Your Principal Residence Exemption and the Capital Gains Decrease

it is sold, provided you live in part of the house. However, where a large home is renovated to add a self-contained suite, CCRA may try to tax the gain later as if it were the sale of two properties: one principal residence and one rental property with no exemption.

To preserve the principal residence status if you rent out your entire property, you must limit the rental to four years, not claim depreciation and file an election or notice with CCRA stating your wish to preserve the principal residence status.

Canada Customs and Revenue Agency states you cannot designate a property as a principal residence if you claim depreciation, which is loss of value for the building as it ages. If you had a 150 square-foot home office in a 1400 square foot home, but did not claim depreciation as a business expense, the tax-free status would be preserved. If you did claim depreciation as a tax deduction for your home-based business, the office would not be designated as your principal residence but the remaining 1250 square feet would be.

If you made a profit on the sale of your cottage but did not report it on your tax return, Revenue Canada may consider the cottage as your designated principal residence and disallow tax-free status for your home. You can also lose the exemption if you move frequently since that may be considered a business activity which does not qualify.

Tax-free profit is alluring but it can be elusive.

　

CCRA, TAXATION INTERPRETATION BULLETIN SUBJECT: INCOME TAX ACT Principal Residence NO. IT-120R4 DATE: March 26, 1993 REFERENCE: Subsection 40(2) and paragraph 54(g) (also sections 45, 54.1, 110.6, 116 and 216, subsections 13(7), 40(4), 40(5), 40(6), 40(7), 70(6), 73(1), 107(2), 107(2.01), 107(4) and 252(1) and paragraph 104(4)(a) of the Act and Part XXIII of the Regulations) Application This bulletin replaces and cancels Interpretation Bulletin IT-120R3 dated February 16, 1984. Current revisions are indicated by vertical lines. Summary This bulletin discusses the principal residence exemption which eliminates or reduces for income tax purposes a gain on the disposition of a principal residence. In order to qualify for designation as a taxpayer's principal residence for a taxation year, the property must be owned by the taxpayer. Joint ownership with another person qualifies for this purpose. The residence generally must be inhabited in the year by the taxpayer or certain family members. For taxation years after the 1981 year, only one property per family unit can be designated as a principal residence. If the land on which a housing unit is situated is not in excess of 1/2 hectare, it usually qualifies as part of a principal residence. In some cases, land in excess of 1/2 hectare may qualify, if established to be necessary for the use and enjoyment of the housing unit as a residence. A principal residence may be located on farm land. The taxpayer has a choice of two methods for determining what portion of a gain realized on a disposition of a farm property can be eliminated by the principal residence exemption. A complete or partial change in the use of a property from principal residence to income-producing, or vice-versa, results in a deemed disposition at fair market value. A taxpayer may be able to elect that the deemed disposition on a complete change in use does not apply. A property covered by such an election can qualify as a principal residence for up to 4 years, or possibly longer in the case of a work relocation. The above topics are discussed more fully below, as well as other topics relating to the principal residence exemption. Discussion and Interpretation Topics Discussed and Their Applicability 1. Various topics concerning the principal residence exemption are discussed under the headings listed below. It should be noted from these headings that some of the topics are not relevant for all taxpayers. For example, a resident of Canada who owns only one housing unit which is situated in Canada on land of 1/2 hectare or less and which has been used since its acquisition strictly as his or her residence, will usually find that 20 to 45 below have no particular relevance. Paragraph Qualification as a Principal Residence 2-7 Meaning of "Housing Unit" 8 Meaning of "Co-operative Housing Corporation" 9 Ownership of a Property by Spouses 10 Partnership Property 11 Meaning of "Ordinarily Inhabited" 12 Designation of a Property as a Principal Residence (Form T2091) 13 Calculation of Gain on Disposition of a Principal Residence - The Principal Residence Exemption 14 More Than One Residence in a Taxation Year 15 Construction of a Housing Unit on Vacant Land 16 Property Owned on December 31, 1981 17 Property Acquired from a Trust 18 Loss on Disposition of a Residence 19 Land Contributing to the Use and Enjoyment of the Housing Unit as a Residence 20 Land in Excess of 1/2 Hectare 21-22 Disposition of Bare Land in Excess of 1/2 Hectare 23 Disposition of Part of a Principal Residence 24 Disposition of a Property Where Only Part of It Qualifies as a Principal Residence 25 Principal Residence on Land Used in a Farming Business 26-30 Complete Change in Use from Principal Residence to Income-Producing 31-33 Complete Change in Use from Income-Producing to Principal Residence 34-35 Partial Changes in Use 36-38 Change in Use Rules Regarding CCA, Deemed Capital Cost and Recapture 39-40 Principal Residence Outside Canada 41 Non-Resident Owner of a Principal Residence in Canada 42-44 Disposition of a Principal Residence in Canada by a Non-Resident Owner 45 Qualification as a Principal Residence 2. In order for a property to qualify as a taxpayer's principal residence for any particular taxation year, the requirements in paragraph 54(g) of the Income Tax Act must all be satisfied. The basic requirements are described in 3 to 6 below. 3. A housing unit or leasehold interest in a housing unit can qualify as a principal residence. Also, a share of the capital stock of a co-operative housing corporation, if acquired for the sole purpose of obtaining the right to inhabit a housing unit owned by that corporation, can qualify. 4. The property must be owned in the taxation year by the taxpayer. The meaning of "ownership of property" for this purpose is discussed in the current version of IT-437. The taxpayer's ownership of the property qualifies under paragraph 54(g) whether such ownership is "jointly with another person or otherwise". These words include sole ownership, joint tenancy, tenancy-in-common and co-ownership. 5. The housing unit must be ordinarily inhabited in the taxation year by the taxpayer or by the spouse, former spouse or a child of the taxpayer. Alternatively, an election under subsection 45(2) or (3) must be in force for the year (see 32 and 35 below, respectively). 6. The property must be designated by the taxpayer as his or her principal residence for the taxation year and no other property may have been so designated by the taxpayer for that year. Furthermore, where the taxpayer is designating the property as his or her principal residence for a taxation year that is subsequent to the 1981 year, no other property may have been designated as the principal residence of any member of the taxpayer's family unit for that year. For this purpose, the "family unit" includes, in addition to the taxpayer, (a) the taxpayer's spouse throughout the year, unless the spouse was throughout the year living apart from, and was separated pursuant to a judicial separation or written agreement from, the taxpayer; (b) the taxpayer's children, except those who were married persons or 18 years of age or older during the year; and (c) where the taxpayer was neither a married person nor 18 years of age or older during the year, the taxpayer's mother and father, as well as the taxpayer's brothers and sisters who were neither married persons nor 18 years of age or older during the year. 7. A property transferred by a taxpayer (transferor) to his or her spouse or to a spousal trust under the rollover provisions of subsection 70(6) (for a transfer on death) or subsection 73(1) (for an inter vivos transfer) may qualify as a principal residence of the spouse or spousal trust for taxation years ending after the transfer, as well as for taxation years prior to the transfer in which the property qualified as a principal residence of the transferor. For a discussion on this topic see the