Tax tip/warning for Canadians building their own houses

I think most people know that when you sell a house, you can designate it as your principal residence and thereby avoid a taxable capital gain.

What about if you buy vacant land and build a house on it? Well, if there was no house on the land for one or two or ten years, the property can't be designated your principal residence for those years. So if you owned the land for 10 years and lived in a house you built for 8, only 8 of the 10 years will be exempt from capital gains. You might think, fine, there wouldn't be much change in the value of vacant land over two years, so no big deal. But that's not how it works.

You buy vacant land for $10,000. A couple years later you build a house on it and settle in. Your property assessment that year says the land is worth $9000, but you could probably sell it for $11,000. The next year your assessment goes up to $200,000 since there's now a house on it. Eight years after that you sell the property for $500,000.

Here's what happens

500,000-10,000=490,000 profit

You only pay tax on 50% of that so
490,000/2=245,000 taxable gain

And you can designate it as your principal residence for 8 years so
245,000/10*8=196,000 tax exempt portion

So that leaves a taxable gain of $49,000.

Yup. Even though in the two years you weren't living there the value barely changed, for some reason you're paying tax on $49,000. Part of the value of the house is being attributed to years there was no house on the land. To me this seems like major discrimination against people who build their own houses. Principal residence is supposed to be tax exempt, but in this situation you'd end up paying tax on part of it, unlike someone who bought an already built house.

Luckily, you can mitigate this by claiming the expense of building the house, legal fees, realtor commission, etc., which you wouldn't normally be able to do when selling a fully tax exempt principal residence. But you have to know about it beforehand.

So that's the tip/warning. Keep track of all your expenses and keep receipts forever. Scan or photograph as much as you can, especially the receipts on heat sensitive paper.

This year at work, I had to help a few people in this situation. None of them had any clue that there would be a capital gain because they hadn't always lived on the property, and none of them had any record of any expenses.

Wow, great tip, Jan.

Building materials are so expensive right now that I bet a lot of people who have recently or are planning to buy land may decide to wait a year or two before building. So this advice/warning is quite timely.

Jan, I've been thinking about this some more.

So if you owned the land for 10 years and lived in a house you built for 8, only 8 of the 10 years will be exempt from capital gains.

Does this also applies to large parcels with a house, if you are running a farm? I've heard that the "principal residence" only applies to the land the house is on, so I could see how the situation you outlined could be especially bad for someone who was homesteading or farming on their land as well. I haven't checked this with a farm specific accountant yet, so correct me if I'm wrong, but my read of the situation, using your example: if you bought the land for 10K and then the value went up to 500K 10 years later after building a house after 2 years, and the property is 100 acres of mostly "farmland" (besides the fact there aren't many places you could get 100acres for 10k, 10 years ago..):

500,000-10,000=490,000 profit

You only pay tax on 50% of that so
490,000/2=245,000 taxable gain

And you can designate it as your principal residence for 8 years so
245,000/10*8=196,000 tax exempt portion

except now the house is only on maybe 10% of the land, the other 90% is a "farm", then you can only claim 1/10th of your exemption:

196,000 * .1 = 19,600

So your capital gain is now:

245k - 19,6 = 225,400

??!! wowzers. Talk about sticking it to the small farmer..

Jan White wrote:
So that's the tip/warning. Keep track of all your expenses and keep receipts forever. Scan or photograph as much as you can, especially the receipts on heat sensitive paper.

THIS. As a procrastinator I can attest to the ephemeral nature of register tapes on thermal paper. Is this a receipt for lunch or lumber? We'll never know...?
The enemies of the register tape: hot car (even worse on the sunny dashboard), hot and sweaty wallet, in the bag with the nuts and bolts, pants/jacket pocket (forget it if then you wash the pants), alcohol hand sanitizer, and four years from now no matter where you put it...

Another tip is to keep the receipts simple, make two (or more) purchases, so that your house building materials is a separate purchase from other stuff you may also get in the same trip. Don't feel weird doing it, the cashiers deal with it all the time with contractors keeping track of materials for different jobs.
A photocopy, or a printout of scans/photos would satisfy me, with a fear of losing data to poor backup protocol (I can do that later, right?).
It also standardizes the format from curly random sized tapes to 8-1/2"x11"/a4, with extra space for notes about the project.