All About Capital Gains Tax For Real Estate In Canada
When you own real estate that is not your principal residence, you’ll likely run into capital gains tax somewhere down the road. We sat down with Gary Li, CPA, CA, to clarify the key capital gains tax implications for real estate properties in Canada. Let’s get started!
When Is Real Estate Capital Gains Tax Triggered?
You may be subject to capital gains tax when you sell a property for more than your cost to purchase and improve it. Capital gains tax may also be triggered when you change the use from a rental property to a principal residence, or vice versa.
However, there are exceptions. Most taxpayers know that you can claim the principal residence exemption if your property was used as your primary home. Less commonly known is that if an incidental portion of your primary home was used to generate income, you may still qualify for the full principal residence exemption if you meet these three conditions:
- Your rental or business use of the property is relatively small in relation to its use as your principal residence;
- You do not make any structural changes to the property to make it more suitable for rental or business purposes;
- You do not deduct any CCA on the part you are using for rental or business purposes
Capital Cost Allowance (CCA): An annual tax deduction that can be claimed on depreciable assets. CCA will be recaptured and subject to income tax when the proceeds of the sale is more than your undepreciated cost plus any improvements.
How Do You Calculate Capital Gains Tax?
If your activity with respect to a property is in the nature of an investment as opposed to a business, the gain on the sale of the property will be taxed as a capital gain – i.e. 50% of the gain is taxed at your marginal tax rate. When you sell an investment property, capital gains (or losses) are calculated by taking the difference between the selling price of the property and the cost of acquiring and making significant improvements to the property. As a reminder, gains in the nature of business (such as property flipping), as well as rental income, are 100% taxable at your marginal tax rate.
If you change the use of your property, the CRA deems a sale to have taken place on that date even though there wasn’t an actual sale. In this case, your capital gain is calculated based on the difference in fair market value (FMV) on the date of the change and the property’s cost basis – often, the cost basis would have been reset during a previous change in use to a rental property.
The most accurate way to get your FMV is to get a formal appraisal, but if one is not available or practical, it is generally acceptable for the FMV to be determined based on sales data from market comparables at that time. In some cases, the principal residence exemption kicks in to eliminate or reduce the taxable capital gains from the deemed sale.
When Must Capital Gains Tax Be Paid?
In the case of a true sale of an investment property, capital gains tax must be paid when you file your tax return for the year the sale occurred. The same rules apply in the case of a change of use (i.e. a deemed sale); however, the CRA recognizes that property owners may face difficulty paying capital gains tax when a sale has not occurred.
In this case, the CRA allows owners to file an election to defer the payment of tax until a true sale takes place, provided you do not claim CCA during the years affected by the election. If you are a Canadian resident, the election also allows you to designate the property as your principal residence for up to 4 additional years even though it is being rented out, as long as you do not have another property designated as your principal residence during the same years.
Should I Elect To Defer Capital Gains On A Deemed Sale?
By now, you may have realized that in the case a deemed sale, you will have to consider the trade-off between taking the deferral election and continuing to claim CCA expense against your yearly rental income. Everyone’s situation is different so there is no absolute answer.
Deferring capital gains and potentially claiming the principal residence exemption for up to four additional years is a significant benefit in Toronto since property prices and appreciation rates are high. On the other hand, properties with lower appreciation rates and a longer holding period may mean that you do not expect to have significant gains that need to be deferred, and claiming CCA can be a better option. Also, the additional four years of principal residence may not be useful to you on this property if the designation is better used on another primary home that you own at the same time.
The best way to decide which option is best for your situation is to compare the projected tax implications.
Let’s go over an example where we purchased a rental property in Year 1 at $600,000. In Year 5, it was converted to a principal residence when the FMV was $850,000. In Year 10, the property was sold for $1,100,000. In this example, assume there is enough net rental income available to claim the maximum CCA expense each year and the value of the building at the start is 50% of the property’s purchase price at $300,000.
Option 1: Deferral election is not taken, but can claim CCA
Without the deferral election, the appreciation of $250,000 from Year 1 to Year 5 is taxable in Year 5, even though you didn’t truly sell the property. The taxable portion of $125,000 ($250,000 capital gain x 50% inclusion rate) is taxed at your marginal tax rate. Your new cost basis as of Year 5 would be $850,000.
However, you would be allowed to claim CCA expense of the undepreciated building cost (4%, subject to income limitations) to offset a portion of rental income each year until Year 5 when the deemed sale takes place.
Option 2: Deferral election is taken, but cannot claim CCA
With the deferral election, any tax on the appreciation of $250,000 from Year 1 to Year 5 will be deferred until the true sale occurs in Year 10. Furthermore, assuming you are a Canadian resident and do not have any other properties designated as your principal residence during the same time frame, you can designate this property as your principal residence for Years 2 through 5 (i.e. up to 4 tax years leading up to the change of use).
Therefore, the taxable portion related to Years 1-5 could be as little as $25,000 ($250,000 capital gain x 20% not covered by principal residence exemption x 50% inclusion rate). Remember that if the election is taken, CCA expense cannot be claimed to reduce rental income from Year 1 to Year 5.
Here’s a schedule of taxable income for the two options:
| Year | Option 1: CCA With No Election | Option 2: No CCA With Election |
|---|---|---|
| 1 | 0 | $6,000 Lost CCA Expense |
| 2 | 0 | $11,760 Lost CCA Expense |
| 3 | 0 | $11,290 Lost CCA Expense |
| 4 | 0 | $10,838 Lost CCA Expense |
| 5 | $125,000 Taxable Capital Gain + $50,292 CCA Recapture | $10,404 Lost CCA Expense |
| 6 | 0 | 0 |
| 7 | 0 | 0 |
| 8 | 0 | 0 |
| 9 | 0 | 0 |
| 10 | 0 | $25,000 Taxable Capital Gain |
One way to compare the two options is to look at the future value of total taxable income based on an inflation rate of 3% per year. The future value of Option 1 is $203,212 at the end of Year 10, whereas the future value of Option 2 is $86,613. So in this case, choosing the election is much more advantageous.
How We Can Help
As you can see, capital gains taxes can vary depending on tax deferral choices, appreciation rates, your holding period, and your overall income situation over time.
Besides helping you buy and sell real estate, our Elevate team is happy to connect you with great accountants and are ready to grow with you. This means we can also work together with your accountant to analyse your unique real estate position and help you make better investment decisions throughout your real estate investing journey.