current version of IT-366. Note: If proposed amendments to the Income Tax Act contained in Bill C-92 (which received first reading by the House of Commons on November 26, 1992) are enacted, a property could qualify as a principal residence of any trust, and not just a spousal trust, for the years in which the property was owned by the trust, provided certain conditions have been met. This change in the law would apply for property dispositions occurring after 1990. For more information, see Form T2091. Meaning of "Housing Unit" 8. The term "housing unit" includes a house, an apartment in a duplex, apartment building or condominium, a cottage, a mobile home, a trailer or a houseboat. Meaning of "Co-operative Housing Corporation" 9. The term "co-operative housing corporation" means an association, incorporated subject to the terms and conditions of the legislation governing such incorporation and formed and operated for the purpose of providing its members with the right to inhabit, by reason of ownership of shares therein, a housing unit owned by the corporation. To qualify as a principal residence, a share in such a corporation must have been acquired by a taxpayer solely to obtain the right to inhabit a housing unit owned by the corporation. Ownership of a Property by Spouses 10. Where there is a gain on the disposition of a property owned by a taxpayer and his or her spouse in one of the forms of ownership described in 4 above, both spouses will have a gain on the disposition. If one of the spouses designates the property as his or her principal residence for any taxation year after the 1981 taxation year, the other spouse should consider so designating the same property because, in accordance with the rule described in 6 above, no other property can be designated as a principal residence of that other spouse for that year. For the 1981 and prior taxation years, there was no such restriction and one of the spouses could designate a property (or an interest therein) owned by that spouse while the other spouse could designate another property (or an interest therein) owned by that other spouse. Partnership Property 11. A housing unit, a leasehold interest therein, or a share of the capital stock of a co-operative housing corporation can be a partnership asset. The partnership is not a taxpayer and cannot use the principal residence exemption on the disposition of such a property. However, a member of the partnership could use the principal residence exemption to reduce or eliminate the portion of any gain on the disposition of the property which is allocated to that partner pursuant to the partnership agreement, provided that the other requirements of paragraph 54(g) are met (e.g., the partner resided in the partnership's housing unit for the years in question). Meaning of "Ordinarily Inhabited" 12. The question of whether a housing unit is "ordinarily inhabited" in a taxation year by a taxpayer or by the spouse, former spouse or a child of the taxpayer must be resolved on the basis of the facts in each particular case. Where a housing unit is occupied by such a person for only a short period of time in the year (e.g., a seasonal residence occupied during a taxpayer's vacation or a house sold early or bought late in the year), it is the Department's view that the person ordinarily inhabits the housing unit in the year, provided that the principal reason for owning the property is not for the purpose of gaining or producing income. Where a taxpayer receives incidental rental income from a seasonal residence, the property is not considered to be owned principally for the purpose of gaining or producing income. Designation of a Property as a Principal Residence (Form T2091) 13. Section 2301 of the Regulations provides that any designation of a property as a principal residence for one or more taxation years shall be made in the taxpayer's income tax return for the taxation year in which he or she has disposed of the property or granted an option to another person to acquire the property. Form T2091, which is available at any local taxation office, may be used for this purpose. However, in accordance with the Department's practice, Form T2091 need not be completed and filed with the taxpayer's income tax return unless a taxable capital gain on the disposition of the property remains after using the principal residence exemption but before claiming any capital gains deduction under section 110.6 (see note below regarding a proposed amendment to the capital gains deduction rules). Note that where a taxpayer using the principal residence exemption to eliminate a gain on the disposition of a property is not, in accordance with the above-mentioned practice, required to complete and file Form T2091, a designation of such property is still considered to have been made by the taxpayer for the years in question as far as the limitations discussed in 6 above are concerned. Also note that where a property is transferred by a taxpayer (transferor) to his or her spouse or to a spousal trust, a designation of the property as the principal residence of the transferor for one or more years may be relevant in order for the property to qualify for designation at a later date as the principal residence of the spouse or spousal trust for those same years. Further particulars on the transfer of a principal residence to a spouse or spousal trust, including comments on the manner and timing of filing these designations, are contained in the current version of IT-366. Note: If proposed amendments to the Income Tax Act contained in Bill C-92 (which received first reading by the House of Commons on November 26, 1992) are enacted, the capital gains deduction (which is a deduction in calculating taxable income) would generally not be available for any portion of a taxable capital gain on the disposition of real property that is attributable to the period after February 1992. Any portion of the taxable capital gain that is attributable to the period before March 1992 would still be eligible for the capital gains deduction to the extent allowed by section 110.6. (The calculation of the portion of the gain attributable to each of these two periods would be by means of a simple proration based on the number of months in each period.) Calculation of Gain on Disposition of a Principal Residence - The Principal Residence Exemption 14. The principal residence exemption contained in paragraph 40(2)(b) provides that a taxpayer's gain otherwise determined on the disposition (or deemed disposition) of any property that was the taxpayer's principal residence at any time after its acquisition date, is reduced by the portion of that gain which is calculated under the following formula: A x C --- B where A is 1 + the number of taxation years ending after the acquisition date for which the property was the taxpayer's principal residence and during which the taxpayer was resident in Canada, B is the number of taxation years ending after the acquisition date during which the taxpayer owned the property, and C is the gain otherwise determined on the disposition. The "acquisition date" is defined to be the later of December 31, 1971 and the date on which the taxpayer last acquired or reacquired the property or is deemed to have last acquired or reacquired it. For the meaning of "resident in Canada", see the current version of IT-221. The word "during" in reference to a taxation year means "at any time in" rather than "throughout the whole of" the taxation year. More Than One Residence in a Taxation Year 15. While only one property may be designated under paragraph 54(g) as a taxpayer's principal residence for a particular taxation year, the formula in paragraph 40(2)(b) recognizes that the taxpayer can have two residences in the same year, i.e., where one residence is sold and another acquired in the same year. The effect of the "one plus" in the formula above is to treat both properties as a principal residence in such a year, even though only one of them may be designated as such for that year. Construction of a Housing Unit on Vacant Land 16. Where a taxpayer acquires land in one taxation year and constructs a housing unit on it in a subsequent year, the property may not be designated as a principal residence for the years that are prior to the year in which the taxpayer, his spouse, former spouse or child commences to ordinarily inhabit the housing unit. Such prior years (when the