Understanding the Principal Residence Exemption and the “Change-in-use” Rules when Selling Your Home

Selling a home can create unexpected tax questions, especially when it comes to the rules surrounding the principal residence exemption (PRE). In this article, we outline what qualifies as a principal residence, the forms the CRA requires a taxpayer to file when a property is sold or deemed to be sold, and the elections that may be available when the use of a property changes from a principal residence to an income-producing rental property, or the other way around.

To begin, what is the PRE? The PRE is an election in the Canadian tax system that may be claimed to eliminate or reduce income taxes on the capital gain on the disposition, or deemed disposition, of a housing unit which was ordinarily occupied by a taxpayer and their family unit. The types of property that can qualify as a principal residence include, but are not limited to, a house, cottage, mobile home, houseboat, apartment or condominium.

In order for a property to be considered a taxpayer’s principal residence for a particular year, they must designate it as such for the year and no other property may have been so designated by the individual for the applicable year. Furthermore, no other property may have been designated as the principal residence of any member of the taxpayer’s family unit for the year. The family unit is generally considered to be an individual, the individual’s spouse or common-law partner (CLP), and the individual’s children, except those who were married, in a common-law partnership, or 18 years of age or older during the year. The family unit test for the purposes of the PRE applies on a per tax year basis, not only in the year the property is sold. This means that a property can still qualify as a principal residence for earlier years in which the taxpayer was the only member of their family unit, even if the taxpayer had a family unit at the time of sale.

In addition, the taxpayer must own the property (joint ownership arrangements generally qualify for this purpose) in the year in question and the property must be “ordinarily inhabited” in the year by the taxpayer or by an individual within their family unit. Whether a housing unit is ordinarily inhabited in a year by a person or their family unit is a question of fact. Even if a taxpayer inhabits a housing unit for only a short period of time during the year, this is generally sufficient for the housing unit to be considered ordinarily inhabited by that person in that year. For example, where a taxpayer disposes of their residence early in the year or acquires it late in the year, the housing unit may still be considered ordinarily inhabited in that year. The definition of a “principal residence” is generally limited to up to one-half hectare of subjacent and immediately contiguous land. 

PRE formula and example

For illustrative purposes, the information below demonstrates how to calculate the exempt portion of the capital gain for purposes of the PRE. The formula for this is as follows:

Capital Gain × ((1+A)/B)

where

• The capital gain incurred upon disposition is calculated as the difference between the proceeds of disposition and the adjusted cost base (ACB) less any outlays and expenses incurred to sell the property.
• A is the number of taxation years ending after the acquisition date for which the property was the individual’s principal residence and during which the individual was a resident in Canada; and
• B is the number of taxation years ending after the acquisition date during which the individual owned the property.

For dispositions after October 3, 2016, the “1+” portion of the formula only applies if the individual was a resident in Canada during the year in which the home was acquired. 

As illustrated by the formula, the PRE can only be claimed for the years that an individual is a tax resident in Canada. If a taxpayer continues to own a principal residence after becoming a non-resident, they could shelter the gains for the years of residency plus one year, provided they were a resident in Canada in the year of initial acquisition of the property.

Consider the following example: in 2018, Brian purchased a house in Canada for $800,000 while he was a resident in Canada, and started to ordinarily inhabit the housing unit. He used the property as his principal residence until he left Canada. He became a non-resident in 2023 and subsequently sold the house for $1,400,000 in 2025. The resulting capital gain before applying the PRE is $600,000 (calculated as $1,400,000 - $800,000). The portion that can be sheltered under the PRE is $525,000, calculated as the following:

Capital Gain = $600,000 × ((1+6)/8)

where

A = 6 is his number of years of Canadian residency (2018 to 2023) during years of ownership; and

B = 8 is his total years of ownership (2018 to 2025).

Since Brian was a resident in Canada in the year of acquisition (2018), he is able to utilize the “1+” rule and as a result, may shelter 7/8 of the capital gains on his property. After applying the PRE, the remaining portion of the capital gain subject to tax is $75,000, calculated as $600,000 - $525,000. Half of this amount would be included in his income in the year of disposition.

Applicability of PRE for non-residents

It is possible, in limited circumstances, for a Canadian property owned by a non-resident to qualify as their principal residence for a given year. For example, the conditions may be met where a spouse satisfies the ordinarily inhabited requirement or where a subsection 45(2) or 45(3) election applies (discussed further below). However, the PRE is restricted based on the number of years the taxpayer claiming the PRE was resident in Canada. As a result, even if the property technically qualifies as a principal residence, the non-resident individual may not be able to fully eliminate the capital gain on disposition due to the residency requirement.

It is important to note that real property is excluded from the departure tax (i.e. the deemed disposition that would otherwise occur) that applies when a taxpayer becomes a non-resident of Canada. Therefore, the PRE would generally not need to be claimed upon departure from Canada to shelter the capital gains on the principal residence, as departure tax does not apply to Canadian real or immovable property. Generally, real property situated in Canada is classified as Taxable Canadian Property (TCP) for income tax purposes. As a result, when a non-resident individual disposes of TCP, whether through an actual disposition or a deemed disposition, specific compliance requirements apply under section 116 of the Income Tax Act (ITA). These requirements impose certain notification and withholding obligations that must be satisfied to ensure compliance with Canada Revenue Agency rules. A detailed discussion of the section 116 requirements applicable to TCP is beyond the scope of this article. Taxpayers should consult their financial advisor or tax professional for further guidance based on their specific circumstances.

