Ever wonder how to deal with tax on real estate sales in Canada? If you own a rental property or a real estate investment in Canada, and have sold or are thinking of selling, then it is very important that you read this article because it provides helpful tax tips that can save you $$$ thousands.
Paying Capital Gains Tax – Tax on Real Estate Sales in Canada
When you sell an investment property in Canada you are required to pay capital gains tax on real estate sale in Canada. ‘Capital Gains Tax’ simply means that only half of the profit (i.e. gain) the sale of your real estate investment in Canada will be taxable.
For example, if the profit (gain) is $100,000 on a real estate sale in Canada, then only half of the gain ($50,000) would be taxable at your marginal tax rate.
Profit on the Sale of Real Estate Investments in Canada
How do you calculate the profit on real estate sales in Canada?
It is a very simple formula:
Net Sales Proceeds minus the Cost = Profit (Gain).
The Net Sales Proceeds is equal to the selling price less legal fees paid to your lawyer and commissions paid to your Realtor.
The cost is computed as the original purchase price, which should be shown on your purchase and sale agreement when you first bought the property, plus land transfer tax, legal fees paid and the cost of any improvements made to the property.
What are Improvements? – Tax on Property Sales in Canada
When computing year end tax on real estate sales in Canada, you should consider improvements. Improvements increase the cost of your property and therefore reduce the gain and tax on the sale of your real estate investment.
Improvements (also know as capital expenditures) are something that better the quality of the property or extend the life of your real estate investment in Canada. For example, if you replaced the windows on your property, then that is an improvement because it has extended the life of your property. Windows usually last 10 to 20 years.
Another example of an improvement would be replacing your old gas furnace with a high energy efficient furnace. That improves the quality of your property and therefore it is an improvement.
Repairs are not improvements and they would not increase the cost of your property for tax purposes. Repairs include fixing a leaky faucet or repairing a squeaky floor board. Repairs are tax deductible as a current expense on your tax return.
Capital Cost Allowance – Tax on Real Estate Sales in Canada
If you are considering selling a property in Canada, you must factor in depreciation, also known as Capital Cost Allowance. Depreciation represents the wear-and-tear on your property and is tax deductible.
When selling depreciable assets such as real estate in Canada, the Capital Cost Allowance that you claim in the prior taxation years must be included in your taxable income in the year of the sale. This is known as recapture. For example, if you claimed $100,000 of Capital Cost Allowance in prior taxation years, then $100,000 of previously claimed Capital Cost Allowance will be included in your taxable income in the year of sale.
Remember that when selling eligible CCA real estate in Canada, the sale must be reported on your personal tax return, including the capital gain realized and recapture. Since the tax on sale of real estate sales and rental properties can be complex, I encourage you to engage the services of a Chartered Accountant in Mississauga / Toronto. If you are in the business of selling properties, you may want to know why you are not entitled to certain deductions. Get ready condo flippers, CRA is hunting you, will tell you why you pay higher taxes when selling property.
Different Tax Structures for Selling Rental Properties
The following video will illustrate the different tax structures available to individuals in Canada when selling real estate.
Tax on Sole Proprietor When Selling Real Estate
The first way that a rental property in Canada can be acquired is through a sole proprietorship. This means that you, the sole proprietor, is listed as the sole owner of the property on the deed of purchase.
Buying and selling real estate for tax purposes in Canada is simple for a sole proprietor. A sole proprietor will pay capital gains tax on real estate sales in Canada of a rental property.
The capital gain on the sale is reported on Schedule 3 and line 127 of your tax return. In addition, you must complete form T776, Statement of Real Estate Rentals annually to report the profit earned from the property.
When should you consider becoming a sole proprietor? A sole proprietorship is appropriate when the property value is low and the risk is low. The reason for this is because a sole proprietor does not have limited liability protection. This means that you, as a sole proprietor, could lose all of your assets (home, car, savings, etc.) should a tenant sue you or another party sue you.
An example of a low risk and low value property is as follows:
- A good neighborhood
- Good quality of tenants
- House price is not material relative to your investment portfolio
Tip: General liability insurance: will protect your business from lawsuits involving injuries or damages to customers, employees, vendors or visitors that occurs on your premises. You may want to consider investing in this type of insurance in real estate since tenant issues are fairly common.
General Partnership Tax on Real Estate Sales in Canada
A general partnership has more benefits with respect to capital gains tax on the disposition of real properties.
If you make your spouse a partner in your real estate business they can share the profit or loss similar to any other partnership. In order for your spouse to qualify as a partner the CRA requires they:
- Devote a reasonable amount of time to business
- Contribute cash to purchase the business assets
Example: John and Jane are married. John sells a rental property and as a result has a taxable capital gain of $150,000.
This capital gain alone will put John in the highest federal tax bracket along with what other income he may have during the year. His effective tax rate would be 46.41% on the all income including the $150,000 taxable capital gain. Without income splitting he would be taxed $69,615 for the year.
If John makes Jane a partner in his real estate business, then he can transfer part of the capital gain to Jane. Instead of John claiming the $150,000 by himself it can now be split 50/50. Now both John and Jane would have taxable income of $75,000. By doing this John and Jane will be taxed at a lower marginal tax rate of 32.98%. John and Jane would have to pay $24,735 and a total of $49,470.