taxpayer owned only the vacant land or the land with a housing unit under construction) would not be included in the numerator "A" in the formula in 14 above. However, all years, commencing with the year in which the taxpayer acquired the vacant land, would be included in the denominator "B". Therefore, it is possible that when the property is later disposed of, only part of the gain otherwise determined will be eliminated by the principal residence exemption. Example A taxpayer acquired vacant land for $25,000 in 1983, constructed a housing unit on it costing $75,000 and started to ordinarily inhabit the housing unit in 1986, and disposed of the property for $150,000 in 1992. The principal residence exemption would reduce the $50,000 gain otherwise determined ($150,000 - $100,000) by only $40,000, computed as follows: 1 + 7 (1986 to 1992) x $50,000 = $40,000 exempt portion ----------------------- of gain. 10 (1983 to 1992) Property Owned on December 31, 1981 17. A taxpayer is allowed to designate a property as his or her principal residence for any taxation year prior to the 1982 year even if another property has been designated as the principal residence of another member of the family unit for that year. However, as indicated in 6 above, a taxpayer may not designate a property as his or her principal residence for any taxation year after the 1981 year if another property has been designated as the principal residence of any other member of the family unit for that year. Where a taxpayer disposes of a property which he or she has owned (whether jointly with another person or otherwise) continuously since before 1982 and the property cannot be designated as the taxpayer's principal residence for one or more years after the 1981 year because of the above-mentioned rule, a transitional provision in subsection 40(6) places a limitation on the amount of gain (if any) on the disposition. Schedule A at the end of this bulletin provides examples which illustrate how the rule in subsection 40(6) works. Property Acquired from a Trust 18. Where - a personal trust has distributed a property to a beneficiary in satisfaction of all or any part of the beneficiary's capital interest in the trust in circumstances to which the rollover provision in subsection 107(2) applies and subsection 107(4) (see below) does not apply, and - the beneficiary later disposes of the property,for purposes of claiming the principal residence exemption, the beneficiary is deemed by subsection 40(7) to have owned the property since the trust last acquired it. The following illustrates the effect of this deemed ownership provision in subsection 40(7): Example A trust acquired a residential property on October 1, 1986 for $75,000. On August 10, 1989, the property was distributed to Mr. X in satisfaction of his capital interest in the trust. Under the provisions of subsection 107(2), Mr. X was deemed to have acquired the property on a rollover basis at a cost equal to its $75,000 cost amount to the trust. Mr. X lived in the residence from October 15, 1986 until he disposed of the property on May 30, 1992 for $125,000, incurring no costs in connection with the disposition. Subsection 40(7) deems him to have owned the property from October 1, 1986 rather than from August 10, 1989. His gain on the disposition of the property after using the principal residence exemption is nil. That is, the $50,000 gain otherwise determined is fully eliminated by the amount calculated under the formula in 14 above, which is as follows: A x C = 1 + 7 (1986 to 1992) x $50,000. --- ---------------------- B 7 (1986 to 1992) Mr. X's gain is nil because the property has qualified for and been designated as his principal residence for all of the relevant years. However, if neither Mr. X nor his spouse, former spouse or child had ordinarily inhabited the residence until it was distributed by the trust to Mr. X on August 10, 1989, then the gain after using the principal residence exemption would be $14,286, since the $50,000 gain otherwise determined would be reduced by only $35,714, calculated as follows: A x C = 1 + 4 (1989 to 1992) x $50,000. --- ---------------------- B 7 (1986 to 1992) A spousal trust may generally be described as an inter vivos or testamentary trust created by a taxpayer under which the taxpayer's spouse is entitled to receive all the trust's income arising before the spouse's death and no one else may receive or use any of the trust's income or capital before the spouse's death. Since a spousal trust is a type of personal trust, the subsection 107(2) rollover provision and subsection 40(7) deemed ownership provision, as described and illustrated above, both generally apply where the spousal trust distributes a property to the spouse who is the beneficiary of the trust. There are exceptions, however, to these general rules: (a) The subsection 40(7) deemed ownership provision does not apply where a post-1971 spousal trust distributes a property to a person other than the spouse and subsection 107(4) prevents a subsection 107(2) rollover from occurring. The precise meaning of what is referred to above as a "post-1971" spousal trust is contained in paragraph 104(4)(a). Note: There are some proposed amendments to subsection 107(4) and paragraph 104(4)(a) contained in Bill C-92, which received first reading by the House of Commons on November 26, 1992. (b) Where a spousal trust has distributed a property to the spouse who is its beneficiary in circumstances to which subsection 107(2) applies, if the property qualifies as its principal residence (see 7 above and the current version of IT-366) for a taxation year, the spousal trust can instead make an election under subsection 107(2.01). Under this election the trust would be deemed, just before the distribution to the spouse, to have disposed of and reacquired the property at fair market value. This could be done, for example, in order for the spousal trust to use the principal residence exemption to eliminate or reduce the gain on the property to that point in time. The cost of the property to the spouse (beneficiary) would be that same fair market value, and he or she would not be deemed by subsection 40(7) to have owned the property during the period of time in which it was held by the trust prior to the distribution. Note: If proposed amendments to the Income Tax Act contained in Bill C-92 (which received first reading by the House of Commons on November 26, 1992) are enacted, the subsection 107(2.01) election would be available to any personal trust and not just a spousal trust. This change, which would be as a consequence of the general extension of the principal residence exemption to all personal trusts as mentioned in the note at the end of 7 above, would have application for trust distributions occurring after 1990. For more information, see the T3 Guide and Trust Return. Loss on Disposition of a Residence 19. A property which is used primarily as a residence, i.e., for the personal use and enjoyment of those living in it, or an option to acquire a property which would, if acquired, be so used, is "personal-use property". Therefore, a loss on the disposition of such a property or option is deemed to be nil by virtue of subparagraph 40(2)(g)(iii). Land Contributing to the Use and Enjoyment of the Housing Unit as a Residence 20. Subparagraph 54(g)(v) provides that the principal residence of a taxpayer for a taxation year shall be deemed to include, except where the property consists of a share of the capital stock of a co-operative housing corporation, the land upon which the housing unit stands and any portion of the adjoining land that can reasonably be regarded as contributing to the taxpayer's use and enjoyment of the housing unit as a residence. Evidence is not usually required to establish that 1/2 hectare of land or less, including the area on which the housing unit stands, contributes to the taxpayer's use and enjoyment of the housing unit as a residence. However, where a portion of that land is used to earn income from business or property, such portion will not usually be considered to contribute to such use and enjoyment. Where a taxpayer claims a portion of the expenses related to the land (such as property taxes or mortgage interest) in computing income, the allocation of such expenses for this purpose is normally an indication of the extent to which the taxpayer considers the land to be used to earn income. Land in