One of the most lucrative tax breaks for some Canadians is the tax-free gain on the sale of their principal residence. The principal residence exemption (PRE) provides homeowners with a complete exemption from tax on the entire capital gain realized when you sell a home designated as your principal residence.
Four criteria must be satisfied under the Income Tax Act in order for a property to qualify as your principal residence: the property must be a housing unit; you must own the property (either alone or jointly with someone else); you, your spouse or kids must “ordinarily inhabit” the property; and, you must “designate” the property as a principal residence.
Why this taxpayer had to pay taxes on what he thought was the sale of his principal residence
Note that a seasonal residence, such as a cottage, cabin, or lake house, can be considered to be “ordinarily inhabited in the year,” even if you only use it during the summer months, “provided that the main reason for owning the property is not to gain or produce income.”
Since 1982, you can only have one principal residence per family unit in a particular year. If you own more than one residence, you will need to do some analysis to determine which property should be designated for each tax year in which you own multiple properties. Factors to consider include the accrued gain to date on each property, the anticipated holding period and future anticipated appreciation of each property.
Four years ago, the Canada Revenue Agency announced it was changing its long-standing administrative policy regarding PRE claims. Historically, taxpayers were not required to report the sale of a principal residence if the entire gain was exempt from tax. That changed in 2016 and taxpayers are now required to report the sale of their principal residence on the revised Schedule — Capital Gains (or Losses) of the personal tax return. Information you’re required to provide includes the date of acquisition, proceeds of disposition and the address of the home that was sold.
The CRA is now able to more easily track all real estate dispositions, even if the sale doesn’t result in a taxable gain. It can review transactions where the PRE was claimed to see whether the exemption was properly taken, which, in some instances, it’s not.
Take a recent tax case, decided earlier this month, that involved a Montreal taxpayer who was hit with a gross negligence penalty for inappropriately claiming the PRE when he disposed of a condo. In 2005, the taxpayer, who is now retired, acquired a building in the heart of Old Montreal. The building dated back to 1830, was listed under the Cultural Property Act, and included four residential apartments and a commercial space. The taxpayer paid $2 million for it, and spent another $1 million on renovations over five years.
In 2013, one of the units, representing 16 per cent of the building, was converted into a condo and sold. The taxpayer did not report the real estate transaction, which resulted in a capital gain of $271,756, half of which ($135,878) was taxable. The taxpayer deposited the proceeds of the sale into his bank account and did not provide the information to his accountant. The unreported gain represented 100 per cent of the taxpayer’s 2013 income.
The taxpayer acknowledged that he didn’t report the sale of the unit on his 2013 return, alleging “that it was a simple error attributable to a misinterpretation of the act.” He explained that he believed the entire building could be considered his principal residence. Consequently, he believed the sale of part of his principal residence was not subject to tax and that he did not have an obligation to declare the transaction in his 2013 return.
According to the CRA, the unreported income constituted a “false statement or omission made knowingly or in circumstances amounting to gross negligence.” Under the Income Tax Act, anyone who “knowingly or in circumstances amounting to gross negligence makes a false statement or omission … is liable to a penalty.”
Since the taxpayer admitted that he failed to report the income or gain from the disposition of the condo, this clearly constitutes a false statement or omission. But did he do so “knowingly or in circumstances amounting to gross negligence”?
Prior jurisprudence has found that being “willfully blind” amounts to gross negligence. As the Federal Court of Appeal wrote in a 2017 case, “A taxpayer is willfully blind in circumstances where the taxpayer becomes aware of the need for inquiry but declines to make the inquiry because the taxpayer does not want to know, or studiously avoids, the truth. The concept is one of deliberate ignorance … The law will impute knowledge to a taxpayer who, in circumstances that suggest inquiry should be made, chooses not to do so.”
The taxpayer, who the judge referred to as “an experienced businessperson,” owned several properties in France, Portugal, Ontario and Quebec, and had invested significant sums of money to purchase and renovate them. He carried out several sophisticated real estate transactions, such as converting the apartments into condo units. “(He) thus had access to professionals who could advise him adequately,” the judge noted.
Yet, there was no evidence that the taxpayer consulted his accountant or another professional adviser about the tax consequences arising from the sale of the condo. In the judge’s opinion, a prudent and informed taxpayer should at least have questioned the tax treatment of the transaction and raised the issue with his advisers. The judge decided the taxpayer was, indeed, negligent in not taking advice from these professionals, and he knew, or at least should have known, that the PRE could not apply in his case since he had never lived in the condo that was sold.
The judge, in upholding the penalty, concluded that the taxpayer demonstrated willful ignorance and committed gross negligence in not declaring in his income tax return the benefit that he knew he had realized when disposing of the condo, finding that the taxpayer “was negligent in not checking with his advisers about the conditions for applying the principal residence exemption.”