The rapidly overheating Canadian real estate market has been receiving a lot of attention. Many believe the runaway prices in major metropolitan centres, such as Toronto and Vancouver, are being driven by demand from foreign buyers. According to the Canada Mortgage and Housing Corp., foreign buyers make up approximately 10 per cent of the market in Toronto and Vancouver. However, unofficial data indicate that foreign buyers account for a much larger proportion of housing purchases.

Public outcry over the erosion of affordable housing in Canada has been growing over the last few years, and the federal government has been urged to enact legislative changes to deter foreign investors from taking advantage of Canadian tax rules and driving up housing prices.

In response to this public pressure, on Oct. 3, 2016, the Department of Finance introduced important changes to the principal residence rules. The new rules effectively close a loophole, which was popular with foreign buyers, that allowed non-resident investors to benefit from a principal residence exemption and to reduce their tax liability on the disposition of property.

Principal residence exemption rules enable Canadians to shelter a capital gain on the sale of their principal residences. Usually, the sale of a principal residence doesn’t attract any tax, and a taxpayer or a family member must “ordinarily inhabit” the residence to take advantage of the exemption. It’s accepted that an individual who occupies the residence even for a single day may be considered to “ordinarily inhabit” it for the purpose of the tax rules. However, only one residence can be designated as the principal residence during the year. Based on this rule, taxpayers who buy a new home and sell their old one in the same year would be unfairly penalized. As such, the principal residence exemption formula provides for a “bonus” year to address these situations.

The “bonus” year, however, unduly benefited non-resident homeowners. Tax rules stipulate that one must be a Canadian resident to designate a property as a principal residence for every year of ownership. This stipulation didn’t apply to the “bonus” year, however, making it possible for a non-resident who owned property in Canada to shelter some of the capital gain.

Consider this example. A non-resident purchases a property in Toronto for $500,000, and occasionally occupies it over two years. As housing prices increase, the non-resident sells the property after two years of ownership for $750,000 and realizes a capital gain of $250,000. Under the old rules, half of that gain could be sheltered because of the “bonus” year in the principal residence exemption formula, which was also available to non-residents. In this specific case, the non-resident would be subject to Canadian tax on just $62,500 (the taxable portion of the non-sheltered capital gain).

The new rules eliminate this advantage by ensuring that the “bonus” year is available only to taxpayers who were residents of Canada in the year they acquired the property. In other words, the principal residence exemption won’t be available to shelter any portion of the gain if the taxpayers were permanent non-residents of Canada.

While these rules were primarily designed to deal with foreign buyers, they may also have far-reaching consequences for Canadians. Under the old rules, there was no requirement to report the sale of a property that was a principal residence for every year of ownership. However, under the new rules, all dispositions of property, including principal residences, must be reported on the tax return. Not reporting the sale of a principal residence could result in a maximum penalty of $8,000, when you later amend the return to avoid paying tax on the gain.

So, if you sell your home during the year, just remember to report it on your tax return.