Excess of 1/2 Hectare 21. Where the total area of the land upon which a housing unit is situated exceeds 1/2 hectare, the excess land is deemed by subparagraph 54(g)(v) not to have contributed to the use and enjoyment of the housing unit as a residence and thus will not qualify as part of a principal residence, except to the extent that the taxpayer establishes that it was necessary for such use and enjoyment. The excess land must clearly be necessary for the housing unit to properly fulfil its function as a residence and not simply be desirable. Land in excess of 1/2 hectare could be so necessary where the size or character of a housing unit together with its location on the lot make such excess land essential to its use and enjoyment as a residence or where the location of a housing unit requires such excess land in order to provide the taxpayer with access to and from public roads. Other factors which may in some cases be relevant in determining whether land in excess of 1/2 hectare is necessary for the use and enjoyment of the housing unit as a residence are severance or subdivision restrictions and minimum lot sizes (see 22 below). In all cases, however, it is a question of fact as to how much, if any, of the excess land is necessary for the use and enjoyment of the housing unit as a residence. 22. A property used for residential purposes may be affected by a law or regulation of a municipality or province requiring a minimum lot size for a residential site. A legally imposed minimum lot size, for residential use, exceeding 1/2 hectare that was in effect on the date the property was acquired by the taxpayer, is generally considered to be the minimum amount of land necessary for the use and enjoyment of the housing unit as a residence throughout the period that the property is continuously owned by the taxpayer after that acquisition date. However, where a portion of the minimum lot size is not used for residential purposes but rather for income-producing purposes, such portion is usually not considered to be necessary for the use and enjoyment of the housing unit as a residence. Disposition of Bare Land in Excess of 1/2 Hectare 23. Where a taxpayer's housing unit is situated on land in excess of 1/2 hectare and part or all of that excess land is severed from the property and sold, the land sold is generally considered not to be part of the principal residence unless the housing unit can no longer be used as a residence due to the land sale. If the housing unit can still be so used, such a sale indicates that the land sold was not necessary for the use and enjoyment of the housing unit as a residence. However, where circumstances or events beyond the taxpayer's control cause a portion of the land to cease to be necessary for the use and enjoyment of the housing unit as a residence (e.g., a minimum lot size requirement in effect at the date of acquisition is subsequently relaxed) and the taxpayer then sells such unnecessary excess land, the Department considers it to have been "necessary" until the time of its sale. Disposition of Part of a Principal Residence 24. Where only a portion of a property qualifying as a taxpayer's principal residence is disposed of, such as in the type of situation described in the last sentence of 23 above or as a result of the granting of an easement or the expropriation of land, the taxpayer may designate the property as his or her principal residence in order to use the principal residence exemption for the portion of the property disposed of. It is important to note that such a designation is made on the entire property (including the housing unit) that qualifies as the principal residence and not just on the portion of the property disposed of. Accordingly, when the remainder of the property is subsequently disposed of, it too will be recognized as the taxpayer's principal residence for the taxation years for which the above-mentioned designation was made. No other property may be designated by the taxpayer (or, after the 1981 taxation year, by any of the other persons in the family unit as described in 6 above) as a principal residence for those years. Disposition of a Property Where Only Part of It Qualifies as a Principal Residence 25. In some cases, only a portion of a property that is disposed of for a gain will qualify as a principal residence (see 20 to 22 above). If the taxpayer designates such qualifying portion of the property as his or her principal residence, it will be necessary to calculate the gain on it separately from the gain on the remaining portion of the property which does not qualify as a principal residence. This is because the gain on the portion of the property designated as the principal residence may be reduced or eliminated by the principal residence exemption, whereas the gain on the remaining portion of the property results in a taxable capital gain (for which a capital gains deduction may be available under section 110.6; see, however, the note at the end of 13 above). In allocating the proceeds of disposition and adjusted cost base of the total property between the two portions, consideration must be given to any kind of restriction on the severability of any part of the property, including the portion that does not qualify as the principal residence, imposed by a law or regulation of a province or municipality and in effect at the date of disposition or at the date of acquisition. Example A property with a residence on it has a total area of fifteen hectares consisting mostly of scrub land. At all relevant times the legally imposed minimum lot size for a residential property in the area is ten hectares and thus the land considered to be necessary for the use and enjoyment of this particular housing unit as a residence is ten hectares. However, the portion of the total value of the property, as of the dates of purchase and sale, attributed to the excess five hectares would be relatively low because such excess land would have no intrinsic value of its own and could never have been severed and sold separately. The comments in this paragraph do not apply if the property includes land used in a farming business (see instead 26 to 29 below). Principal Residence on Land Used in a Farming Business 26. Where the taxpayer is an individual who disposes of land used in a farming business carried on by him or her at any time and such land includes property that was at any time the taxpayer's principal residence, paragraph 40(2)(c) provides that any gain on the disposition of the land may be calculated using either one of two methods described in the following paragraphs. 27. First Method : The taxpayer may regard the land as being divided into two portions: the principal residence portion and the remaining portion, part or all of which was used in the farming business. The proceeds of disposition and adjusted cost base of the total land must be allocated on a reasonable basis between the two portions in order to determine the gain for each. The gain otherwise determined for the principal residence portion may be reduced or eliminated by the principal residence exemption (based on the formula in 14 above), whereas the gain on the remainder of the land results in a taxable capital gain (see, however, 30 below). For purposes of determining what portion of the proceeds of disposition of the total land may reasonably be allocated to the principal residence, the Department's usual practice is to accept the greater of (a) the fair market value, as of the date of disposition of the land, of 1/2 hectare of land estimated on the basis of comparable sales of similar farm properties in the same area (the fair market value of more than 1/2 hectare could be used to the extent that such excess land was necessary for the use and enjoyment of the housing unit as a residence - see 21 and 22 above), and (b) the fair market value, as of the date of disposition of the land, of a typical residential building site in the same area. Whichever basis is chosen, (a) or (b), for allocating a portion of the proceeds of disposition of the total land to the principal residence, the same basis should be used to allocate a portion of the adjusted cost base of the total land to the principal residence (in this case the fair market value used in (a) or (b) above would be as of the date of the acquisition of the land). Schedule B at the end of this bulletin provides an example which illustrates the use of the first method (please note that although the first method provided for in paragraph 40(2)(c) pertains only to the land, values for the residential and farm buildings are also included in this example). 