Principal Residence Exemptions: New Capital Gains Reporting Requirements

  • February 17, 2017
  • Alan G. Silverstein

One of the hallmarks of the Canadian income tax system is the “principal residence exemption” in Section 40(2)(b) of the Income Tax Act of Canada (the “ITA”)  – an exemption from paying capital gains tax when Canadians dispose of their principal residence, whether by way of sale, gift or death. However, the principal residence exemption was always intended to be limited to Canadian resident individuals and trusts, not non-residents. Another long-standing feature, this one a significant restriction: since 1982 only one property can be designated as a principal residence for each ‘family unit’ in any given year. That prevents two spouses from each utilizing the principal residence exemption i.e. one spouse claiming the city home as their principal residence, while the other spouse did the same with the rural cottage.

Since the fall of 2015, Canadian news media have been regularly reporting on non-residents abusing the principal residence exemption to sidestep the payment of capital gains tax.  An article in the Globe and Mail explained (much better than I ever could) how non-residents were defrauding the system:  

“the breadwinner claims to be a resident  of Canada but then doesn’t report their worldwide income to the Canada Revenue Agency, as required by law. Because they claim to be residents, they can sell Canadian properties in their name, tax-free, even if they spend little or no time in Canada.

If these homeowners make their living in China, experts said it’s difficult for anyone to determine what they actually earn, because it’s next to impossible to get tax records from that country, even though China and Canada have a long-standing tax treaty. As a result, experts say, these wealthy people get away with claiming little or no income on their Canadian tax returns, while selling homes tax-free.”  

Facilitating this scam was the Canada Revenue Agency’s (“CRA”) lax reporting requirement on the disposition of a principal residence.  To the surprise of many people, a form actually exists [Form T2091(IND) Designation of a Property as a Principal Residence by an Individual (Other Than a Personal Trust)] that individuals are supposed to complete in the year of disposition, designating a property as a principal residence.  However, Form T2091(IND) only had to be included with an income tax return for the year of disposition if a capital gain had to be reported . If the disposition of a principal residence qualified for the full capital gains exemption, nothing had to be reported to or filed with the CRA.  So Form T2091 (IND) would gather dust in an individual’s personal tax file, if it was even completed.  This “no-tax no-tell” policy meant the CRA clearly operated at a self-imposed disadvantage when trying to track down and tackle cheaters abusing the principal residence exemption.  

However, the CRA did have to be notified about the disposition of a principal residence in some situations:

  • when a property was a principal residence for only part of the time the individual owned it (i.e. another property such as a cottage was designated as the principal residence for one or more of the years of ownership, but not all).  As the full principal residence would not be available, Form T2091 (IND) had to accompany the individual’s T1 Income Tax Return;
  • when an individual died owning a principal residence, and the deceased was not a Canadian resident during the entire period of time they owned a principal residence.  Again, the full principal residence exemption would not be available.  If a capital gain had to be reported, Form T1255 Designation of a Property as a Principal Residence by the Legal Representative of a Deceased Individual had to be completed and filed with the Terminal Return for the deceased.  (However, that form did not have to be completed and filed if no capital gain had to be reported); and
  • when a trust owned a principal residence for one or more tax years, on its disposition the trust had to designate the property as a principal residence by completing Form T1079 Designation of a Property as a Principal Residence by a Personal Trust, and attaching it to the trust’s T3 Trust tax return.

Changes to the ITA affecting principal residences were announced on October 3, 2016 by Federal Minister of Finance Bill Morneau.  According to an accompanying Backgrounder, the goal is to improve tax fairness and close loopholes: 

“The Government is committed to tax fairness, and to ensuring that the exemption from capital gains tax on the sale of a principal residence is available only in appropriate cases. Proposed changes to the tax rules would ensure that the principal residence capital gains exemption is not abused, including by non-residents buying and selling a property in the same year. An additional measure would improve compliance and administration of the tax system with respect to dispositions of real estate, including the sale of a principal residence" 

[As of the preparation of this paper, only the Notice of Ways and Means Motion has been published. Draft legislation had not yet been introduced in Parliament. Therefore, changes are possible before these proposals become law.]

Here is a summary of the proposed changes – three substantive, the last one administrative:

1.     For dispositions made after October 2, 2016, an individual will not qualify for the principal residence exemption in the year they acquired a residence if they were a non-resident of Canada in that year.  

It is trite law that only one property can be designated as a principal residence for any given tax year. However, the principal residence exemption rules also state that a taxpayer can have two residences in the same year when one residence is sold and another is acquired in the same year.  This is accomplished via the special “one plus” rule for principal residences, that allows a taxpayer to treat both properties as a principal residence for the year of transition.  On the other hand, the “one-plus” rule was never intended to be used by non-residents to capitalize on the principal residence exemption.  The proposed amendment to the ITA would eliminate the “one plus” rule if an individual was not a Canadian resident during the year of acquisition.  

