Imagine this scenario: You plan to sell your city house and rent instead, keeping your cottage for summer living. You expect to apply the principal residence exemption to the house sale to avoid taxation on the capital gain, and then designate your cottage as your principal residence from then on.
In a nutshell: Many families own more than one home. Choosing which to designate as the principal residence for each year of ownership is a tax-optimization opportunity. The proportion of the capital gain that is exempt from taxation is approximately* equal to the number of years the property was designated as the principal residence taken as a fraction of the total number of years that the property was owned. In some cases, the cottage may have increased in value by a greater average amount per year than the house, and the taxpayer would benefit by designating the cottage as the principal residence and paying capital gains tax on the house proceeds.
One way this could really matter: Should the cottage be sold shortly after the house, the entire gain would be exempt from tax if the cottage was designated as the principal residence for the full term of ownership. If the cottage was designated as the principal residence for only a small portion of the term of ownership (the time since the city house was sold), then a lesser exemption and a larger capital gains tax burden would apply. That tax burden might be greater than the tax on the sale of the city house had the house not been designated as the principal residence.
For a detailed example and further exploration please see our article on Principal residence.
We strongly recommend you consult with an accountant to help you decide the how best to use the principal residence exemption.
*see page 3 of the article for the exemption formula, which adds 1 year to the number of years a property is designated as the principal residence.