(Posted April 2026)
The principal residence exemption (PRE) is a commonly tested topic on the CPA Common Final Examination (CFE) and often appears straightforward at first glance. However, complications such as rental use, changes in use, and multiple properties can significantly impact the exemption’s availability.
This technical spotlight outlines the key rules related to the PRE and highlights common issues CPA candidates should be prepared to address in case writing.
Principal Residence Exemption – Overview
A qualifying principal residence is generally a housing unit that is ordinarily inhabited by the taxpayer, their spouse or common-law partner, or their children. Only one property per family unit per year may be designated as a principal residence. The property does not need to be located within Canada, but the taxpayer must be a resident of Canada for tax purposes to be eligible to use the PRE.
When a principal residence is disposed of, or deemed to have been disposed, all or part of the resulting capital gain may be exempt using the following formula:
Capital Gain x (Number of Years Designated as Principal Residence + 1) / Number of Years Owned
The “+1” year is intended to account for the year of acquisition or disposition. The maximum number of years to designate a property as a principal residence should be one less than the number of years owned.
Change in Use
A change in use occurs when a property changes from personal use to income-producing use, or vice versa. When there is a change in use, the property is deemed to have been disposed of at the fair market value (FMV) of the property on the date that the change in use occurred and reacquired at the same value (i.e., the FMV becomes the new adjusted cost base (ACB) of the property). As such, a change in use may result in a capital gain. Absent any elections (discussed below), some or all of the capital gain may be exempt from tax if the property was a qualifying principal residence prior to the change.
Subsection 45(2) Election – from personal use to income-producing
If a property changes from personal use to income-producing, the taxpayer may be able to elect under subsection 45(2) to defer the change in use and therefore, also defer the deemed disposition. Initially, the taxpayer can defer the change in use for up to four years, but the period can be extended beyond four years if certain conditions are met.
If a subsection 45(2) election is filed, the taxpayer may designate the property as a principal residence even if the property produces income (e.g., is rented out) as long as:
- The taxpayer is a resident of Canada,
- Capital cost allowance (CCA) is not claimed on the property, and
- No other property is designated as their principal residence during this period.
The subsection 45(2) election must be filed with the taxpayer’s tax return for the year that the change in use occurred.
Subsection 45(3) Election – from income-producing to personal use
If a property changes from income-producing to personal use, the taxpayer may be able to elect under subsection 45(3) to defer the change in use until the property is sold, and therefore, eliminate the deemed disposition.
If a subsection 45(3) election is filed, the taxpayer may designate the property as a principal residence for the four-year period before the election is made. Like the subsection 45(2) election, CCA must not have been claimed.
The subsection 45(3) election must be filed with the taxpayer’s tax return for the year that the property is sold (or 90 days after the date that the CRA asks for it to be filed, whichever is earlier).
Partial Income-Producing Use
Where part of a qualifying principal residence is used to earn income, the PRE may be restricted or unavailable for the income-producing portion. The exemption may still apply where the income-producing use is ancillary, no structural changes were made, and no CCA was claimed. Do not assume that any rental or business use automatically eliminates the PRE.
Multiple Properties
If a taxpayer owns more than one property that is ordinarily inhabited and would be a qualifying principal residence, such as a house and a cottage, only one property per year can be designated as a principal residence.
To determine the number of years to designate as a principal residence for each property (if any), calculate the capital gain per year for each property (i.e., capital gain from the (deemed) disposition divided by the numbers of years owned). The property with the highest capital gain per year should receive the largest number of years (e.g., all years owned, minus one year to take advantage of the “+1” year rule).
Remember that:
- Only one property can be designated as a principal residence for each calendar year.
- Designating a property as a principal residence for at least one year triggers the “+1” year rule which may be advantageous to the taxpayer even if the capital gain per year for the property is not the highest
Reporting Requirements
The disposition of a principal residence must be reported on the taxpayer’s tax return for the year in which the (deemed) disposition occurred, even if the entire gain is exempt. Failure to report the disposition may result in penalties and the loss of the PRE.
If an election is made under subsection 45(2) or 45(3), the election must be filed with the taxpayer’s tax return as well.
Case Writing Tips
When addressing principal residence issues on the CFE, candidates should:
- Identify whether a disposition or deemed disposition has occurred using case facts (e.g., if the property has been sold or transferred, if there has been in a change in use, etc.)
- Confirm that the property qualifies as a principal residence using case facts and considering family unit restrictions.
- Apply case facts to calculate the PRE and determine if there will be a capital gain. If there are multiple properties, use case facts to determine the year(s) to designate to each property before calculating the principal residence exemption for each property.
- Discuss the impact of rental or business use, including partial exemptions, using case facts.
- For added depth, which is likely required on Day 2, consider and discuss the elections if applicable.