“Change in use” rules

Other tax rules regarding the PRE must be considered when a change-in-use of a property (i.e., the real estate) has occurred. This means that the taxpayer either decides to change the property from principal residence to a property held solely for the purposes of producing income (e.g., a rental property) or vice versa, meaning the taxpayer decides to convert their rental property to a principal residence in which they live in. We have outlined the tax considerations of each of these scenarios below.

If a taxpayer’s housing unit experiences a change in use from a principal residence to a property held solely for the purpose of producing income, a deemed disposition and reacquisition generally occurs at fair market value (FMV). Any gain otherwise determined on this deemed disposition may be eliminated or reduced by the PRE. An individual can elect under subsection 45(2) of the Canadian ITA to defer the recognition of the capital gain until the year in which the property is disposed of. It should also be noted that capital cost allowance (CCA) must not be claimed on the property for the election to be valid and remain in force. If CCA is claimed, the election is automatically rescinded as of the first day of the taxation year in which the CCA claim is made. In the context of real estate, CCA is a CRA tax deduction that allows property owners to deduct the cost of depreciable assets, such as a rental building, over several years rather than all at once.

Additionally, an election under subsection 45(2) allows the property to still be designated as the individual’s principal residence even if it is not ordinarily inhabited for up to the four tax years following the year the election and change in use occurred.

If a taxpayer changes the use of a housing unit from an income-producing property to a principal residence, they will be deemed to have disposed of the property at FMV and then reacquired it at FMV. The deemed disposition may result in a capital gain which is generally not eligible for the PRE. However, an individual can elect under subsection 45(3) of the ITA to defer the capital gain until the actual disposition of the property, provided the property becomes a principal residence. The election under subsection 45(3) is generally unavailable if the individual, or the individual’s spouse or CLP, deducted CCA on the property. Whether or not a change in use occurs is dependent upon the previously discussed parameters that define a principal residence.

Consistent with the treatment under a subsection 45(2) election, a property may qualify as a taxpayer’s principal residence for up to four taxation years preceding a change in use that is subject to a subsection 45(3) election, even if the property was not ordinarily inhabited by the taxpayer during those years.

Both change-in-use elections under subsections 45(2) and 45(3) of the ITA can be made by attaching a letter signed by the taxpayer to their tax return for the year in which the change in use occurred.

Additional note: partial change in use rules

In situations where a partial change in use of a property has occurred, such as where a taxpayer partially converts a principal residence to an income producing use, the first step is to determine the nature of the change. Specifically, it must be assessed whether the partial change in use is substantial and of a more permanent nature, which generally involves a structural change to the property, or whether the income producing use is merely ancillary to the property’s primary use as a residence and does not involve any structural changes.

Where the partial change in use is substantial and permanent in nature, there is generally a deemed disposition and an immediate deemed reacquisition of the portion of the property that has been converted to income producing use. The deemed disposition occurs at proceeds equal to the income producing portion of the property’s proportionate share of the total property’s FMV at that time. Examples of partial changes in use that the CRA would typically consider substantial include the conversion of part of a house into a self-contained domestic establishment for rental purposes, or the conversion of the front portion of a residence into a retail store. In these circumstances, the principal residence exemption may be available to reduce or eliminate the capital gain arising from the deemed disposition. If the portion of the property that was converted to income producing use is subsequently converted back to use as part of the principal residence, a second deemed disposition and deemed reacquisition will generally occur at FMV at that time.

By contrast, where the partial change in use results in an income producing use that is ancillary to the main use of the property as a residence, there is no structural change to the property, and where no capital cost allowance is claimed, the deemed disposition rules do not apply. These conditions may be met, for example, where a taxpayer rents out one or more rooms in the home or uses part of the home as an office or other workspace in connection with a business or employment.

In cases where a partial change in use from a principal residence to an income producing property has occurred and would otherwise result in a deemed disposition, taxpayers may, for changes in use occurring after March 19, 2019, elect under subsection 45(2) to defer the deemed disposition until the property is actually sold. Similarly, where there is a partial change in use from an income producing property to a principal residence, taxpayers may elect under subsection 45(3) so that the deemed disposition that would otherwise arise does not apply. A subsection 45(2) election is made by filing a signed letter with the taxpayer’s income tax return for the year in which the change in use occurs. A subsection 45(3) election is made by filing a signed letter with the income tax return for the year in which the property is ultimately disposed of.

Tax Reporting and Forms

When a principal residence is disposed or deemed to be disposed of, there are reporting obligations from the taxpayer. Taxpayers who sell their principal residence have to report the sale on page 2 of Schedule 3, Capital Gains (or Losses), of the T1 Income Tax and Benefit Return. The CRA will only allow the PRE to be claimed if the sale and designation of the principal residence is included in the taxpayer’s income tax return. Additionally, Form T2091 (IND), Designation of a Property as a Principal Residence by an Individual (Other than a Personal Trust), must be completed to designate a property as a principal residence while the taxpayer is still alive. If the taxpayer has passed away, the legal representative or executor must generally file Form T1255, Designation of a Property as a Principal Residence by the Legal Representative of a Deceased Individual, to designate the deceased’s property as a principal residence. It is important to note that these forms are still required for the designation even in cases where the property was not a taxpayer’s principal residence for all the years that it was owned.

Ultimately, the principal residence exemption can be a powerful tool for reducing or eliminating capital gains on the sale or deemed disposition of a home, but its application depends on careful attention to ownership, use, residency status, and timely tax reporting. Properly completing the required CRA forms and understanding the availability and timing of elections under the Income Tax Act can materially affect the amount of tax payable. By planning ahead and addressing these issues early, taxpayers can reduce the risk of unexpected tax liabilities and ensure the principal residence exemption is applied correctly and efficiently.