the principal residence.
High-Level General Mechanics of the PRE
1. Calculate the Taxable Capital Gain (the “TCG”)
Proceeds of Disposition [POD] – Adjusted Cost Base [ACB] – Selling Expenses = Capital Gains [CG] * Inclusion Rate [50%] = Taxable Capital Gain [TCG]
2. Calculate the PRE
[# years designated as PR + 1 (only if Canadian resident at the time of purchase and have designated at least 1 year)] / total # years owned) * Taxable Capital Gain [TCG]
3. Calculate the Net Taxable Capital Gain (the “NTCG”)
Taxable Capital Gains [TCG] minus Principal Residence Exemption [PRE] = Net Taxable Capital Gain [NTCG] * Applicable Personal Tax Rate [X%] = Personal Tax Liability [PTL]
ACB = Adjusted Cost Base
CG = Capital Gains
NTCG = Net Taxable Capital Gain
POD = Proceeds of Disposition
PR = Principal Resident
PRE = Principal Resident Exemption
PTL = Personal Tax Liability
TCG = Taxable Capital Gain
Now that we have a general idea of what PRE is and its high-level general mechanics, let us look at how PRE works on your death and when it involves gifts to children.
What happens on my death?
On death, you are deemed to have disposed of all your capital property immediately before your death at fair market value (the “FMV”) as noted by s. 70(5)(a) of the ITA. The executor will have to determine the PRE and in particular, any capital gains on the deemed disposition and report it on your terminal return. Once this is determined, the estate acquires the real property (assuming your principal residence) at ACB equal to the FMV determined immediately before your death [s. 70(5)(b) of the ITA] and that ACB will be the ACB for the receiving beneficiary under the Will or pursuant to the laws of intestacy.
Suppose the receiving beneficiary is your surviving spouse or common law partner and satisfies the Canadian resident requirement at the time of your death. In that case, the principal residence may be rolled over. This means that there will no need to consider the PRE as your surviving spouse or common-law partner will inherit the principal residence entirely. Your surviving spouse or common-law partner will inherit your ACB of the principal residence and your tax situation as it pertains to the principal residence (s. 70(6) and s. 40(4)).
Essentially, there will be no tax implications for the principal residence property transferred to surviving spouses/partners on your death. However, your surviving spouse or common-law partner may elect out of this rollover should they choose to, and the rollover does not apply if they are not considered a Canadian resident at the time of your death (s. 70(5)). The corresponding tax attributes (i.e., principal resident designation) also flow to the surviving spouse/partner. Thus, making the PRE available to the surviving spouse/partner.
How about Gifts to my child?
Suppose you gift your principal residence to your child. In that case, you are deemed to have disposed of your interest in the principal residence for the gift portion at fair market value (FMV). Your child will be deemed to have acquired the portion of the principal residence at that FMV as their ACB (general application of s. 70(5) of the ITA).
Generally, if you satisfy all the conditions of PRE there will be a full shelter from taxable capital gain with PRE when your portion of the principal residence is rolled over (s. 70(6) of the ITA and if not elected out of under s. 70(6.2) of the ITA) to your surviving spouse or partner on your death. Then upon your surviving spouse or partner’s death, if your child inherits the real property wholly pursuant to the Will, there would be a full shelter of taxable capital gain with PRE.
However, if you gift prior to your death or if your surviving spouse or partner gifts to your child prior to their death, any appreciation in the value of the principal residence (the real property) may likely result in a taxable capital gain to your child when they dispose of the real property as the child likely does not ordinarily inhabit the house and may want to preserve his PRE for the child’s own principal residence.
This article provides you with a general overview of taxes and your principal residence. However, in any estate planning, there are many more considerations than just capital gains taxes and PRE. There may be other considerations like Estate Administration Taxes, etc. and most importantly, your legal position and control over your real property.
For more information and details regarding your real property and other tax consequences when you pass away, please refer to our article on “Estate Sale of Real Property. Please also be mindful that the Income Tax Act is continuously changing and being updated. Any reference to sections or information regarding laws in this article may change as a result. Please always consult a tax professional for proper guidance so that you may make an informed decision.
There are various hiccups and complications throughout the estate planning process, which may seem demanding and complex. Nevertheless, with the assistance of Landmark Law, we will work with you and guide you step-by-step to ensure proper planning. Be rest assured that a dedicated and caring team will be assisting you.
Disclaimer: This article does not contain legal advice and only provides general information. It is not intended to replace advice from a qualified legal professional and should not be relied upon to make decisions. In all cases, contact your legal professional for advice on any matter referenced in this article before making decisions. The use of this article does not establish a lawyer-client relationship.