What tenants need to know about buying out their rental

Q. I live in an apartment in a big home in Toronto. We have built a nice little community in this house and, as the landlord is getting older, most of us have “adopted” him as an uncle/grandfather. He doesn’t want the responsibility of looking after the house anymore and would like to see the home stay in our “family”—so is amenable to selling the home to us and another of the tenants. 

He would also like to reduce his capital gains tax. If we buy the house from him outright in a single purchase, he is looking at a $50,000 capital gains hit. Would it soften the blow if we structured the sale over five to 10 years? And, as the value of the house changes from year to year, would we/he need to re-calculate the capital gains as we go along?
–Douglas

A. While there are several considerations to work through in your situation, Douglas, this sounds like it could be an opportunity for everyone involved.

I want to point out the potential drawbacks of buying a property with your fellow tenant. When you buy real estate with someone else and borrow money to do so, you are on the hook for the full mortgage and mortgage payments. If they do not make their share of the payment, you will need to pay the full mortgage. The lender will not care if the debt is only “half” yours. 

You and your co-tenant would also have to come up with parameters for things like repairs and renovations. What happens if there is a repair and one of you cannot afford to do it right away? What about if one or the other of you wants to do a renovation or some other capital improvement, and the other disagrees? What if one of you wants to sell but the other does not? Decisions like these are hard enough for a married couple, but can be even more complicated for friends, family members, or other co-owners of real estate. A real estate lawyer may be able to help you with a formal agreement; or, at the very least, you may be able to develop some informal ground rules among yourselves. 

You and your potential purchase partner should likely own the property as tenants in common. This will allow you to leave your share of the property to whomever you wish if you die, rather than having it pass to the surviving co-owner.  

You asked about capital gains for your landlord. When an investor sells a rental property, they will often have tax to pay. If the property has appreciated since the original purchase, even after considering renovations, buying and selling costs, there will be a capital gain. Half of a capital gain is taxable at tax rates that often exceed 50%. That means a large capital gain could be taxed at 25% or more. 

For an aging rental property owner, it is worth noting that capital gains are triggered on death unless you leave a capital property to a surviving spouse. A large capital gain may be taxable at the same rate during one’s life as upon their death.

One opportunity that could apply for your landlord, Douglas, is to sell the property over multiple years. You mention a five- to 10-year period to help him with the tax hit. There is a concept called a capital gains reserve that allows a capital gain to be brought into income over up to five years if the sale is structured to take place over multiple years. It is uncommon in the case of a rental property, as the buyer and seller typically want the transaction to be finalized all at once. 

A capital gains reserve could be a possible strategy for your landlord. It may or may not save him tax, depending on his usual sources of income, but it is important to note there is an opportunity cost to him to not have his money from the home sale all at once, as well. 

You and he may structure the sale so that one-fifth of the purchase price is payable each year for five years, with interest payable on the outstanding balance. 

If the estimated tax is $50,000, I am guessing the capital gain is about $200,000. That may not be a large enough gain to warrant a five-year timeline for the transaction, but even doing it over two years with payments in December and January could help with his tax bill. 

You and the other tenant may be able to borrow the money from the bank to pay him back each year. However, there should be no need to recalculate the tax each year, as the sale price would generally be based on the price determined in the first year. For both your benefit and his, you would likely want the price to be determined upfront, rather than valuing the property and literally buying a part of it based on a new price each year. You and your co-owner would generally own 100% of the property upfront, but would simply pay the purchase price over multiple years. 

If you can determine a price between you and the landlord, you may not need real estate agents. Because real estate commissions are paid by the seller, this could save the landlord 5% or more of the transaction price, depending upon where you live. You could agree to split the difference to determine a fair value, and reduce it by a notional 5%. That price could be based on a valuation from a real estate appraiser or by mutual agreement.

If you chose to work with an appraiser, you may want to each get an appraisal and then use the midpoint between the two as the selling price, as an example. Your landlord may leave money on the table, especially given the hot real estate market, by not listing the property and selling to the highest bidder. He could potentially list the property and give you the first right of refusal to match the best offer. 

So, while there could be an opportunity for you to help your landlord reduce his capital gains tax, it may not save him a lot of tax, depending on his other typical sources of income. There are other things for all parties to consider related to co-ownership and valuation. Hopefully, you can all come to an agreement where everybody wins.

Jason Heath is a fee-only, advice-only Certified Financial Planner (CFP) at Objective Financial Partners Inc. in Toronto. He does not sell any financial products whatsoever.

MORE FROM ASK A PLANNER:

• Tax planning for Canadians who invest in the U.S.
• “Where do we pay income tax if we retire abroad?”
• When does it make sense to sell real estate in a larger city and buy in a smaller one?
• Tax implications of building a laneway suite
• New investment approaches for risk-averse Canadians

About Jason Heath, CFP

Jason Heath is a fee-only, advice-only Certified Financial Planner (CFP) at Objective Financial Partners Inc. in Toronto. He does not sell any financial products whatsoever.

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