28. Second Method : The taxpayer may elect under subparagraph 40(2)(c)(ii) to compute the gain on the disposition of the total land (including the property that was the principal residence) without making the allocations described above or using the principal residence exemption formula in 14 above. With regard to this election, section 2300 of the Regulations requires that a letter signed by the taxpayer be attached to the income tax return filed for the taxation year in which the disposition of the land took place. The letter should contain the following information: (a) a statement that the taxpayer is electing under subparagraph 40(2)(c)(ii) of the Income Tax Act; (b) a statement of the number of taxation years ending after the acquisition date for which the property was the taxpayer's principal residence and during which the taxpayer was resident in Canada (for the meanings of "acquisition date", "resident in Canada" and "during", see 14 above); and (c) a description of the property sufficient to identify it with the property designated as the taxpayer's principal residence. Under this election, the gain otherwise determined for the total land is decreased by the total of $1,000 plus $1,000 for each taxation year in (b) above. Schedule B at the end of this bulletin provides an example which illustrates the use of the second method (please note that although the second method provided for in paragraph 40(2)(c) pertains only to the land, values for the residential and farm buildings are also included in this example). 29. When the second method is used, the exemption of $1,000 per year, which is to allow for the fact that a portion of the total land pertains to the principal residence rather than the farm, is not reduced where part of the residence itself is used to earn income (e.g., there could be an office in the house which is used in connection with a business). However, any gain or capital cost allowance recapture pertaining to the portion of the residence so used to earn income (either or both of which can occur, for example, where the use of such portion of the residence is changed back from income- producing to non-income-producing - see 36 and 40 below) cannot be reduced by the $1,000 per year exemption. 30. Where an individual has a taxable capital gain from the disposition of a farm property, a section 110.6 capital gains deduction (which is a deduction in calculating taxable income) may usually be claimed. Further particulars on this topic are contained in the chapter on Capital Gains in the Farming Income Tax Guide. Complete Change in Use from Principal Residence to Income-Producing 31. When a taxpayer has completely converted a principal residence to an income-producing use, he or she is deemed by paragraph 45(1)(a) to have disposed of the property (both land and building) at fair market value ("FMV") and reacquired it immediately thereafter at the same amount. Any gain otherwise determined on this deemed disposition may be eliminated or reduced by the principal residence exemption. The taxpayer may instead, however, defer recognition of any gain to a later year by electing under subsection 45(2) to be deemed not to have made the change in use of the property. This election is made by means of a letter to that effect signed by the taxpayer and filed with the income tax return for the year in which the change in use occurred. If the election is rescinded in a subsequent taxation year, there is a deemed disposition and reacquisition at FMV (with the above-mentioned tax consequences) on the first day of that subsequent year. If capital cost allowance ("CCA") is claimed on the property, the election is considered to be rescinded on the first day of the year in which that claim is made. It is the Department's usual practice to accept a late-filed election provided that no CCA has been claimed on the property since the change in use has occurred and during the period in which the election remains in force. 32. A property can qualify under paragraph 54(g) as a taxpayer's principal residence for up to four taxation years during which a subsection 45(2) election remains in force, even if the housing unit is not ordinarily inhabited during those years by the taxpayer or by the spouse, former spouse or a child of the taxpayer. However, the taxpayer must be resident, or deemed to be resident, in Canada during those years for the full benefit of the principal residence exemption to apply (see the numerator "A" in the formula in 14 above). It should also be noted that the rule described in 6 above prevents the designation for any particular year of more than one property by the taxpayer or, after 1981, any other member of the family unit. Thus, a designation for the same year of one property by virtue of a subsection 45(2) election being in force and another property by virtue of the taxpayer ordinarily inhabiting it would not be permitted. Example Mr. A and his family lived in a house for a number of years until September 30, 1985. From October 1, 1985 until March 31, 1990 they lived elsewhere and Mr. A rented the house to a third party. On April 1, 1990 they moved back into the house and lived in it until it was sold in 1992. Mr. A designates the house as his principal residence for the 1986 to 1989 taxation years inclusive by virtue of the subsection 45(2) election, which he filed with his 1985 income tax return, having been in force for those years. (He is able to make this designation because no other property has been designated by him or a member of his family unit for those years.) He designates the house as his principal residence for all the other years in which he owned it by virtue of his having ordinarily inhabited it during those years, including the 1985 and 1990 years. Having been resident in Canada at all times, Mr. A's gain on the disposition of the house is therefore completely eliminated by the principal residence exemption. Any income in respect of a property (e.g., the rental income in the above example), net of applicable expenses, must be reported for tax purposes. However, for taxation years covered by a subsection 45(2) election, CCA should not be claimed on the property (see 31 above). 33. Section 54.1 removes the above-mentioned four-year limitation for taxation years covered by a subsection 45(2) election if all of the following conditions are met: (a) the taxpayer does not ordinarily inhabit the housing unit during the years covered by the election because the taxpayer's or spouse's place of employment has been relocated, (b) the employer is not related to the taxpayer or spouse, (c) the housing unit is at least 40 kilometres farther from such new place of employment than is the taxpayer's subsequent place or places of residence, and (d) the taxpayer resumes ordinary habitation of the housing unit during the term of such employment by such employer or before the end of the taxation year immediately following the taxation year in which such employment terminates, or the taxpayer dies during the term of such employment. Two corporations that are members of the same corporate group, or are otherwise related, are not considered to be the "same employer". Complete Change in Use from Income-Producing to Principal Residence 34. When a taxpayer has completely changed the use of a property (for which an election under subsection 45(2) is not in force) from income-producing to a principal residence, he or she is deemed by paragraph 45(1)(a) to have disposed of the property (both land and building), and immediately thereafter reacquired it, at FMV. This deemed disposition can result in a taxable capital gain (for which a section 110.6 capital gains deduction may be available; see, however, the note at the end of 13 above). The taxpayer may instead defer recognition of the gain to a later year by electing under subsection 45(3) that the above-mentioned deemed disposition and reacquisition under paragraph 45(1)(a) does not apply. This election is made by means of a letter to that effect signed by the taxpayer and filed with the income tax return for the year in which the property is ultimately disposed of or earlier if a formal "demand" for the election is issued by the Department. 