My name is Mark Goodfield. Welcome to The Blunt Bean Counter ™, a blog that shares my thoughts on income taxes, finance and the psychology of money. I am a Chartered Professional Accountant. This blog is meant for everyone, but in particular for high net worth individuals and owners of private corporations. My posts are blunt, opinionated and even have a twist of humour/sarcasm. You've been warned. Please note the blog posts are time sensitive and subject to changes in legislation or law.

Monday, May 21, 2018

How the Principal Residence Exemption Works When You Construct a New Home

Several provinces have experienced booming real estate markets the last few years and some people have used the increased equity in their home to buy land and construct their dream home. In some cases, people sell their current home and rent until the new home is ready to occupy, while others continue to own and live in their present home and then sell it before they move into their new home.

In both these situations, people are often surprised at how the Principal Residence Exemption (“PRE”) must be calculated. Today, I will review what the possible tax consequences are under these scenarios.

Construction of a Home on Vacant Land

Where you acquire vacant land for the purpose of constructing a home for you and your family in a future year, the property cannot be designated as your principal residence until you and your family commence to ordinarily inhabit the newly constructed home.

Consequently, if the newly constructed home goes up significantly in value prior to you moving in, those years while the home was under construction may be problematic for purposes of the PRE. I review the details below.

The Principal Residence Exemption

As you may be aware, the PRE is a formulaic calculation that determines the amount of the gain on the sale of your principal residence that is exempt. I set forth the formula below:

The capital gain on the sale of your home multiplied by:

The number of years you have lived in your home & designated the property as your PR, plus 1 divided by the number of years you have owned the property

The one-year bonus is meant to ensure that you are not penalized when you move from one home to another in the same year. Thus, where you live in your home the entire time you owned it, you are typically not subject to tax on the sale of the home (don’t forget, you are now required to report the sale of your principal residence on your personal income tax return as I detailed in this recent blog post titled Reporting the Sale of Your Principal Residence). 

Income Tax Folio S1-F3-C2 Principal Residence

Income tax folio S1-F3-C2 sets forth a great example of how the PRE works where you have constructed a new home. The example (2.29) is as follows:

“In 2002, Mr. A acquired vacant land for $50,000. In 2005, he constructed a housing unit on the land, costing $200,000, and started to ordinarily inhabit the housing unit. In 2011, he disposed of the property for $300,000. Mr. A’s gain otherwise determined on the disposition of the property is equal to his $300,000 proceeds minus his $250,000 adjusted cost base = $50,000 (assume there were no costs of disposition). Mr. A can designate the property as his principal residence for the years 2005 to 2011 inclusive, but not for the years 2002 to 2004 inclusive because no one lived in a housing unit on the property during those years. The principal residence exemption formula cannot, therefore, eliminate his entire $50,000 gain otherwise determined, but rather can eliminate only $40,000 of that gain, as shown in the following:

Applying the formula A × (B ÷ C):

A is $50,000

B is 1 + 7 (being tax years 2005 to 2011)

C is 10 (being tax years 2002 to 2011)

= $50,000 x (8 ÷ 10)

= $40,000”

How the Principal Residence Exemption Works When You Continue to Own Your Current Home While You are Constructing a New Home

So, what the heck happens when you have a home and build a new one? Essentially two things:

1. As noted in the CRA example above, for the years you did not ordinarily inhabit the new home while it was under construction you will at most only be able to protect one year of those years you did not inhabit the home from being taxable when you eventually sell.

2. If your old home had a yearly gain smaller than the yearly gain on the home under construction before you move in, you cannot save (not designate) those years with the larger gain on the newly constructed home.

What this means is the following. Typically, you would suspect the result would be similar to where you owned say a home and a cottage. In those circumstances (since you ordinary inhabit both properties) where you sell your home, if your home went up $5,000 a year in value and your cottage for example went up $25,000 a year, you would likely not designate all the years to your home, since you would want to save as many years as possible of your PRE exemption for when you sell the cottage (since you would be saving $25k a year versus $5k a year) and pay some tax on the sale of your home.

However, where you had a home under construction for say three years that goes up in value $25,000 per year, you will not have the option to not designate all three years on your home sale and you can at best only protect one year, because you did not ordinarily inhabit the home under construction. Yes, I know, clear as mud.

Clearly this is a very fact specific situation, but the income tax result is often an unexpected tax hit. In any case, I strongly suggest you obtain income tax advice if you are in this situation, since it is obviously extremely complex.

This site provides general information on various tax issues and other matters. The information is not intended to constitute professional advice and may not be appropriate for a specific individual or fact situation. It is written by the author solely in their personal capacity and cannot be attributed to the accounting firm with which they are affiliated. It is not intended to constitute professional advice, and neither the author nor the firm with which the author is associated shall accept any liability in respect of any reliance on the information contained herein. Readers should always consult with their professional advisors in respect of their particular situation. Please note the blog post is time sensitive and subject to changes in legislation or law.