Can we avoid capital gains tax?

Yesterday, I blogged about the difficulties regarding taxes owed on inherited property. Today, I’m going to answer a reader’s question that dives a little deeper into this topic, but highlights the importance of when a property is inherited and how quickly you decide to sell or change the use of that property (and the implications the timing of these decisions has on your taxable profit).

READER QUESTION: My wife & I live in an apartment in Vancouver. The apartment is owned 100% by me because it was bought before our marriage. Her mom owns a house in Edmonton, with a small home equity line of credit balance outstanding. What will happen to the tax situation when the mother passes away? My wife is the only child. Also, is it better to add her name to her mom’s property now? Any tax implication?

Great question and thanks for writing in to Home Owner: MoneySense.ca.

Since the Edmonton home is considered your mother-in-law’s primary residence there would be no taxes owing by the estate when your mother-in-law passes away. That’s because it’s the estate, not your wife, the inheritor, that’s responsible for capital gains taxes — and since a primary residence is exempt from capital gains tax, no taxes would be owed.

However, once the property is in your wife’s name the rules change. That’s because only a primary residence is tax exempt and, according to what you stated in your question, the Edmonton house cannot be considered her primary residence because:

• She currently resides in her marital home (the home designated as the primary residence for a common-law or married couple, even if only one person is on title);
• Only one residence may be considered a primary residence per family unit (the CRA tightened these rules about 20 years ago to prevent couples from splitting up real estate assets and claiming one property each as their primary residence);
• Finally, your wife doesn’t live in Edmonton, Alta., nor will she reside in the Edmonton home for the vast majority of any calendar year.

What does all this mean? It means your wife would be subject to capital gains tax once she determines what she will do with the Edmonton house. From what I can gather, her choices are:

• Rent out the property;
• Sell the property;
• Move into the property;
• Do nothing and leave the property vacant.

I’m going to assume that the last two options are not really viable options.

That means you can either rent out the property or sell the property — and if either of these options are completed shortly after your wife inherits the property, then the tax implications are the same: she will be taxed on the difference between the fair market value (FMV) and the sale price.

If the inherited Edmonton home was appraised at $350,000 (at the time of inheritance), but your wife sold it for $400,000, she would owe capital gains tax on the $50,000 profit (the difference between the FMV and the sale price). If she sold it for less than $350,000 she would owe no tax as there was no profit.

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However, if she opted to rent out the house (as an income property) she would still be subject to  capital gains tax — as the use of the property has changed and this change in use is what the taxman calls a “deemed disposition.” Just as if she sold the property, she would be taxed on the difference between the FMV and the sale price, only in this situation, the FMV and the “deemed disposition” sale price would be the same. Hence, she’d owe no tax as long as the FMV of the home was the same, or similar, to the FMV of the home when it’s use changed to a rental property. That also means that if there is a lapse in time she could be subject to capital gains tax. For instance, if the FMV of the inherited home is $350,000 and then six months later, when she rents the house, the appraised value is now $400,000, she would have to pay capital gains tax on $50,000. She would then have to pay additional tax when she sold the property. So, if she sold the property three years later for $450,000, she would either pay capital gains tax on $100,000 or $50,000 depending on how quickly she’d calculated the deemed disposition after the inheritence.

Keep in mind that capital gains are one of the more favourable taxable profits, when compared to other types of investment gains. For instance, income is 100% taxable at your  marginal rate (which increases as your income increases), where as interest income (on, say, bonds) is also subject to 100% taxation at your marginal tax rate. Only half of any capital gain you receive is subject to your marginal tax rate. That means if you sold the home for a $50,000 profit, you’d only be taxed on $25,000.

I hope this helps, although I strongly suggest you seek out legal and/or financial expertise before launching into any plan of action.