The article “When does the “plus 1” rule apply to a principal residence?” was originally published in MoneySense on January 23, 2023 . Photo by Karolina Grabowska from Pexels.

There are tax implications to inheriting a second property. But in certain circumstances, you can have two principal residences in the same year.

“If I am willed a house and prefer to sell my primary residence to move into the inherited house, do I pay capital tax on the sale of my house?

Is it better to be on title of the house I will inherit, even though I own another house, or leave it as an inherited house only to save taxes?” Doris

Tax implications of inheriting a second property

When someone dies owning real estate, there may or may not be tax payable. Death results in a deemed disposition, as if you sold all of your assets the day you die. If the real estate qualified as the principal residence of the deceased for all years they owned it, it would be tax-free to their estate. If some or all of the capital gain is taxable, their estate would pay tax accordingly on the final tax return of the owner.

When you receive an inheritance, Doris, it is tax-free to you as a beneficiary. The fair market value of a capital asset like real estate at the time you inherit it becomes your cost base for capital gains tax purposes.

Say, for example, you kept the inherited house and used it as a rental property, renting it to tenants. The capital appreciation from the time you inherited it to the time you sell it would be subject to capital gains tax. If, on the other hand, you used the house for personal use, like a cottage or vacation property, that changes things.

What qualifies as a principal residence?

In order for a property to qualify as your principal residence, you need to use it occasionally. It does not need to be the place you live primarily, and it does not need to be the address you use on your tax return.

According to Canada Revenue Agency, the “requirement is that the housing unit must be ordinarily inhabited in the year by the taxpayer.” In addition, “even if a person inhabits a housing unit only for a short period of time in the year, this is sufficient for the housing unit to be considered ordinarily inhabited in the year by that person.”

You claim the principal residence exemption when you sell a property, or when you are deemed to have sold a property, as is the case upon your death. Say you own a property for 20 years, inherit another property, and then own them both for 10 more years. If you sell both properties and claim the principal residence exemption for the inherited property for all 10 years of ownership, that means only twenty-thirtieths (or two-thirds) of the capital gain on the initial property will be tax-free (the first 20 years of ownership). The other 10 years (or one-third) will be taxable. This is because a taxpayer can only claim one principal residence in a given year.

What is the principal residence “plus 1” rule?

In your case, Doris, you are planning to sell your house. If your home qualifies as your principal residence for all years that you have owned it, it will be tax-free. If you move into your new home relatively soon after inheriting it, the future appreciation on that house may also be totally tax-free to you.

This is because there is a “plus 1” rule whereby two properties can be treated as the taxpayer’s principal residence and qualify for the exemption in a year when one residence is sold and another is acquired in the same year. If you sell your home in the same year you inherit the other house, both might be fully tax-free.

How the transfer of ownership will take place

You ask if it is better to have your name on the title of the house you will inherit or to leave it as an “inherited” house. The executor of the estate will need to transfer the property’s ownership and legal title to you as part of the settlement of the estate. So, there is no flexibility as to how you will take title to the property. The property will be registered in your name.

In summary, Doris, you may be able to avoid tax on both properties. But if you do not sell your home in the same year you inherit the other house, it is possible that your ownership of the inherited home, for whatever length of time you own both properties, will be subject to tax one day. This may be upon the home’s future sale or upon your own death.

Jason Heath is a fee-only, advice-only Certified Financial Planner (CFP) at Objective Financial Partners Inc. in Toronto. He does not sell any financial products whatsoever.