If you are researching how to avoid paying capital gains tax on the sale of your rental property, you presumably expect to have a taxable gain on your rental property. With all things considered, that’s a desirable place to be, and congratulations are in order. However, the excitement from the sale has likely been muted by the thought of how much capital gains tax you will pay.
There are several opportunities to reduce the amount of tax you will pay on a capital gain that is onside with the Canada Revenue Agency (CRA). First, it is important to note that selling an investment property and realizing a capital gain will create a tax liability. However, the trick is to pay the least amount of tax on the capital gain as possible.
Below are five strategies that investors can use to reduce their tax liabilities when selling their rental properties and realizing a capital gain in order to maximize their return on investment. However, before we get into the specific strategies, let's start with some basic information on capital gains.
- What is a capital gain?
- 5 Ways to avoid capital gains tax on a rental property in Canada
- 1. Sell at the right time
- 2. Offset capital gains tax with capital losses
- 3. RRSP contribution
- 4. Capital gain reserve
- 5. Donate Rental Property
- FAQs About Avoiding Capital Gains Tax on a Rental Property in Canada
What is a capital gain?
A capital gain is realized when a capital asset is sold for more than the price you paid to acquire it. The purchase price and direct costs to acquire the property are called the adjusted cost base. When you sell a rental property, which is a capital asset, for more than the adjusted cost base, a capital gain is realized. When that happens, the seller will owe a tax on that gain, called capital gains tax. Unfortunately, mortgage interest and other personal expenses are not used in capital gain calculations.
How to calculate a capital gain
To calculate the capital gain on a rental property sale, the adjusted cost base will first be calculated. For example, if a rental property was purchased for $200,000, and a deck and garage were added for $30,000, the starting point for the adjusted cost base would be $230,000 ($200,000+$30,000).
If the realtor fees are $10,000 and legal fees are $3,000, these incurred costs to sell the rental property can be added to the adjusted cost base. In this example, the adjusted cost base to determine the rental property capital gain would be $243,000.
Any sale price greater than this amount would result in a capital gain. If the final realized sale price is $300,000, the capital gain would be $57,000 ($300,000-$243,000), and the seller would need to pay a capital gains tax on this amount.
The capital gain formula when selling a rental property is:
Capital Gain = Sale price – (Adjusted Cost Base + Selling Expenses)
Using the example above, it looks like this:
$57,000 = $300,000 – ($200,000 + $30,000 + $10,000 + $3,000)
Unfortunately, mortgage interest and other personal expenses are not used in capital gain calculations. However, the owner can expense these costs in the year they occur.
Calculating capital gains taxes
In the example above, the capital gain is $57,000. However, the Canada Revenue Agency (CRA) requires the seller to only pay tax on 50% of the capital gain amount, which would be $28,500 ($57,000/2).
This taxable gain amount will be added to the seller’s taxable income, and each seller will pay a different tax rate depending on their tax bracket and what their individual tax rate is for their next dollar of taxable income, also known as the marginal tax rate.
5 Ways to avoid capital gains tax on a rental property in Canada
Got a rental property you're itchy to sell? Here are 5 ways to legally avoid capital gains tax if the sale will generate a gain.
1. Sell at the right time
Canada has a progressive tax system where taxpayers pay different income tax rates depending on what tax bracket their income falls in. As a taxpayer’s income increases, so does their marginal tax rate, which is the tax rate they will pay on the next dollar earned.
With a progressive tax system, it makes financial sense to sell a rental property with a taxable gain when the seller isn’t in their high-earning years. This will include retirement years, when a spouse is on maternity leave, or if the seller hasn’t earned much income in a specific year due to being laid off, injury, and so on.
2. Offset capital gains tax with capital losses
Investors who invest in stocks may not be aware that when they sell stocks and incur a loss, they can use this capital loss to offset the capital gain from the sale of their rental property. For example, if an investor purchased and sold a particular stock and incurred a loss of $50k, they can carry forward that $50k capital loss until they can use it to offset a realized capital gain.
The CRA also allows Canadians to carry back capital losses for up to three years. This means that a taxpayer can reduce the capital gains reported in these previous years by the capital loss realized, resulting in capital gain tax savings for those years. Even if an investor has no capital gains to offset a capital loss, they should still report the capital loss on their taxes for future use.
It is important to clarify that a capital loss from the sale of stocks can only be used to reduce capital gains tax when incurred in a taxable account. This means that if a loss was incurred by purchasing and then selling a stock within a Registered Retirement Savings Plan (RRSP) or Tax Free Saving Account (TFSA), the investor can’t use the capital loss to offset their capital gain.
