The purchase of a first home is a milestone in anyone’s life, for many reasons. A home purchase is likely the largest single financial transaction most Canadians will enter into in their lives, and having the ability to buy one’s own home has traditionally been perceived as a marker of financial success and stability.
While there are many intangible benefits to owning a home, home ownership also provides some very tangible and significant financial advantages. Specifically, it provides the opportunity to accumulate wealth through increases in home equity, and to realize that wealth on a truly tax-free basis.
Most Canadians who purchase a home do so by making a down payment and borrowing the remainder of the purchase price of the home from a financial institution. That borrowing – the home mortgage – is paid off, with interest, usually over a 25- or 30-year period, at the end of which the homeowner owns the property outright. And, in virtually all instances, the value of that property is likely to be many times more than the original purchase price. In many locations in Canada, a home purchased in 1998 for $200,000 could have, by 2023, a market value of $1,000,000.
The real benefit of such asset growth, however, is found in the way such increases in value are treated for tax purposes. The Canadian tax system is a very comprehensive one, and there are very few sources of income or investment gains which escape the tax net. Home ownership is one of those few exceptions.
Under Canadian tax rules, where an asset is sold, the increase in the value of that asset over its original purchase price is treated as a capital gain, 50% of which must be included in taxable income and taxed as such. However, where a family home is sold, any increase in value (that is, any gain) is exempt from tax, regardless of the amount of such gain. Continuing the above example, a homeowner who paid $200,000 for a home in 1998 and sells that home in 2023 for $1,000,000 has a gain of $800,000. Assuming that the property was lived in and used as a home (a “principal residence” in tax parlance) for the entire 23 years of ownership, the full $800,000 gain can be received tax-free. If that gain were treated as a capital gain, and taxed as such, approximately $200,000 of the gain would have to be paid in capital gains tax.
The tax-free status of gains made on the sale of a family home is known, for tax purposes, as the principal residence exemption (PRE) and has been available to Canadians since 1972. And, for nearly 45 years after that, there were no changes made to the rules governing the availability of the exemption, or the reporting requirements for claiming it. In the last eight years, however, and especially in 2023, the rules with respect to the exemption have been tightened.
The need for changes arose out of a perceived change in the way the housing market operated, resulting from unprecedented increases in the price of residential properties over a relatively short period of time. While there are have always been individuals or companies who purchased properties with the intent of reselling them, perhaps after undertaking renovations, most purchases of residential real estate were made by individuals or families intending to live in them. However, it became possible, over the past 10 or 15 years, to purchase a property and re-sell it relatively soon thereafter for a very substantial profit. And, where the PRE was claimed on that sale, the entire profit would be received tax-free.
These changes in the housing market led to what the federal government perceived as a situation in which housing was being bought and sold as a commodity rather than for its traditional purpose of providing a home, and that the principal residence exemption was being used to avoid the payment of profits made from the “flipping” of properties in a way that was never intended. A secondary effect of such “commodification” of residential real estate was to drive up the price of properties, putting home ownership further and further out of the reach of the average Canadian.
For both these reasons, the federal government moved, in 2016 and again in 2023, to make changes to ensure that the principal residence exemption was being used for its intended purpose, and only by those who were entitled to claim it.
The first such change, which took effect as of January 1, 2016, was an administrative measure which required taxpayers, for the first time, to report any transaction for which the PRE was being claimed. Beginning with the 2016 tax year, individuals who are claiming the PRE for a property sale which took place during the year are required to complete Schedule 3 on their tax return for the year, confirming that fact and indicating the tax years for which the exemption is being claimed.
It’s important to note that the new requirement to report any claims for the PRE does not in any way change the rules respecting either eligibility for the exemption or the tax treatment of amounts received on the sale of a principal residence. What it does, however, is provide the tax authorities with information which could flag claims for the PRE which those tax authorities view as requiring further investigation. For instance, where an individual claims the principal residence exemption on two sales of residential property within a three-year period, it’s very likely that the tax authorities will want further information to determine whether either or both such transactions fit within the ambit of the rules governing the PRE.
In fact, as reported in the media, the Canada Revenue Agency has sent out “educational letters” to several hundred taxpayers who have claimed the PRE in circumstances which the CRA believes merit further investigation. Those letters suggest that taxpayers contact the CRA to provide an explanation for their use of the PRE, or to amend their return(s) if necessary.
These CRA enforcement activities are unlikely to affect taxpayers who sell a principal residence perhaps two or three times during their lifetime: the CRA’s efforts are directed at those who may be repeatedly using the PRE to shelter income or capital gains which should be reported as (and taxed as) income. Nonetheless, it remains the case that anyone claiming the PRE in any year after 2015 must file a Schedule 3 with their return for the year, certifying that fact, in order to be able to benefit from it.
The second change made by the federal government with respect to the PRE was much more substantive, and aimed directly at those who, in the government’s view, are misusing the PRE. That change, which is effective as of 2023, provides that anyone who sells a property which they have owned for less than 12 months would be considered to be “flipping” properties. Where that is the case, 100% of any gain made on the sale of the property would be included in income and taxed as business income. In other words, not only would the seller of the property not be eligible for the PRE, the gains made on the sale of the property would not be treated as a capital gain (only half of which is included in income for tax purposes) but as business income, the entirety of which is included in income and taxed as such.
The difference in the tax result is best illustrated using the example above. An individual who purchases a property for $200,000 and sells that property for $1,000,000 has a gain of $800,000. The result of the different possible tax treatments of that gain is as follows:
- Where the sale is fully eligible for the principal residence exemption, the total tax payable on the gain is $0;
- Where the gain is treated as a capital gain, the total tax payable on that gain is about $200,000; and
- Where the property sale takes place after 2022 and the property was owned for less than 12 months, the new rule will apply, and the total tax payable on the gain will be about $400,000.
Of course, while most Canadians who purchase a home to live in as a principal residence don’t intend to sell within a year of purchase, life’s circumstances can sometimes dictate a different outcome. Consequently, exemptions from the new tax consequences of selling within 12 months of purchase will be provide for Canadians who sell their home due to specified life events, such as a death, disability, the birth of a child, a new job, or a divorce.
The changes made to the PRE rules in 2016 and 2023 don’t change the fact that home ownership remains one of the very best tax savings and wealth building strategies available to Canadians. Those who buy intending to live in the property as a family home are unlikely to be affected by the 2023 rule changes, and compliance with the new reporting requirements introduced in 2016 will ensure that they make the most of the tax saving possibilities available to them.
More information on the rules governing the sale of a principal residence and claiming the exemption can be found on the CRA website at https://www.canada.ca/en/revenue-agency/services/tax/individuals/topics/about-your-tax-return/tax-return/completing-a-tax-return/personal-income/line-12700-capital-gains/principal-residence-other-real-estate/sale-your-principal-residence.html and https://www.budget.canada.ca/2022/report-rapport/chap1-en.html#2022-4.
The information presented is only of a general nature, may omit many details and special rules, is current only as of its published date, and accordingly cannot be regarded as legal or tax advice. Please contact our office for more information on this subject and how it pertains to your specific tax or financial situation.