Tuesday, December 27, 2011

Math Home Work

Owning a home –a principal residence -- is a tax shelter that most Canadians aspire to.  Besides providing one with a place to live, home ownership provides the homeowner with a tax-free capital gain for any increase in the value of the home.  Of course, this assumes that the home has always been used exclusively as the private home of the homeowner.

The rules for realizing a tax-free capital gain on a home involves some basic math.  The tax exemption is calculated by applying a fraction.  The top part of the fraction (the numerator) is equal to one plus the number of years that the property qualified as a principal residence.  The bottom part of the fraction (the denominator) is the total years of ownership.  So if I owned land for 7 years and had my principal residence on that land for 4 of those 7 years, 5/7th of any capital gain on sale of the land would be exempt from capital gains tax (the applicable fraction is 5/7th rather than 4/7th because of the “1 plus” in the top part of the fraction).

This assumes that the home is located on a lot that is less than ½ hectare (about 1.2 acres) in size.

Up to ½ hectare of the land surrounding the home is deemed to be part of the home.  Any excess land will be treated as part of the home only if the excess land is necessary to the use and enjoyment of the building as a home.

Excess land can be considered necessary for various reasons.  For example, part of the excess land may be necessary for access to the house or for a septic field.  Excess land will be considered necessary if subdivision restrictions impose a minimum lot size before one can build on the land.  For example, municipal zoning rules might require that the lot size be at least 5 hectares before one can build a home on the lot.  In that case, the whole 5 hectares would qualify as part of the home and the capital gain on the whole 5 hectares would be free from tax.  If there is no minimum lot size and the excess land cannot otherwise be considered necessary for the use of the home as a home, the tax-free capital gain would be restricted to the gain on the house and just ½ hectare of the surrounding land.

What if municipal zoning changes over the period of ownership?  For example, what if the minimum lot size was 5 hectares at the time that you purchased the house but was reduced to ½ hectare a few years before you sold the house?  Would the capital gain on the whole 5 acres still be exempt from tax on the basis that you had to buy the whole 5 hectares to acquire the house in the first place?

The courts have grappled with this on several occasions and have given seemingly different answers.  In some cases, the court seemed to say that the minimum lot size at the time of sale was the important factor.  In other cases, the minimum lot size at the time of purchase seemed to govern.

The latest case on this point is Cassidy.  In this case, the Federal Court of Appeal applied a year-by-year test to determine the exempt portion of the capital gain.

Returning to our previous example, assume that you lived in a house on a 5-hectare lot throughout your seven years of ownership but that the minimum lot size was 5 hectares for 4 years and ½ hectare for the final three years.  In that case, the capital gain on the house and ½ hectare would be free from tax.  Only 5/7 of the capital gain on the 4.5 hectares of excess land would be tax-free.

While taxpayers who had to purchase excess land in order to acquire a house may find this result harsh if the minimum lot size decreases during the period of ownership, the decision is more consistent with the mathematical way in which the Income Tax Act determines the tax-free portion of the capital gain on a personal home.

- Blair P. Dwyer

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The above article provides general commentary of an educational nature. It does not constitute advice for any specific person or any specific set of circumstances. Because circumstances vary, readers should consult professional advisers in order to obtain advice that is applicable to their specific circumstances.