35. Similar to the treatment for a subsection 45(2) election (see 32 above), a property can qualify as a taxpayer's principal residence for up to four taxation years covered by a subsection 45(3) election (such years would in this case be prior to the change in use), in lieu of fulfilling the "ordinarily inhabited" requirement. As in the case of a subsection 45(2) election, residence or deemed residence in Canada during the years covered by the subsection 45(3) election is necessary for the full benefit of the principal residence exemption to apply, and the rule described in 6 above prevents the designation for any particular year of more than one property by the taxpayer or, after 1981, any other member of the family unit. Example Mr. X bought a house in 1984 and rented it to a third party until mid-1990. He and the other members of his family unit then lived in the house until it was sold in 1992. Mr. X has been resident in Canada at all times. He designates the house as his principal residence for the 1990 to 1992 taxation years inclusive by virtue of his having ordinarily inhabited it during those years. He also designates the house as his principal residence for the 1986 to 1989 years inclusive (i.e., the maximum 4 years) for which his subsection 45(3) election, which he files with his 1992 income tax return, is in effect. (He is able to make this designation because no other property has been designated by him or a member of his family unit for those years.) However, his gain on the disposition of the house in 1992 cannot be fully eliminated by the principal residence exemption because he cannot designate the house as his principal residence for the 1984 and 1985 years. Any income in respect of a property (e.g., the rental income in the above example), net of applicable expenses, must be reported for tax purposes. However, for taxation years covered by a subsection 45(3) election, CCA should not be claimed on the property by the taxpayer, the taxpayer's spouse or a trust under which the taxpayer or the spouse is a beneficiary. Such a CCA claim would, by virtue of subsection 45(4), nullify the subsection 45(3) election as if it had never been made. Partial Changes in Use 36. When a taxpayer has partially converted a principal residence to an income-producing use, paragraph 45(1)(c) provides for a deemed disposition of the portion of the property so converted (such portion is usually calculated on the basis of the area involved) for proceeds equal to its proportionate share of the property's FMV. Paragraph 45(1)(c) also provides for a deemed reacquisition immediately thereafter of the same portion of the property at a cost equal to the very same amount. Any gain otherwise determined on the deemed disposition is usually eliminated or reduced by the principal residence exemption. If the portion of the property so changed is later converted back to use as part of the principal residence, there is a second deemed disposition (and reacquisition) thereof at FMV. A taxable capital gain attributable to the period of use of such portion of the property for income-producing purposes (for which a section 110.6 capital gains deduction may be available; see, however, the note at the end of 13 above) can arise from such a second deemed disposition or from an actual sale of the whole property subsequent to the original partial change in use. An election under subsection 45(2) or (3) cannot be made where there is a partial change in use of a property as described above. 37. The above-mentioned deemed disposition rule applies where the partial change in use of the property is substantial and of a more permanent nature, i.e., where there is a structural change. This occurs, for example, with the conversion of the front half of a house into a store, the conversion of a portion of a house into a self-contained domestic establishment for earning rental income (a duplex, triplex, etc.) or alterations to a house to accommodate separate business premises. In these and similar cases, the taxpayer reports the income and may claim the expenses pertaining to the altered portion of the property (i.e., a reasonable portion of the expenses relating to the whole property) as well as CCA on such altered portion. 38. It is the Department's practice to not apply the deemed disposition rule, but rather to consider that the entire property retains its nature as a principal residence, where all of the following conditions are met: (a) the income-producing use is ancillary to the main use of the property as a residence, (b) there is no structural change to the property, and (c) no CCA is claimed on the property. These conditions can be met, for example, where a taxpayer carries on a business of caring for children in his or her home, rents one or more rooms in the home or has an office or other work space in the home which is used in connection with his or her business. In these and similar cases, the taxpayer reports the income and may claim the expenses (other than CCA) pertaining to the portion of the property used for income-producing purposes. Certain conditions and restrictions are placed on the deductibility of expenses relating to an office or other work space in an individual's home (if the income is income from a business, see the current version of IT-514). In the event that the taxpayer commences to claim CCA on the portion of the property used for producing income, the deemed disposition rule is applied as of the time at which the income-producing use commenced. Change in Use Rules Regarding CCA, Deemed Capital Cost and Recapture 39. When the taxpayer completely or partially changes the use of a property from principal residence to income-producing, subsection 13(7) provides for a deemed acquisition of the property or portion of the property so changed that is depreciable property. For purposes of claiming CCA, the deemed capital cost of such depreciable property is its FMV as of the date of the change in use unless that FMV is greater than the cost of such depreciable property. In the latter case, the deemed capital cost is determined by a formula which essentially limits it to the actual cost plus the taxable part of the gain on the depreciable property but only to the extent that a capital gains deduction is not claimed to offset such taxable part of the gain. The formula is as follows: C + R(FMV - (C + rE)) where C is the cost of the depreciable property, FMV is the FMV of the depreciable property as of the date of the change in use, E is the amount of capital gains deduction claimed under section 110.6 to offset the taxable portion of the excess of FMV over C (if a portion of the gain is attributable to a period of time after February 1992, see the note at the end of 13 above), R is the capital gains inclusion rate in effect in the year of the change in use, and r is the reciprocal of R (i.e., R x r = 1). Example Mr. A completely converted his house to a rental property in January 1992, at which time its cost and FMV were $60,000 and $100,000, respectively (the cost and FMV of the land are ignored in this example as they are not taken into account under subsection 13(7)). The principal residence exemption reduced Mr. A's $40,000 gain otherwise determined by $10,000 to $30,000 (the house did not qualify as his principal residence for all of the years in which he resided in it because Mrs. A had designated a cottage as her principal residence for some of those years). The 3/4 capital gains inclusion rate in effect for 1992 resulted in a taxable capital gain of $22,500 to Mr. A. In calculating taxable income, he claimed a corresponding capital gains deduction of $22,500 under section 110.6. The deemed capital cost of Mr. A's house at the time of its change in use to a rental property was calculated as follows: C + R(FMV - (C + rE)) = $60,000 + 3/4 of ($100,000 - ($60,000 + 4/3 of $22,500)) = $60,000 + 3/4 of ($100,000 - ($60,000 + $30,000)) = $60,000 + 3/4 of ($100,000 - $90,000) = $60,000 + 3/4 of $10,000 = $60,000 + $7,500 = $67,500. To summarize, the change in use of the principal residence to a rental property in January 1992 resulted in a potentially taxable amount of $30,000, i.e., 3/4 of Mr. A's $40,000 gain otherwise determined. $7,500 of this amount was exempted from taxation by means of the principal residence exemption, i.e., 3/4 of the above-mentioned $10,000 reduction to the gain otherwise determined. The remaining $22,500 of the $30,000 potentially taxable amount was reported as a