If John and Jane enter a partnership and split the capital gain they will save $20,145 in tax. Canada runs on a marginal tax system. The more you earn the more you will be taxed. By splitting your income or capital gains, you can take advantage of lower tax rates in Canada. The example used above is fairly common with respect to tax on real estate sales.
As a partnership you will only be required to fill out your T1 Personal Tax Return and form T776 Statement of Real Estate Rentals for rental income, similar to a sole proprietor. This makes it easy and simple for tax purposes with no registration needed. However there is unlimited liability with a partnership and if sued your personal assets will be at risk.
Make sure that you are investing in low risk properties to reduce liability.
A limited partnership is a legal entity where the investors own units representing their ownership interest in the partnership. The money from investors is pooled together so that the partnership has the funds to acquire a real estate investment.
Usually the limited partners do not know each other and do not take part in the management of the real estate. The day to day activities of the properties is left up to a general partner. Theses activities include:
- Collecting rent
- Paying mortgages and taxes
- All tenant management
For individuals looking for a hassle free real estate investment, a limited partnership is definitely the right choice.
Taxation on Real Estate for a Limited Partnership in Canada:
Partnerships relating to real estate sales do not pay tax in Canada. Instead, the income generated from the partnership is reported on the individual’s tax return. The CRA requires that a T5013 Partnership Information Return is filed. The return contains important information about the partnership including:
- Each partner’s share of the partnership’s income for the year (including capital gains),
- Each partner’s ownership % in the partnership,
- Capital cost allowance claimed;
Partners are required to report their partnership income on line 122 of their personal return. If they have a partnership loss it can be deducted on line 251 of your T1 personal return. Income from real estate sales is flowed through the partnership onto your personal return for tax purposes.
Income Splitting When Selling Real Estate in Canada:
Let’s take a look at the same example as above with John and Jane. Say John and Jane want to make their General Partnership into a Limited Partnership to reduce liability. The only problem is John doesn’t know who to make the General Partner. He doesn’t want it to be himself because he has the majority of the family’s assets. He also doesn’t want to put the risk on his wife or kids. What John can do is set up a Canadian corporation to be the general partner.
If John initially invests $100 of share capital into the corporation, this would be the corporation’s only asset on its books. John can then make the corporation the general partner owing 1% of the units in the partnership.
The corporation as the general partner bares most of the risk, but has limited liability protection and a nominal amount of assets (i.e. $100). In this way, John has reduced his and his family’s liability. This is a fairly common practice in Canadian real estate as long as all the management of the property is carried on through the corporation.
Taxes for Corporations on Real Estate Sales in Canada
The main advantage of buying real estate through a corporation is the limited liability. A corporation and shareholders are two separate entities in the eyes of the law. If your property suffers a loss or a potential lawsuit occurs, then your personal assets will remained unharmed.
There are some negative tax implications when selling real estate through a corporation. In most cases there will be double taxation. When the corporation sells a rental property for profit it must pay capital gains tax. Another incidence of tax occurs when the after-tax profits of the corporation are distributed to the shareholders in the form of dividend. When the shareholders receive dividends, they pay tax personally. There is some relief in the form of the dividend tax credit which can help individuals reduce their taxes payable.
Another major disadvantage of tax on real estate through a corporation is investment income tax is high in Canada. In Ontario a CCPC which earns investment income pays a combined federal and provincial rate of 46.17%.
Change in Use of Property
What happens when I convert my principal residence into a rental property?
The CRA stipulates the ways you can change the use of your property:
1.) Convert all or part of your principal residence to a rental or business operation
2.) Change rental or business operation to principal residence
When either of theses scenarios occurs, the CRA deems you to have sold the portion of your property for its fair market value at the time of conversion, and to have immediately reacquired it for the same price. The portion deemed sold is the business-use portion or rental-use portion of your home.
If you generate a profit (fair market value price > adjusted cost base) from the change in use, then a taxable capital gain must be reported on your personal tax return that year.
What happens if you rent out a part of your home (principal residence)?
In most cases if you are still living in the house then the capital gain realized on the change-in-use from personal purposes to rental / business-purposes will be tax exempt due to the principal residence exemption.
Your principal residence is not considered to have changed its use (i.e. to a rental property) if:
1.) Rental or business property is small compared to personal residence part
2.) There is no structural changes to the property making it more suitable for business or rental purpose
3.) No CCA has been deducted on the business or rental part
If all of theses requirements are met then all of the residence will qualify as your principal residence even the rental or business part.
If theses conditions are not met when selling the property then you have to:
1.) Split the selling price between the rental part and principal residence part. CRA will allow a split by square metres or the number of rooms as long as the split is reasonable.
2.) Report any capital gains on the part you used for rental purposes. No gains will be reported for the principal residence portion.
Additionally, If you are a Canadian planning on purchasing real estate property in the United States, make sure to consult this tax guide for Canadians buying US real estate.
Also, get access to Allan Madan’s Free Report, “20 Tax Secrets on How to Beat the Tax Man,” 20-free-tax-secrets-from-allan-madan
About the Author – Allan Madan
Allan Madan is a CPA, CA and the founder of Madan Chartered Accountant Professional Corporation.
Allan provides valuable tax planning, accounting and income tax preparation services in the Greater Toronto Area.
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