Taxes on selling your home: Myths vs. realityWhen you sell your home, you may realize a capital gain. If this property was your principal residence for every year you owned it, you do not have to report the sale on your income tax return and you do not have to pay tax on any gain from the sale. However, if at any time during the period you owned the property it was not your principal residence, you may have to report all or part of the capital gain.
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A principal residence can be any of the following types of housing units:
- a house
- a cottage
- a condominium
- an apartment in an apartment building
- an apartment in a duplex
- a trailer, mobile home or houseboat
Tax on your principal residence - myths and reality
One of the few tax breaks available to most taxpayers is the exemption from tax on the increase in value of a principal residence. However, it's also an area that is not well understood by many and there can be traps for the unwary.
Myth #1: When I die, it's no longer my principal residence, so my children will have to pay tax on it.
Fact #1: False. When you die, your executor must file your final income tax return. All your income to the date of death must be reported on this return.
However, on that same return your executor can claim the principal residence exemption for the years you lived in the property. So there is no more tax payable than if you had sold the property shortly before you died.
The critical issue at your death, then, is whether the property was your principal residence, not whether your child will use it as a principal residence. Of course, if your child keeps it and does not use it as his or her principal residence, he/she will eventually have to pay tax on any increase in its value during the time he/she owns it.
Myth #2: I will transfer the ownership of my principal residence to my child or children to minimize probate fees upon my death.
Fact #2: This strategy is definitely not a good option since it changes a non taxable asset to a taxable asset in the hands of the children due to the fact that it will now be considered an investment for the children. As well, in many cases, these children already own a principal residence. Another concern is this property is subject to any creditors of the newly named owners.
Myth #3: If I sell my principal residence in the city and move to the cottage and live in the cottage for a few years, the cottage is now my principal residence and when I sell it, or when I die, there is no tax on its growth in value.
Fact #3: It would be great if this were true. But it's only partly true. So what is the real story?
Firstly, since 1982 two spouses can only have one property count as their principal residence at any point in time.
The Income Tax Act contains a formula that is used to calculate the amount of the capital gain that is eligible for the capital gains exemption. Essentially, the part of the gain that is exempt is based on the ratio of the time during which the cottage was your principal residence to the time during which you owned it.
The formula is as follows:
1 + Number of years residing at the cottage as your principal residence (sold your home)
Number of years in total that you owned the cottage
So while the cottage is in fact your principal residence during the years you actually live there, it wasn't your principal residence throughout all the years you owned it and therefore some of the capital gain will be exposed to income tax when you sell the property, transfer it to your children, or die.
Scenario: Bill and Linda owned a home in the city. In 1976 they decided to purchase a cottage. When they retired in 2000, they sold their home and permanently moved to their cottage. At the time when Bill and Linda choose to sell the cottage or when the last partner dies, the formula above will be used to determine the portion of the capital gain that is exempt from taxes.
Assume Linda dies in 2007. There is no issue here if the property goes to the surviving spouse or spousal trust. In this case, there is no deemed disposition and no capital gains tax. When Bill dies in 2010, being the second spouse, there will be a deemed disposition of that spouse’s property for fair market value and potential capital gains tax exposure for that spouse’s estate.
Based on the above scenario, 34.3% of any capital gains assessed on the cottage property at the time of disposition will be exempt.
They have owned the property for 35 years and have resided there as their principal residence for 11 years.
Using the formula above: 1 + 11 / 35 = 34.3%
What can you do to provide for this?
If you give the cottage to your children now, you'll have to pay income tax on the non-exempt portion of the capital gain that has already built up (it's not your children who have to declare this gain, it's you as the owner). And your children will own the cottage and you may find that you can't use it as frequently as you would like to, if they truly treat it as their own property.
If the family’s intention is to pass their cottage property intact to their children after their death, that intention could be frustrated by the capital gains tax liability if the estate lacks the cash needed to pay the taxes. In that case, the property will have to be sold (and sold in time to raise the cash needed to pay the tax) or the heirs receiving the property would have to pay the tax bill themselves.
Even if the estate had enough cash to pay the tax, paying the tax could make other bequests impossible or difficult to accomplish, such as helping the children pay off their mortgages, or helping the grandchildren pay for their educations.
Value of life insurance
It's times like these that the value of life insurance is most apparent. It can be a ready source of cash to pay the tax liability when you die, and may help to resolve anxieties about whether or not the cottage will have to be sold. Life insurance proceeds can also provide for the other types of bequests you would want to make.
This information was provided by: Susan Zaiser CARP Recommended Advisor at Sun Life. For professional advice Susan can be reached at 905-337-0039 Ext. 2244. www.sunlife.ca
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Have you had experience with tax issues after selling a house or cottage? What advice do you have for others in this situation? Share it in the comments section below.