taxable capital gain but was then, in effect, exempted from taxation by means of the capital gains deduction (if a portion of the gain had been attributable to a period of time after February 1992, see the note at the end of 13 above). In determining the deemed capital cost of the house as a rental property for purposes of claiming CCA, the formula permitted the $7,500 to be added to the $60,000 cost of the house, but did not permit the $22,500 to be added. In the case of a complete change in use of a property from principal residence to income-producing, a subsection 45(2) election will cause subsection 13(7), as described above, not to apply. However, if the election is rescinded in a subsequent taxation year (e.g., by claiming CCA on the property), a subsection 13(7) deemed acquisition of depreciable property will occur on the first day of that subsequent year. A subsection 45(2) election cannot be made, and thus such an election cannot cause subsection 13(7) not to apply, where there is only a partial change in use of a property from principal residence to income-producing. However, subsection 13(7) would have no particular relevance and would not be applied to a partial change in use where conditions (a) to (c) in 38 above have been met, including the condition not to claim CCA on the portion of the property used to earn income. 40. When a taxpayer completely or partially changes the use of a property from income-producing to principal residence, there is a deemed disposition at FMV, by virtue of subsection 13(7), of the portion of the property so changed that is depreciable property. This can result in a recapture of CCA previously claimed on the property. A subsection 45(3) election cannot be used to defer such a recapture, caused by the operation of subsection 13(7), of CCA claimed for taxation years prior to those covered by that election (the claiming of CCA during the years covered by the subsection 45(3) election is prohibited - see 35 above). Principal Residence Outside Canada 41. A property that is located outside Canada can, depending on the facts of the case, qualify as a taxpayer's principal residence (see the requirements in 2 to 6 above). A taxpayer who is resident in Canada and owns such a qualifying property outside Canada during a particular taxation year can designate the property as a principal residence for that year in order to use the principal residence exemption (see 14 above for the meanings of "resident in Canada" and "during"). Should a non-resident of Canada who owns a property outside Canada become resident in Canada, the provisions of the Income Tax Act normally apply to deem that person to acquire the property on the date of immigration to Canada at fair market value, thereby ensuring that any unrealized gain on the property accruing to that date will not be taxable in Canada. Thereafter, the comments in the first two sentences of this paragraph may apply. Non-Resident Owner of a Principal Residence in Canada 42. A property in Canada owned in a particular taxation year by a non-resident of Canada may qualify as his or her principal residence for that year. That is, the property would qualify if the housing unit were ordinarily inhabited in that year (see 12 above) by the non-resident or by the spouse, former spouse or a child of the non-resident (see 5 above) or if an election under subsection 45(2) or (3) were in force for that year (see 32 and 35 above), provided that the property met the other requirements of paragraph 54(g). However, it should be noted that the use of the principal residence exemption is limited by reference to the number of taxation years ending after the acquisition date during which the taxpayer was resident in Canada (see 14 above for the principal residence exemption formula and the meanings of "acquisition date", "resident in Canada" and "during"). Therefore, the non-resident may not be able to use the principal residence exemption for all the years for which the property qualifies as his or her principal residence. That is, the principal residence exemption can benefit the non-resident only for those taxation years in which he or she was at some time resident in Canada (the benefit is increased, however, by the extra year discussed in 14 and 15 above, or the extra $1,000 discussed in 28 above). As a result of this limitation, even in a case where the property qualifies as the non-resident's principal residence for all the years in which he or she owned it, a disposition of the property could result in a taxable capital gain resulting from the gain accruing in some or all of those years. 43. In spite of the limitation mentioned in 42 above in connection with the principal residence exemption, an election under subsection 45(2) or (3) could allow the non-resident individual owning a property in Canada to defer a taxable capital gain which would otherwise result from a deemed disposition of the property on a change in its use (see 31 and 34 above). 44. Where the non-resident has rented a property in Canada in a particular taxation year for which an election under subsection 45(2) or 45(3) is in effect, CCA should not be claimed on the property (see 31 and 35 above, respectively). This restriction on CCA applies where an election is made to report the rental income under section 216 (that election is discussed in the current version of IT-393). Disposition of a Principal Residence in Canada by a Non-Resident Owner 45. Where a non-resident wishes to obtain a certificate under section 116 of the Income Tax Act for a property in Canada which he or she proposes to dispose of or has disposed of within the last 10 days, a prepayment on account of tax must be made or security acceptable to the Department must be given before the certificate will be issued. Form T2062, Notice by a Non-resident of Canada Concerning the Disposition or Proposed Disposition of Taxable Canadian Property, or a similar notification, must be filed in connection with a request for a section 116 certificate. Further particulars regarding the above are contained in the current version of Information Circular 72-17. Where part or all of any gain otherwise determined on the disposition of the property by the non-resident is or will be eliminated by the principal residence exemption, the amount of prepayment on account of tax to be made or security to be given may be reduced accordingly. An application for such a reduction should be made by means of a letter signed by the taxpayer and attached to the completed Form T2062 or similar notification. Such letter should contain a calculation of the portion of the gain otherwise determined that is or will be so eliminated by the principal residence exemption. Other Publications I Interpretation Bulletins Current version of IT-221 Determination of an Individual's Residence Status IT-437 Ownership of Dwelling Property IT-366 Principal Residence - Transfer to Spouse, Spouse Trust or Certain Other Individuals IT-393 Election re Tax on Rents and Timber Royalties - Non-Residents IT-514 Work Space in Home Expenses II Information Circulars Current version of 72-17 Procedures Concerning the Disposition of Taxable Canadian Property by Non-Residents of Canada - Section 116 III Tax Guides Current version of - Capital Gains Tax Guide (see comments regarding Principal Residence) - Farming Income Tax Guide (see comments regarding Capital Gains - Principal Residence) - T3 Guide and Trust Return (see comments regarding Principal Residence) If you have any comments regarding the matters discussed in this bulletin, please send them to: Director, Technical Publications Division Legislative and Intergovernmental Affairs Branch CCRA Taxation 875 Heron Road Ottawa, Ontario K1A 0L8 Schedule A Illustration of the Rule in Subsection 40(6) (see above) Where a taxpayer disposes of a property which he or she has owned (whether jointly with another person or otherwise) continuously since before 1982, the rule in subsection 40(6) provides that the gain calculated under the usual method, using the principal residence exemption formula in above, cannot be greater than the maximum total net gain determined under an alternative method. Under the alternative method, there is a hypothetical disposition on December 31, 1981 and reacquisition on January 1, 1982 of the property at fair market value ("FMV"). The maximum total net gain determined under the alternative method is then calculated as follows: pre-1982 