2.     Starting in 2017, trusts will only be eligible to designate a property as a principal residence if additional eligibility criteria are met, criteria designed to more closely align the principal residence exemption for trusts with those for individuals.  For example, a trust must be a spousal or common-law partner trust, an alter ego trust (or a similar trust for the exclusive benefit of the settlor during the settlor’s lifetime), a qualifying disability trust, or a trust for the benefit of a minor child of deceased parents. Furthermore, “the trust’s beneficiary who, or whose family member, occupies the residence for the year will be required to be resident in Canada in the year, and will be required to be a family member of the individual who creates the trust ”. Transitional provisions will be introduced for affected trusts where a principal residence is owned at the end of 2016 and disposed after 2016. 

3.     For all dispositions on and after January 1, 2016, individuals who dispose of their principal residence must report the disposition and designation to the CRA as part of their next T1 Income Tax Return, in order to claim the principal residence exemption. This will be the case, even if the entire gain is tax-free using the principal residence exemption. Clearly this is a major change to the way Canadians handle the disposition of a principal residence. According to the best information available at this time, a modified Schedule 3 (Capital Gains) will have to be completed and filed with the T1 Income Tax Return for the year of disposition.  If a property was an individual’s principal residence the entire time they owned it, the information to be provided will include the year of acquisition, proceeds of disposition, and a description of the property conveyed (these requirements are subject to change). Note that this new reporting requirement is retroactive to January 1, 2016 i.e. it will affect all dispositions of principal residences in 2016 and subsequent years, even those that closed between January 1, 2016 and October 2, 2016.   

Bottom line: relief from the payment of capital gains tax when a principal residence is sold or gifted (or disposed on death) is no longer automatic. To benefit from the principal residence exemption (and not pay capital gains tax), individuals will have to report the disposition and designation of the principal residence in prescribed form to the CRA for the year of disposition.  

More CRA audits are inevitable, too. Armed with these designations, imagine how easy it will be for the CRA to audit questionable transactions in order to verify whether an individual truly is entitled to receive the principal residence exemption. Scamming the system using the principal residence exemption just became much more difficult.  

What if an individual disposed of a property and wanted to claim the principal residence exemption, but failed to report the designation on their income tax return for the year of disposition?  The following answer appeared on the CRA website: 

“For the sale of a principal residence in 2016 or later tax years, CRA will only allow the principal residence exemption if you report the sale and designation of principal residence in your income tax return. If you forget to make a designation of principal residence in the year of the sale, it is very important to ask the CRA to amend your income tax and benefit return for that year (emphasis mine).  Under proposed changes, the CRA will be able to accept a late designation in certain circumstances, but a penalty may apply. 

The penalty is the lesser of the following amounts:

1.    $8,000; or
2.    $100 for each complete month from the original due date to the date your request was made in a form satisfactory to the CRA. ”

4.     Normally the CRA has 3 years from the date of the initial notice of assessment to re-assess an individual.  If these proposals are enacted, the CRA would have an extended period of time (apparently: indefinitely) to assess (or reassess) taxpayers regarding dispositions of real estate (a) where the disposition is not reported for the year in which the disposition is made, (b) if the taxpayer fails to file an income tax return for that year; or (c) if a partnership in which the individual had an interest (direct or indirect) failed to file an income tax return.  For property disposed of by a corporation or partnership, the extended assessment period would apply only to property that is capital property.  Also, the CRA states that any reassessment under this extended assessment period would be limited to amounts reasonably relating to the unreported or previously unreported disposition of real estate (time will tell if the CRA will honour this commitment, and not delve further into the taxpayer’s activities during this extended assessment period).  

These changes will apply equally to deemed dispositions of property, including a change of use from principal residence to a rental or business operation, and a change in use from a rental or 
business operation to a principal residence.  

How will this new disclosure requirement impact the real estate bar?  No client wants to be penalized for failing to advise the CRA when they dispose of a principal residence and were entitled to claim the full capital gains exemption.  And no real estate lawyer wants to feel the wrath of a (likely former) client who faces a penalty, unaware they must advise the CRA about the disposition and designation of a principal residence in a timely manner.  The real estate bar can easily fulfil our professional obligations by adding a short paragraph to our closing direction and / or sale reporting letter, similar to the following (the word “sale” has been used rather than “disposition”, as most dispositions will be sales.  The appropriate change can be made if a principal residence is disposed by gift, or on death). 

“The Canada Revenue Agency will now only allow sellers to claim the principal residence exemption (the exemption from payment of capital gains tax) if the sale is reported in prescribed manner when filing their next income tax return.  The penalty for non-compliance can be quite high.  You should ensure the appropriate schedule is completed and attached to your next income tax return."

This paper was originally prepared for The Law Society of Upper Canada’s Continuing Professional Development Program titled “The Six-Minute Real Estate Lawyer 2016”, held on November 8, 2016.


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