How to save on capital gains tax when selling a rental property

How capital gains tax works

First, let’s run through how capital gains tax works.

A capital gain occurs when an asset, such as stocks, shares in exchange-traded funds (ETFs) and certain properties, appreciates in value over time and is sold for a profit. 

Canada taxes capital gains earned outside tax preferred accounts like registered retirement savings plans (RRSPs) and tax-free savings accounts (TFSAs), and on real estate that is not your principal residence. It is calculated by taking half of the appreciated earnings and charging the asset-owners’ marginal tax rate. Since tax rates vary by province, the amount of capital gains tax owed will depend on your province of residence. 

Capital gains tax applies only to homes that have not served as your principal residence, typically cottages, rental and investment properties. Since the property in question is a rental, Gary, capital gains will be made when the property is sold. 

What does this mean? It means that when making decisions about selling capital assets, it’s best to try to time the sale of these assets in years when income is lower. Why? Because the more income you earn, the higher your marginal tax rate and that means you’ll pay more capital gains tax in those years.

If your concern is that capital gains inclusion rate will change in the future, consider this: Though it has changed a handful of times since the late-1980s—and was once as high as 75%—the inclusion rate has sat at 50% since 2000. (The NDPs included speculation on an inclusion rate increase of capital gains tax to 75% in its election platform from last fall. And the recent NDP and Liberal agreement for a Liberal minority could mean we see this as part of the next federal budget or a future one.

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Capital gains when inheriting or buying a family property

The scenarios you are considering have different tax implications, Gary. But in both situations, it is your parents who will pay taxes on the property—whether you buy it or inherit it from them. 

Upon the first death, the property could pass tax deferred to the surviving spouse. On the second death, there would be a deemed disposition as if the property were sold at the then fair market value with capital gains tax payable accordingly. It may also be beneficial to mention that if the parents claimed depreciation (capital cost allowance), there would be a recapture (income inclusion and tax payable at regular tax rates) on this. This would apply if they sold it to him, transferred it to him, or on the second death.

Upon the first death, the property could pass, tax-deferred, to the surviving spouse. Upon the second death, there would be a deemed disposition as if the property were sold at the then fair market value with capital gains tax payable accordingly. If the parents claimed depreciation (capital cost allowance), there would be a recapture (income inclusion and tax payable at regular tax rates) on this. This would apply if they sold it to him, transferred it to him, or on the second death.

What about estate taxes and probate fees?

Quite often, decisions around whether or not to bequeath property through an estate are clouded by an overwhelming desire to avoid probate tax. 

In Canada, beneficiaries do not pay estate or inheritance tax. Instead, taxes are applied to the estate before it is distributed. Assets that pass through the estate are subject to probate fees or estate administration tax. These fees, often misinterpreted as taxes, are administered by the provincial courts. They pay for the standard court services that help verify and legally transfer a person’s estate to a chosen heir (and certain assets are exempt, such as property held as joint tenants or registered accounts with designated beneficiaries).

In the grand scheme of things, probate fees are relatively small. For instance, if your parents lived and died in Ontario, their estate would be charged probate fees of $0 on the first $50,000 of their estate, and $15 for every $1,000 above that. That would work out to $3,000 in estate administration fees for an estate worth $250,000—plus legal fees. 

Other factors to consider

Probate fees aren’t the only factors to consider. When an entire estate is left to an heir the final tax bill can be quite significant. All unregistered assets in all accounts are considered to be sold at fair market value (FMV)—this is referred to as a deemed disposition—and the capital gains of the assets is then taxed. (The fair market value less the cost base.)

One option is to transfer ownership of the property to an heir before death. This means the deemed disposition of the property is taxed using the owners’ current capital gains marginal tax rate. The tax could range from 16% to 27% depending on the capital gain, depending on the amount of the capital gain and income. But if a property is inherited, the capital gain is part of the entire estate, which could mean a higher tax rate for the estate, if there are many assets to include. 

How to determine fair market value

Your assumption is correct: The property’s FMV would be used to determine the capital gains tax owed, whether you decide to purchase the property or wait to inherit it. 

The Canada Revenue Agency (CRA) defines FMV as “normally the highest price, expressed in dollars, that property would bring in an open and unrestricted market, between a willing buyer and a willing seller… who are acting independently of each other.” 

This means that the FMV will be the amount for which the home is sold, whether that price is above or below what it might have been under different circumstances. Meanwhile, when distributed through an estate, a property is taxed at a FMV, as though it were sold right before the person’s death. 

However, that would not benefit you as the future owner. Acquiring the property for less than FMV means you are likely to pay more capital gains tax when you, in turn, eventually decide to sell. 

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Read more on capital gains: 

• 6 strategies to help you (legitimately!) pay less capital gains tax
• Principal residence exemption on death and capital gains with joint tenancy
• Slash capital gains with cost deductions
• Calculating expected returns on the sale of real estate

About Justin Dallaire

Justin Dallaire is the senior editor at MoneySense.ca. He was previously an editor at Strategy magazine and has a master’s degree in journalism from Toronto Metropolitan University.

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