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, read this blog for helpful tax tips that can save you thousands.
This blog is divided into 3 separate parts:
- How to Reduce Taxes on the Sale of Real Estate in Canada
- Best Ways to Own Canadian Real Estate Investments
- Tax Implications of Changing Your Primary Residence into a Rental Property
How to Reduce Taxes on the Sale of Canadian Real Estate
1. Capital Gains Treatment
The first way to reduce taxes is to call the profit you made on the sale of Canadian real estate, a “Capital Gain”.
The term, “Capital Gains”, simply means that only half of the profit of your Canadian real estate sale will be taxable to you.
Assume that the profit on a real estate sale is $100,000. As a result, only $50,000, or half of the gain, would be taxable to you at your marginal tax rate.
The profit on real estate sales in Canada is calculated using this very simple formula:
Net Sales – the Cost = Profit (Gain)
The net sales proceeds are the selling price and the cost is the original purchase price. The original purchase price should be shown on the purchase and sale agreement when you first bought the property. Land transfer tax, legal fees paid and other closing costs can be added to the cost of the property for tax purposes. Likewise, commissions and selling expenses can be deducted to arrive at the net sales proceeds.
2. Maximize Capital Improvements
Maximize the number of capital improvements to reduce taxes on property sales. Improvements (also known as capital expenditures) increase the cost amount of your property for tax purposes. A higher cost results in a lower gain on the sale.
Let’s say that you decide to replace all of the old windows on your property. These new window replacements will last 10 to 20 years and extend the life of your property. For tax purposes, the windows are classified as capital improvements and are added to the cost of your property.
Repairs are not considered a form of improvement as they will not increase the cost of your property for tax purposes. However, repairs are tax-deductible as a current expense on your Canadian tax return.
Examples of repairs include:
- Fixing a leaking faucet
- Shampooing carpets
- Fixing holes
3. Do Not Claim Capital Cost Allowance
If you are thinking of selling a Canadian property, you must factor in depreciation or Capital Cost Allowance. Depreciation represents the physical wear-and-tear to your property and is tax deductible.
When selling depreciable assets, such as Canadian real estate, the Capital Cost Allowance that you claimed in prior taxation years must be included in your taxable income in the year of the sale. This is known as recapture.
Let’s say that you claimed $100,000 of Capital Cost Allowance to date. This means that $100,000 of previously claimed Capital Cost Allowance will be included in your taxable income in the year of sale. If you do not claim Capital Cost Allowance, you will avoid recapture.
In conclusion, you should calculate the Capital Gain on the sale of your real estate, maximize the number of capital improvements to your property and factor in the Capital Cost Allowance.
Best Ways to Own Canadian Real Estate Investments
The 4 different ways that you can structure your real estate investments are through a:
- Sole proprietorship
- General partnership
- Limited partnership tax
- Corporation selling your properties.
1. Sole Proprietorship
In Canada, a rental property can be acquired through a sole proprietorship. This means that you, the sole proprietor, will be listed as the sole owner of the property on the deed of purchase.
You should consider becoming a sole proprietor when the value and risk of a property are low. This is because a sole proprietor does not have limited liability protection and could potentially lose all of their assets (such as their home, car, savings, etc.) if a tenant or third party were to sue them.
A low value and low-risk property have the following characteristics:
- It’s located in a good neighborhood
- The tenants are working professionals, have no criminal record, no prior evictions, and a high credit score
- The property price is not material relative to your entire investment portfolio
Essentially, buying and selling Canadian real estate for tax purposes through sole proprietorship is simple. 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.
Having General Liability Insurance will protect you from lawsuits involving injuries or damages to customers, employees, vendors or visitors that occur on the premises of your property. You should consider investing in this type of insurance as tenant issues are fairly common.
2. General Partnership
A general partnership is a relationship between 2 or more persons with a common view to profit. Examples of a general partnership include Joint Venture Agreements and situations where more than 1 person is listed as the registered owner of a property.
General partnerships do not pay tax on profits earned. Instead, each partner is personally liable for taxes on his /her share of the partnership’s income.
How can a General Partnership help me? A general partnership can help you to save taxes by splitting income with family members or unrelated persons.
If you decide to 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 them to:
- Devote a reasonable amount of time to business
- Contribute cash to purchase the business or real estate assets
Let’s take the example of John and Jane, a married couple. John sells a rental property and, as a result has a capital gain of $150,000. John’s tax rate is 40% and Jane’s tax rate is 30%.
