Even a novice investor likely understands that growing a successful real estate portfolio involves taking ownership of several properties. What those same novice real estate investors may not realize is that the CRA will seek to classify each property for tax purposes.
Table of Contents - What is a Principal Residence, and What Does It Mean for Your Investment?
It all begins with the first one, the one you occupy: your principal residence
What is a principal residence?
In its most basic form, a principal residence is a property where you live. It can take the form of any kind of dwelling: an apartment, condo, mobile home or traditional free-standing home.
For a property to qualify as a principal residence in Canada, it must meet all of the following requirements:
- It has to be some sort of qualifying housing unit. A tent won’t cut the mustard.
- You and your legal partner or your children must live there for all or part of the year.
- You must own the property alone or with another person. You must have a long-term stake in the dwelling (i.e. you’re paying monthly rent).
- You must designate the property as your principal residence.
None of that sounds too tricky, right? Things get a little bit more complicated when you try to make some income from your principal residence.
Principal residence investing
If you’re still living in your principal residence while renting out a room, then there isn’t much cause for concern. Make sure to report the income you’re earning, and you’ll be good with the CRA.
If you’re moving out of your principal residence in favour of having a tenant move in, then you’ll have to consider a few things. For example, if you intend to purchase another property as your primary residence, you will likely have to reclassify your former house as a rental property. That means getting a new mortgage and paying a different set of taxes.
If you’d prefer not to jump those hurdles, there are some ways around reclassifying your principal residence as an income-producing property. When you move out of your home, do not classify another property in your primary residence for four years. After that initial period, the Canadian government will cut you some slack, but only in work-related scenarios. Qualifying examples include that your employer is having you relocate.
The capital gains tax and your principal residence
When you’re in the real estate sector, opting to sell your principal residence can have several tax benefits. At the end of the tax year, in addition to all the other fees it enforces, the Canadian Revenue Agency levies what’s known as a capital gains tax.
This annual fee measures the increase in the value of every asset in your portfolio. When it comes to property, the capital gains tax requires that the seller pay taxes on half of the profit earned from selling a given property. For example, let’s say you sell a condo and earn $10,000 in profit when all is said and done. At that point, the CRA would require that you pay taxes on $5,000 of that profit.
However, when you are selling your primary residence, the CRA offers a full exemption. In other words, you don’t have to pay any taxes on the profit earned from the sale of your principal residence. In fact, until 2016, Canadians who sold their primary residence weren’t even compelled to report it on their annual income tax return.
Recent rule changes
As of 2016, the CRA requires that anyone selling their private home must report basic information regarding the date of sale and profit earned. Even those people expecting a full capital gains exemption must report the sale. Sellers must also include a description of their property with their income tax returns.
Failure to report these details could result in the CRA playing closer attention to the sale of your principal residence. These new rules allow the agency to reassess the state of a deal at any moment, instead of the previous three-year statute of limitations. In other words, failure to report could come back to haunt you at any time in the future.
Investors who invest in real estate and rely on the principal residence tax exemption should be aware that the CRA is on the lookout for any suspicious behaviour. Specifically, the agency is hoping to put an end to:
- Fix and flip: Investors who claim the property as their principal residence, even as they’re prepping the place to sell in a hurry. If you’re hoping to get into the “fix and flip” business, that’s fine, just don’t try to pass your investment opportunity off as your home.
- Short-term rental hosts: Sellers who attempt to make a profit on a vacation home by claiming it as their primary residence are also in the crosshairs of the CRA.
- The picky homeowner: People who have a home built, occupy it for the minimum time allowable and then sell it off for a profit.
Be honest, and you’ll be fine
It would seem that the CRA’s overarching aim is to hold investors accountable for their business decisions. If you’re using one room in your principal residence as a rental, you don’t have much to worry about. If, however, you’re trying to beat the system and claiming the property as your primary residence, when it's not, you might be in trouble.
In the long-term, it is inevitably more profitable to pay out the taxes that you owe as they come due rather than hope you can avoid the fees. The government is actively changing the rules to stamp out this behaviour at its source. The most successful investing techniques always require staying on the right side of the law.