gain + post-1981 gain - post-1981 loss = maximum total net gain where the "pre-1982 gain" is the gain (if any), as reduced by the principal residence exemption formula in 14 above, that would result from the hypothetical disposition at FMV on December 31, 1981, the "post-1981 gain" is the gain (if any), as reduced by the principal residence exemption formula in 14 above without the "1 +" in the numerator "A" in that formula, that would result from the hypothetical acquisition at FMV on January 1, 1982 and the subsequent actual disposition, and the "post-1981 loss" is the amount of any loss that has accrued from December 31, 1981 to the date of the actual disposition, i.e., the excess (if any) of the FMV on December 31, 1981 over the proceeds from the actual disposition. Example 1 Mrs. X acquired a house in 1975 for $50,000. She and her husband lived in it until February 1988 when she sold it for $115,000, resulting in an actual gain of $65,000. Ever since the sale of the house in 1988, Mr. and Mrs. X have been living in rented premises. In filing her 1988 income tax return, Mrs. X designated the house as her principal residence for 1975 to 1988 inclusive, and thus her gain otherwise determined was completely eliminated by the principal residence exemption. Mr. X acquired a lot in 1975 for $7,000 and built a cottage on it in 1979 for $13,000. Mr. and Mrs. X used the cottage as a seasonal residence in 1979 to 1992 inclusive. In the fall of 1992 Mr. X sold the cottage for $55,000, resulting in an actual gain of $35,000. In filing his 1992 income tax return, Mr. X designates the cottage property as his principal residence for 1979 to 1981 inclusive, as well as for 1989 to 1992 inclusive. He cannot designate the property as his principal residence for 1975 to 1978 inclusive because it was only a vacant lot and thus no one "ordinarily inhabited" it in those years (see 16 above); nor can he designate the property as his principal residence for 1982 to 1988 inclusive because of his wife's designation of the house as her principal residence for those years (see 6 above). As a result, not all of his $35,000 gain otherwise determined is eliminated by the principal residence exemption formula in 14 above. However, because the property has been owned by Mr. X continuously since before 1982, subsection 40(6) comes into play in computing his gain. Assuming that the fair market value of the cottage on December 31, 1981 was $30,000, the calculations under subsection 40(6) in connection with Mr. X's gain on the cottage are as follows: USUAL METHOD FOR CALCULATING GAIN: Gain otherwise determined ($55,000 - $20,000) $35,000 Reduce by principal residence exemption: 1 + 7 (1979 to 1981 & 1989 to 1992) x $35,000 15,556 ------------------------------------- ------ 18 (1975 to 1992) Gain $19,444 ======= ALTERNATIVE METHOD - CALCULATION OF MAXIMUM TOTAL NET GAIN: Pre-1982 gain: Gain otherwise determined ($30,000 - $20,000) $10,000 Reduce by principal residence exemption: 1 + 3 (1979 to 1981) x $10,000 5,714 ---------------------- 7 (1975 to 1981) ------- Gain $ 4,286 ======= Post-1981 gain: Gain otherwise determined ($55,000 - $30,000) $25,000 Reduce by principal residence exemption: 4 (1989 to 1992) x $25,000 9,091 ----------------- 11 (1982 to 1992) ------- Gain $15,909 ======= Post-1981 loss: N/A $ NIL ======= Pre-1982 gain + post-1981 gain - post-1981 loss = $4,286 + $15,909 - $Nil = $20,195. RESULT: The husband's gain remains at the $19,444 calculated under the usual method since that amount does not exceed the maximum total net gain of $20,195 calculated under the alternative method. Example 2 Assume the same facts as in Example 1 except that the cottage was sold in 1992 for $35,000. The calculations under subsection 40(6) in connection with the husband's gain on the cottage are as follows: USUAL METHOD FOR CALCULATING GAIN: Gain otherwise determined ($35,000 - $20,000) $15,000 Reduce by principal residence exemption: 1 + 7 (1979 to 1981 & 1989 to 1992) x $15,000 6,667 ------------------------------------- 18 (1975 to 1992) ------- Gain $ 8,333 ======= ALTERNATIVE METHOD - CALCULATION OF MAXIMUM TOTAL NET GAIN: Pre-1982 gain: Gain otherwise determined ($30,000 - $20,000) $ 10,000 Reduce by principal residence exemption: 1 + 3 (1979 to 1981) x $10,000 5,714 ---------------------- 7 (1975 to 1981) ------- Gain $ 4,286 ======= Post-1981 gain: Gain otherwise determined ($35,000 - $30,000) $ 5,000 Reduce by principal residence exemption: 4 (1989 to 1992) x $5,000 1,818 ----------------- 11 (1982 to 1992) ------- Gain $ 3,182 ======= Post-1981 loss: N/A $ NIL ======= Pre-1982 gain + post-1981 gain - post-1981 loss = $4,286 + $3,182 - $Nil = $7,468. RESULT: Although the husband's gain calculated under the usual method is $8,333, such gain cannot exceed the maximum total net gain of $7,468 calculated under the alternative method. Therefore, the gain is reduced to $7,468. Example 3 Assume the same facts as in Example 1 except that the cottage was sold in 1992 for $28,000. The calculations under subsection 40(6) in connection with the husband's gain on the cottage are as follows: USUAL METHOD FOR CALCULATING GAIN: Gain otherwise determined ($28,000 - $20,000) $ 8,000 Reduce by principal residence exemption: 1 + 7 (1979 to 1981 & 1989 to 1992) x $8,000 3,556 ------------------------------------- 18 (1975 to 1992) ------- Gain $ 4,444 ======= ALTERNATIVE METHOD - CALCULATION OF MAXIMUM TOTAL NET GAIN: Pre-1982 gain: Gain otherwise determined ($30,000 - $20,000) $10,000 Reduce by principal residence exemption: 1 + 3 (1979 to 1981) x $10,000 5,714 ---------------------- 7 (1975 to 1981) ------- Gain $ 4,286 ======= Post-1981 gain: N/A $ NIL ======= Post-1981 loss: $30,000 - $28,000 $ 2,000 ======= Pre-1982 gain + post-1981 gain - post-1981 loss = $4,286 + $Nil - $2,000 = $2,286. RESULT: Although the husband's gain calculated under the usual method is $4,444, such gain cannot exceed the maximum total net gain of $2,286 calculated under the alternative method. Therefore, the gain is reduced to $2,286. Schedule B Illustration of Calculation of Gain on Disposition of a Farm Property Assume that a taxpayer resident in Canada has sold a 50 hectare farm. The taxpayer owned the farm and occupied the house on it from July 30, 1984 to June 15, 1992. The house and 1/2 hectare of the land have been designated as the taxpayer's principal residence for the 1984 to 1992 taxation years inclusive. The taxpayer's calculations of the gain on the disposition of the farm property, using the two methods permitted by paragraph 40(2)(c) of the Income Tax Act, are as follows: FIRST METHOD (see 27 above) Principal Total Residence Farm Property Proceeds of disposition Land $ 10,000* $ 90,000 $100,000 House 50,000 50,000 Barn 35,000 35,000 Silo 15,000 15,000 -------- -------- -------- $ 60,000 $140,000 $200,000 ======== ======== ======== Adjusted cost base Land $ 2,000* $ 58,000 $ 60,000 House 20,000 20,000 Barn 11,000 11,000 Silo 4,000 4,000 -------- -------- -------- $ 22,000 $ 73,000 $ 95,000 ======== ======== ======== Gain otherwise determined $ 38,000 $ 67,000 $105,000 Less: Principal residence exemption 38,000 - 38,000 -------- -------- -------- Gain $ NIL $ 67,000 $ 67,000 * Since the principal residence portion of the land is 1/100 of the total land (i.e., 1/2 hectare divided by 50 hectares), one way (as described in 27(a) above) of assigning values to the principal residence portion of the land would be to simply use $1,000 (i.e., 1/100 of $100,000) for the proceeds for such portion of the land and $600 (i.e., 1/100 of $60,000) for the adjusted cost base of such portion. Assume, however, that a typical residential site in the area, although less than 1/2 hectare in this example, had a fair market value of $10,000 as of the date of sale and $2,000 as of the date of acquisition. As indicated in 27(b) above, the Department would accept the taxpayer's use of the latter amounts, which in this case would result in a greater portion of the gain being eliminated by the principal residence exemption. SECOND METHOD (see 28 above) Proceeds of disposition for total farm property $200,000 Adjusted cost base for total farm property 95,000 -------- Gain otherwise determined $105,000 Less: Principal residence exemption using subparagraphe 40(2)(c)(ii) election: $1,000 + (9 x $1,000) 10,000 -------- Gain $ 95,000 ======== RESULT: In this example, the first method results in a lower gain to the taxpayer.