Tax loss harvesting
Tax loss harvesting is a term and strategy for recognizing capital losses currently unrealized and sitting in a stock portfolio. For example, say an investor purchased $10k worth of shares, and they are now worth $5k. If an investor continues to hold the shares, they will not realize a capital loss, and it can’t be used to offset the capital gain from the sale of a rental property. However, once they are sold, the investor can use the capital loss to offset the capital gain.
3. RRSP contribution
Contributing to an RRSP is an effective way to reduce capital gains taxes, as well as tax on other income. There are a few things to consider with making RRSP contributions to reduce capital gain taxes.
The first thing to consider is that contributing to an RRSP brings down your taxable income. For example, the capital gain of $57,000 noted earlier in the article would result in a taxable gain of $28,500, as only 50% of the taxable gain is taxable.
Using Alberta’s highest marginal tax rate of 48% results in a capital gain tax of $13,680 ($28,500 x 0.48). People can get confused when they see their income taxes owing and think they need to deposit an equal amount in their RRSP. In reality, they will need to take the taxes owing, including any capital gains tax, and divide it by their marginal tax rate. So in this example, it would take a $28,500 RRSP contribution to wipe out the $13,680 ($13,680/0.48) tax liability.
Another important consideration when using RRSP contributions to avoid capital gains taxes is that the investor will need to have contribution room in their RRSPs. If they diligently contributed to their RRSPs throughout their working life, they may not have any room to make a dedicated contribution to reduce their capital gains tax realized from the sale of their rental property.
4. Capital gain reserve
An investor may be able to avoid paying a higher marginal tax on the capital gain from the sale of their rental property if they can spread the payment out for up to five years. However, for this to work, the buyer has to agree to provide payment over five years rather than upfront.
This could be risky as the buyer may have the cash today to pay the entire amount but may not in the future, regardless if they are committed to it. Given this, selling to trustworthy buyers and/or family is essential to mitigate this risk.
Example: Capital Gain Reserve Calculation
If a buyer of the investor’s rental property agrees to pay $1MM and the investor originally purchased the rental property for $500k, the sale would create a $500k capital gain ($1MM – $500k). However, the investor trusts the buyer, and they agree to spread the payments over five years.
When using a capital gain reserve, the seller would only have to record a taxable gain of $100k ($500k x 20%) in the first year, $80k in the second year ($400k x 20%), and $64,000 ($320,000 x 20%) in the third year, and so on. The intention of a capital gain reserve is to reduce the investor’s taxable income each year resulting in a lower average tax rate.
5. Donate Rental Property
To avoid paying capital gains taxes, the investor can consider donating to a charitable organization they care about. A benefit of donating capital property is that the donation is considered at the fair market value, meaning the donation amount is greater than what the investor purchased the property for.
However, each province will have a maximum donation amount that can be claimed per year, and in Alberta, this is 75% of the taxpayer's reported income. If the taxpayer hasn’t earned enough income to get the full tax advantage of the donation, they can carry it forward and claim it on future tax returns over the next five years.
FAQs About Avoiding Capital Gains Tax on a Rental Property in Canada
To calculate a capital gain on the sale of a rental property, the adjusted cost base will first be calculated. For example, if a rental property was purchased for $200,000, and a deck and garage were added for $30,000 and are considered capital improvements, you can add this amount to the adjusted cost base. The starting point for the adjusted cost base would be $230,000 ($200,000+$30,000). If the realtor fees are $10,000 and legal fees are $3,000, these incurred costs to sell the rental property can be added to the adjusted cost base. In this example, the adjusted cost base to determine the rental property capital gain would be $243,000.
Any sale price greater than this amount would result in a capital gain. If the final realized sales price is $300,000, the capital gain would be $57,000, and the seller would need to pay a capital gains tax on this amount.
The capital gain formula when selling a rental property is: sales price – (adjusted cost base + selling expenses)
The seller of a rental property can reduce their capital gains by selling at the right time, offsetting capital gains tax with capital losses, contributing to RRSPs, using a capital gain reserve, and donating the property to a charity.
An investor may be able to avoid paying a higher marginal tax on the capital gain from the sale of their rental property if they can spread the payment out for up to five years. However, for this to work, the buyer has to agree to provide payment over five years rather than upfront. This could be risky as the buyer may have the cash today to pay the entire amount but may not in the future, regardless if they are committed to it. Given this, selling to trustworthy buyers and, or family is essential to mitigate this risk.