Without a Partnership
Without a partnership, the gain of $150,000 will be attributed all to John. Remember, only half of the gain is taxable at John’s marginal rate of 40%. This results in taxes owing to John of $30,000.
With a Partnership
If John makes Jane his real estate business partner, then he can transfer part of the capital gain to Jane. Instead of John claiming the $150,000 all to himself, the gain can now be split 50/50. By doing this, John will pay $15,000 of taxes on his share of the gain and Jane will pay $11,250 on her share, for a total of $26,250. This results in a tax savings of $3,750.
3. Limited Partnership
A limited partnership is a separate legal entity where investors own units representing their ownership interest in the partnership. Money from investors is pooled together so that the partnership has funds to acquire a real estate investment.
Usually, limited partners do not know each other or take part in the management of real estate. The day to day activities of the properties is left up to a general partner. These 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 a great 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. For most limited partnerships, the CRA requires a T5013 Partnership Information Return to be 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 (also known as depreciation) claimed;
Partners are required to report their partnership income on line 122 of their personal return. If they have a partnership loss in the year, that loss can be deducted on line 251 of their personal return. Income from real estate sales has flowed through the partnership onto your personal tax return for tax purposes.
Example: General Partnership vs. Limited Partnership
Let’s take a look at the example of John and Jane. Assume that John and Jane want to make their General Partnership into a Limited Partnership in order to reduce personal liability. John faces the problem of deciding who to elect for the role of the General Partner. Remember, a Limited Partnership has to have at least one General Partner, who is ultimately liable if things go sour. John doesn’t want to be the General Partner because he’s afraid of the risk involved. In this case, he can set up a Canadian corporation to be the General Partner.
If John initially invests $100 of the 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, owning 1% of the units of the Limited Partnership.
Designating a corporation as the general partner will result in the corporation taking on all risk, but has limited liability protection and a nominal amount of assets (i.e. $100). In this way, John has reduced his personal and his family’s liability. This is a fairly common practice in Canadian real estate as long as the management of the property is carried on through the corporation. This is a fairly common practice in Canadian real estate, as long as the management of the property is carried on through the General Partnership, in this case, a corporation.
The main advantage of buying real estate through a corporation is the liability protection that it provides. A corporation and shareholders are two separate persons in the eyes of the law. If your property suffers a loss or a potential lawsuit occurs, then your personal assets will remain 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 dividends. When the shareholders receive dividends, they pay tax personally. There is some relief in the form of a dividend tax credit, which can help individuals reduce their personal taxes payable.
Another major disadvantage of incorporating real estate in Canada is that the tax on passive investment income is very high. For example, in Ontario, a CCPC (Canadian Controlled Private Corporation), which earns investment income from rent’s net of expenses, pays a tax of almost 50%.
In conclusion, there are different ways to own your real estate investments – through a sole proprietorship, general partnership, limited partnership or corporation. The best structure depends on your personal circumstances. Consult with your accountant before buying real estate to make sure that you do it the right way.
Tax Implications of Changing Your Primary Residence into a Rental Property
When you begin renting your home, there is a change in the use of your property for tax purposes. The CRA deems you to have sold your home to yourself for its market value at that time. At first glance, this concept seems very silly, because you did not really sell your home in actuality. Regardless, if your property increased in value from the time you bought it to the time you began renting it, that increase will be subject to capital gains tax. In other words, half of the increase or gain will be taxable at your marginal tax rate upon conversion.
Fortunately, you can exempt this gain from taxation by claiming the principal residence exemption. If you lived in your home for the entire period that you owned it up to the point it became a rental property, then the entire gain will be exempt because of the principal residence exemption.
Your principal residence is not considered to have changed its use (i.e. to a rental property) if:
- The rental portion of your home is small compared to the size of your entire home
- There are no structural changes to the property, making it more suitable for business or rental purpose
- You have never claim capital cost allowance or tax depreciation on your home
In conclusion, changing your home into a rental property is not a tax-free event. A capital gain can result. To reduce taxes, claim the principal residence exemption if you qualify. Always, consult your accountant before covering your property into a rental.
The information provided on this page is intended to provide general information. The information does not take into account your personal situation and is not intended to be used without consultation from accounting and financial professionals. Allan Madan and Madan Chartered Accountant will not be held liable for any problems that arise from the usage of the information provided on this page.