Steve Ranot, C.A., C.B.V.

True or False?

Q: There is no capital gains tax on the sale of your family home.

A: False. However, many people rely on the generalization that the statement above is true.

The reason for the popularity of the belief in this generalization is that in most cases it can be true. The family home is a personal use capital asset and accordingly, gains thereon are subject to the normal rules governing such assets. The principal residence exemption as contained in the Income Tax Act ("the Act") permits this gain to be sheltered where the dwelling unit is occupied by the taxpayer who owns it, or immediate members of his/her family, including a spouse or former spouse. However, the property must be designated as such for the years it was owned and with certain exceptions, no other property held by the taxpayer and a spouse may be designated in the same year.

As with many other issues, things get complicated on breakdown of marriage. Consider the following: Mr. and Mrs. Doe live in an extremely rare part of Ontario where house prices have risen over the last few years. They separated in 1992 when their house was jointly owned. Mr. Doe moved out and bought another home in the same neighbourhood. Mr. Doe continued to pay all of Mrs. Doe’s and the family’s expenses voluntarily. In 1996, the terms of the payments and other matters were codified in a written separation agreement. Under the terms of the agreement, Mr. Doe transferred his one-half of the matrimonial home to Mrs. Doe.

Mr. Doe could transfer his one-half of the home to Mrs. Doe at cost pursuant to the Act, or he could elect to transfer at fair market value, which would trigger a gain eligible for shelter by the principal residence exemption. Mr. Doe prefers to transfer at cost for the reason being that he has owned another principal residence from 1992 to 1996. Only one of these properties may be designated as his principal residence for this period.

It is true that separated persons are each eligible to claim a principal residence exemption on a separate dwelling unit in the same year, as long as they are separated pursuant to a written agreement throughout the year. As the Does’ written agreement was not entered into until 1996, there are two homes, each of which has increased in value from 1992 to 1996, and only one exemption available for this period.

As a result, if one-half of the property is transferred at cost to Mrs. Doe, then one of Mr. and Mrs. Doe is entitled to claim the principal residence exemption in the years 1992 to 1996, but only one. As the Act has no mechanism to determine who, it boils down to a first come, first served basis. That is, whomever is the first to dispose of his/her principal residence and designate it as such on their respective personal income tax return for the year will be eligible for the exemption. The other party will be left with a four-year "hole" in their own principal residence exemption (because of a technicality called the "one-plus" rule). If Mrs. Doe claims the exemption for the years in question, and Mr. Doe ends up disposing of his home in 2002, then he can claim the principal residence exemption for 6 of the 10 years he owned the home. Accordingly, 60% of his gain is eligible for the principal residence exemption. The remaining 40% of the gain is subject to tax in the year of disposition.

If Mr. Doe transfers his one-half interest at fair market value, he will likely claim the principal residence exemption on his half of the matrimonial home. This prevents him from claiming the exemption on his new home for the years 1992 to 1996 (less one year for the "one-plus" rule). As can be seen, if Mr. Doe is given sound tax advice, he will not choose this route.

Counsel for Mrs. Doe can prevent her from incurring a tax liability on the disposition of her home by including a clause in the written separation agreement that Mr. and Mrs. Doe agree that only the matrimonial home may be designated as a principal residence from the time of its purchase to the year before the signing of the written agreement. With the absence of this clause and a transfer of Mr. Doe’s interest in the home to Mrs. Doe at cost, the race will be on to see who is the first to designate their home as the principal residence from 1992 to 1996!