It’s no secret that if you sell your principal residence, you might be able to sell it tax-free, thanks to the “principal residence exemption” (PRE). The problem? It’s not always clear what should count as a principal residence.

Take Andrew Thurnheer, for example. This man’s home outside Ithaca, N.Y., consisted of a tree house 40 feet in the air, which he built in the mid-1980s, and includes a generator-powered elevator, shower and propane heater. If some lucky buyer managed to acquire this home from him, would it count as a principal residence?

Okay, tree houses aside, there are other examples where it’s not clear that a place should be considered a principal residence. Consider the example where you buy a property, fix it up, live in it for a bit, then sell it for a profit. Many people think that a place like this should qualify as a principal residence and therefore a sale should be sheltered from tax using the PRE. And if not, the profit should at least be taxed as a capital gain, not business income. It seems that, every year, there are court cases in Canada that deal with this issue. Let me share the most recent case, and how the court approached it.

Nathalie Constantin purchased six properties in Quebec over three years – 2006, ’07 and ’08. Ms. Constantin sold the properties shortly after purchasing them. She held the properties for periods ranging from two months to 11 months. The average holding period was nine months.

In this story (see Nathalie Constantin v. The Queen, 2014 TCC 327), the issue was the tax treatment of the profit she realized when she sold the properties. The question was whether to tax the properties as though she were selling capital property that she owned (in which case the profits should be taxed as capital gains), or selling business inventory (in which case the profits should be taxed as business income).

I’ll pause here to mention that, if you hope to use your PRE to shelter income from a tax gain on the sale of a property, it has to be true that the property is a capital property in your hands, and not business inventory. Further, you have to ordinarily inhabit the property in order for it to be counted as a principal residence eligible for the PRE.

Back to the issue of capital property versus business inventory. Think of a tree and fruit analogy. If you were to buy a tree with the intention of growing fruit so that you could sell the fruit to earn income, you could say that the tree is a capital property. On the other hand, if you bought the tree to flip the tree itself for a profit, the tree would be more akin to business inventory. Ms. Constantin argued that it was her intention to keep the properties in order to earn rental income from them. Normally, in this case, a rental property would be considered capital property.

The court, however, disagreed with her. The court shared the criteria that should be looked at when determining whether a profit should be treated as a capital gain, or business income. These criteria were first introduced in the court case Happy Valley Farms Ltd. (1986). Here’s what the court will look at: (1) the nature of the property sold; (2) the length of period of ownership; (3) the frequency and number of similar transactions by the taxpayer; (4) the work expended to make the property more marketable or to attract purchasers; (5) the circumstances responsible for the sale of the property; and (6) the taxpayer’s intention or motive when the property was acquired.

In addition to these criteria, the courts have developed the doctrine of “secondary intention.” That is, even when your main intention was to hold a property as a long-term investment, it might be that you had in mind a possible sale of the property for a profit if your long-term objective couldn’t be achieved. This secondary intention could be enough for a court to say that your profit should be taxed as business income rather than a capital gain. In Ms. Constantin’s case, she would have been content with capital gains treatment, even if she couldn’t claim the PRE. She lost the case.

If you’re going to buy and flip a property for a profit, take a careful look at the criteria the courts – and taxman – will consider when taxing you. If possible, structure your purchase so that you’ll receive capital gains treatment, and perhaps even the PRE.

Tim Cestnick is managing director of Advanced Wealth Planning, Scotiabank Global Wealth Management, and founder of WaterStreet Family Offices.