Canadian Taxes A to Z (2015): P is for Principal Residence Exemption

Today, P for for Principal Residence Exemption. Sixteen letters down. Ten to go!

The principal residence exemption may be the best tax break going for Canadians who own a home. As I've mentioned under earlier alphabet letters, you've usually got to pay tax on capital gains just like on income gains (though at half the normal rate). However, any capital gain on your principal residence is tax free. With home values in Canada generally rising at much faster rates than investment values, this can be a very profitable exemption!

Prior to 1981, each spouse in a couple could designate a principal residence for the purpose of the exemption. So one could choose the cottage, and one the city home, and no one would pay tax on capital gains on either of them. However, since that time couples can only have one joint principal residence.

A couple could pick the cottage as the principal residence if they wish to avoid tax when it comes time to sell it, but for the years of its designation they would lose the exemption on their city home. So designating the cottage would probably only make sense if it had experienced a larger capital gain during the relevant period than the city home. For a couple with a tiny city condo and a palatial waterfront cottage, picking the cottage sale to be tax free would make sense. But for most people, the city home is going to have risen more in value because it was more expensive to begin with. Picking the cottage as the principal residence would help defer tax payments for a while if it is sold prior to disposition of the city home, but if you plan to sell the city home at any time in the future the taxing of its capital gain would eventually catch up with you.

The most important requirement of the principal residence exemption is that the home must have been your principal residence for the entire time you owned it, not just at the time you are selling it. Otherwise, you'll need to take a percentage of a capital gain exemption equivalent to how long the home was your principal residence as compared to the total amount of time you owned the home.