What happens to the principal residence exemption when a homeowner dies?

When a homeowner dies, the Income Tax Act deems them to have disposed of all their capital property — including their home — at fair market value immediately before death. This deemed disposition is reported on the deceased's terminal T1 tax return. If the home qualifies as a principal residence for all years of ownership, the entire accrued capital gain is sheltered by the exemption and no tax is payable.

The property can pass to a surviving spouse or common-law partner at cost (a spousal rollover), deferring the deemed disposition until the surviving spouse sells or dies. This rollover does not require a formal election in most cases but should be considered carefully, since the entire future gain will ultimately be taxable on the surviving spouse's terminal return.

If the home passes to adult children or other beneficiaries, the estate is responsible for any tax arising from the deemed disposition. Beneficiaries receive the property at its fair market value at the date of death as their new cost base, so they do not pay tax on the pre-death appreciation again.