It would seem counter-intuitive that a cottage may qualify for the principal residence exemption because the term implies that it is a person’s principal, or main, residence that is eligible for the exemption. However, a cottage can qualify for the exemption provided that there is some annual use of the cottage by the owner. An individual who owns both a home and a cottage can designate either property as a principal residence.
A designation is only made when a property is sold and should be based on one of three options:
- The property is designated as a principal residence for all years of ownership such that the entire gain on sale is tax-free.
- The property is not designated as a principal residence for any years of ownership such that the entire gain is subject to tax.
- The property is designated as a principal residence for some, but not all, years of ownership, which would mean that part of the gain on sale is subject to tax.
As a general rule of thumb, the property with the greatest average gain per year should benefit from the maximum principal residence exemption because this should maximize the tax savings. A key caveat is that a person may prefer to save tax today on a property sale, based on the understanding that a sale of the other property they own may attract some tax in the future.
You should know that the principal residence exemption formula is such that you do not need to designate all years of ownership to avoid tax on the sale of a property. For example, let us assume that a person acquired both a home and a cottage in 2007 and sold both properties in 2016. The gain on the home was $100,000 and the gain on the sale of the cottage was $150,000. Upon first glance, the optimal planning would seem to be to designate the cottage as a principal residence for all years such that the $100,000 gain on the sale of the home is subject to tax. The following allocation would be a better plan:
- The cottage is designated as a principal residence for the years 2007 to 2015 – this is 9 out of 10 years, however the formula then allows 1 additional year such that 10 / 10 of the gain, or the entire gain is tax-free.
- The home is designated as a principal residence for 2016, the formula allows 1 extra year such that 2 / 10, or 20% of the gain is tax-free. This means that the gain on the home is $80,000, which leads to less tax than if $100,000 of the gain on the home were subject to tax.
In computing the gain on the sale of a property which is not entirely sheltered by the exemption, you should include all amounts which may be added to the cost of the property. This would include upgrades or additions to the property, however should not include repair and maintenance type expenses. A couple shares equal access to the exemption such that having each spouse own one of the properties would not multiply access to the exemption. Finally, a gain on a sale of a home or cottage may be subject to tax, however a loss on a sale of such a property should be denied because the property was not held for the purpose of earning income.