Using the principal residence exemption when transitioning to retirement living

This article was co-written by Rebecca Cicco, CPA, CA, director of tax and estate planning at Mackenzie Investments.

In today’s Canada, where those aged 65 years and older outnumber those aged 14 and younger, adult children are increasingly faced with the challenge of assisting an aged parent with the possible transition from their homes to what’s known as a collective dwelling.

Based on the last census, more than 425,000 Canadians aged 65 and older live in collective dwellings: nursing homes, long-term care facilities and seniors’ residences. The Conference Board of Canada projects that this number will exceed 610,000 by 2026.

For seniors contemplating a move to collective dwelling, they or their children must decide what to do with their principal residence and should understand the related tax and estate implications.

The principal residence usually represents significant value and occupies a central place in estate planning, particularly as the senior contemplates a permanent transition to a collective dwelling, or ultimately upon his or her death. Many seniors may expect their former home to qualify for the principal residence exemption (PRE) throughout their stay in a collective dwelling.

Read: Best tax options to transfer the cottage to kids

This concern is certainly more pronounced for a single individual or a surviving spouse or common-law partner. From a tax perspective, the home must qualify as a principal residence in order to be exempt from capital gains tax when disposed or deemed disposed, which requires the taxpayer (or taxpayer’s child) to ordinarily inhabit the property. Consequently, the taxpayer will not meet the criteria for the tax years spent living in a collective dwelling. This fact catches many families off-guard when a parent dies or the home is sold.

To avoid such a surprise, here are some considerations to help in discussions with your clients and their families as they explore the possibility of transitioning to collective dwelling living.

Sell the home

The default option is to sell the senior’s principal residence, especially if they require the proceeds of sale to fund their new collective living lifestyle. In this case, they can use the PRE to minimize or eliminate any capital gains tax on the property. Additionally, the proceeds could be used to provide an early inheritance for children or other beneficiaries.

Have an adult child reside in the home

If a parent does not wish to sell the property, or they are indecisive while in collective living, they may wish to take advantage of the “ordinarily inhabited” rule by having an adult child occupy the home during this period. In such a scenario, the home can still be designated as the parent’s principal residence for the period when the adult child lives at the property. The onus is on the adult child to ensure this decision makes sense based on their personal circumstances.

Aging in place

A senior may prefer to reside in their principal residence when a live-in caregiver can be retained. This may require renovations to accommodate potential physical limitations. Federal and provincial non-refundable tax credits may be available to assist Canadians when considering this option. This allows the senior to maintain their current lifestyle while still benefiting from the PRE.

Rent out the home (change in use)

If the homeowner does not wish to sell the home but still requires another income stream to fund the collective living lifestyle, they may consider renting the home. For income tax purposes, this means converting the principal residence into an income-producing property.

Read: Deceased mom’s estate causes tax nightmare

When a taxpayer converts a principal residence to a rental property, subsection 45(1)(a) of the Income Tax Act deems the taxpayer to dispose of and to immediately reacquire the property at fair market value. Generally, income-producing properties cannot be designated as a taxpayer’s principal residence unless the taxpayer qualifies for and files a subsection 45(2) election.

The subsection 45(2) election deems no change in use to have occurred and allows a taxpayer to designate the home as their principal residence for up to four tax years during the time it is used for income-producing purposes–thus deferring the deemed disposition until the property is sold–provided:

• no tax depreciation is claimed on the property while the election is in effect; and
• all rental (or business) income is reported.

To designate an income-producing property as a principal residence for an additional four taxation years:

• no other property may be designated by the taxpayer as their principal residence; and
• the taxpayer must remain resident or deemed resident of Canada.

To make the election, the taxpayer must file a letter with the personal T1 income tax return in the year the change in use occurs. The subsection 45(2) election may prove useful if the property’s value is expected to continue appreciating after the change of use. This way, the unrealized gain can be sheltered by the PRE.

Other considerations

As a reminder, CRA’s administrative policy regarding the PRE now requires taxpayers to report actual or deemed sales of real property, including a principal residence, occurring after January 1, 2016, on their personal T1 income tax return.

Read: House flipping has tax consequences: CRA

Further, seniors should consider executing an enduring power of attorney (for property) to provide for certain powers, including rent or sale. If the home is sold pursuant to an enduring power of attorney, the idea would be to hold the sales proceeds in trust for the donor’s benefit, as attorneys are generally precluded from making testamentary dispositions.