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The Principal Residence and Capital Gains Tax – New Rules, New Pitfalls

Most taxpayers know that when you sell an asset which has increased in value, the federal Income Tax Act provides that you will generally be liable for capital gains tax on the net increase in value, unless there is an applicable exemption. One exemption from capital gains tax is for a principal residence. In October of 2016, the federal government introduced draft legislation to amend the rules to restrict the application of the principal residence exemption. The amendments are aimed at stopping non-residents of Canada and real estate developers from unreasonably claiming the exemption. However, the amendments can also affect anyone who currently has or may wish to have a trust which holds a residence for a beneficiary, whether or not they are tax resident in Canada.

The principal residence exemption allows one family unit to designate one property as their principal residence for the purposes of accessing the principal residence exemption, as long as certain conditions are met. The exemption from capital gains tax applies to all years the property is owned plus one additional year to allow for the sale of one principal residence and the purchase of another in the same year. Under existing rules, a home held in a trust can qualify for the exemption.

Changes to the rules now require taxpayers to report the disposition of a principal residence, which was not necessary before. They also take away the “plus one year” allowance in calculating the exemption if the taxpayer was not tax resident in Canada when the property was purchased. Taxpayers who are tax resident in Canada will not be seriously affected by these changes.

However, the changes regarding trusts will affect Canadian tax residents in a variety of circumstances. The new rules have the potential to disqualify a trust from being able to continue to claim the principal residence exemption on a home held in the trust which up to October 2016 would have qualified for the exemption. Given the continuing rise in real estate prices in Toronto, for example, this change could have a significant, unexpected impact on the amount of tax payable going forward.

Under the new rules, any trust which is not an alter ego trust, joint partner trust, spousal/common law partner trust, qualified disability trust or a qualifying trust for a minor child will no longer be able to claim the principal residence exemption. This would, for example, affect a trust set up for asset protection purposes, including for a grandchild, a trust for a adult child which is not a qualified disability trust, and a trust for a minor child of a deceased parent where the child’s other parent is still living. In all these cases, any home held in the trust will be subject to capital gains tax for any tax year ending after 2016.

Even where the trust is one which can still claim the principal residence exemption, the new rules could disqualify the trust in other ways. For example, the trust terms must specifically give the qualifying beneficiary the right to use and enjoy a property held in the trust. It appears that a general right given to beneficiaries to use and enjoy property, which is currently typically used in trust drafting, may not be enough to meet the requirements of the new rules. Another example are trust terms for a minor child which is to extend past the time when the child turns 18, also very typical in trust drafting. A trust with such terms will no longer qualify for the principal residence exemption once the child turns 18. In both cases, the trustees will have to choose: continue holding the home and lose the principal residence exemption after 2016 or do not continue holding the home.

While trusts planned under a will can be adapted to the new rules in many cases, assuming the will-maker is still capable of amending their will, current trusts may no longer be able to claim the principal residence exemption and the options available to deal with this disqualification may be limited. Further, when the new rules have been enacted, which is expected soon, they will apply retroactively to October 3, 2016. It is therefore important that anyone who is currently a beneficiary or trustee of a trust or who is planning a trust which may hold a residence for a beneficiary to obtain professional advice about what can be done either to bring the trust into compliance with the new rules, or minimize the impact of them.

— O’Sullivan Estate Lawyers

The comments offered in this article are meant to be general in nature, are limited to the law of Ontario, Canada, and are not intended to provide legal or tax advice on any individual situation. Before taking any action involving your individual situation, you should seek legal advice to ensure it is appropriate to your personal circumstances.