The principal residence exemption is calculated by a formula using the number of years you’ve owned a property and the number of years you’ve been able to designate it as your principal residence. These two numbers create a fraction – call it the “exemption fraction” – which you apply to your capital gain on the property to find the amount of the gain that is tax free.
The formula looks like this:
#yrs. after 1971 designated as principal residence, +1 = exemption fraction
#yrs. after 1971 you owned the property
Here’s an example: Jack bought his cottage in 1985 for $53,000, and sold it in 2004 for $378,000, for a capital gain of $325,000. Jack also owned a house during those years – but in his case, the cottage is expected to produce the larger capital gain and he wishes to shelter as much as he can. He finds that it’s possible, under the Income Tax Act, to designate the cottage as his principal residence for 14 of the 20 years he owned it, so he does the math:
14 (years as principal residence) +1 = 15 = 75%
20 (years of ownership) 20
Therefore, 75% of the capital gain on the cottage will be tax-free.
(Note that this simplified example doesn’t take into account a number of other factors, such as maintenance and repair costs, that could change the arithmetic.)
The term “principal residence” is broadly interpreted in the Income Tax Act. If you or members of your family are continuing to use the cottage, there may be additional years available for the exemption. For more about the principal residence exemption, see “Cottage Succession” from the April/May 2002 issue of Cottage Life.