Calculating expected returns on the sale of real estate

The ROI on real estate and calculating capital gains

Thanks for your question, Yan. There are a couple of different issues at play here, so I’ll start by clarifying a few points about capital gains. Next I’ll explain how I would approach a target sale price for real estate, as well as for other investments. 

First off, since you refer to your “main resident property.” I want to be clear that the profit you earn on the sale of a property—called a capital gain—is exempt from income tax when that property is your principal residence. 

What qualifies as a principal residence?

A principal residence can be a house, condo, cottage or other property you own and occupy. There may be limitations to this exemption, such as if the property is larger than 1.24 acres, if you owned and sold other real estate during the same period, or if you rented out the property to tenants. You can have only one designated principal residence at a time.

Can you flip a house and claim principal residence? 

Another important consideration may apply if you are “flipping” real estate. That is, if you sell real estate that you did not intend to live in that was primarily a capital investment that you purchased and sold to try to make a profit. 

According to the Canada Revenue Agency (CRA), the principal residence exemption requires that “the housing unit must be ordinarily inhabited in the year by the taxpayer or by his or her spouse or common-law partner, former spouse or common-law partner, or child.” 

If you flip a property you did not intend to live in, like a pre-construction house or condo, you may be subject to full taxation of the proceeds as business income. This can include an assignment sale, when a property is sold before the construction or official sale—a process also known as shadow flipping. The proceeds may also be subject to GST/HST, as well as income tax. 

How to claim the sale of a house on a tax return

Assuming this property qualifies as principal residence, Yan, you will not pay any capital gains tax when you sell it. But you still need to report the details of the sale when you file your taxes—a change that was introduced in 2016. This applies not just to your property in Ontario, Yan, but to principal residences in other provinces and territories, as well. 

The information goes on Schedule 3 of your income tax return, on accompanying Form T2091 (or T1255 for a taxpayer who died in that tax year). You report the proceeds of disposition (the amount you sold the property for); your outlays and expenses related to the disposition (any real estate commissions and legal fees you paid); your adjusted cost base (what you paid for the property plus some additional expenses—more on this below); the years you owned the property; and the years you are declaring it as your principal residence. 

Calculating the capital gain

To determine the capital gain on the sale of a property, subtract the adjusted cost base (ACB) from the net proceeds of the sale. The ACB generally includes:

1. What you paid for the property (sale price)
2. Land transfer taxes
3. Legal fees upon purchase
4. Any capital costs, such as renovations, additions, or improvements to the property, that you paid for throughout the years of ownership

Mortgage interest and property taxes are typically not added to your adjusted cost base. There may be an exception for a property that is flipped, so that these costs may reduce the business income inclusion on your tax return. Otherwise, these expenses are considered personal costs of ownership. (In the case of a rental property, however, you can deduct interest and property taxes annually from your taxable rental income.)

The net proceeds on the sale of a property are more straightforward: that’s the amount you sold the property for, minus any real estate commissions or legal fees you paid on the sale. 

Now you can calculate the capital gain:

Net proceeds – ACB = capital gain

In terms of tax, if the property is not your principal residence, 50% of the capital gain is taxable at your marginal rate. As previously mentioned, there is no capital gains tax on a primary residence.

Setting a sale price for a real estate profit

What list price will give you a reasonable profit on the sale of your property, you ask. I think you may be coming at the question from the wrong direction, Yan.

Your house is worth only what someone else will pay you for it—which depends on factors such as market values, availability of similar properties in the area, interest rates and the general outlook of the economy. I would work with a realtor to determine a reasonable target sale price to start. 

Some realtors list properties for lower than the target sale price to boost interest and generate multiple and competitive offers. Some list above target striving for more money. Others list at target and hope for the best. 

Regardless, I would base your target sale price on the highest amount the market will bear, as opposed to choosing a number that is X% greater than what you’ve spent on the property over the years. 

Stock investors often fall into a similar trap of focusing too much on what they paid for an asset to determine when or if they should sell. In some cases, they’ll hold onto a losing stock longer than they should in the hopes of recovering their initial investment. 

The same can happen with real estate. If you need or want to sell, and can better use the proceeds to invest in other assets, pay down debt, or do something else with the money, I would not let your purchase price or any other notional target impede your sale plans.

How much can you earn selling real estate 

The real rate of return on Canadian residential real estate has been about 3.9% annually over the past 30 years. (That’s 3.9% annual appreciation in excess of inflation.) In the U.S., the inflation-adjusted growth rate on residential real estate has been just 0.4% over the past 130 years. 

While I would not use this data to determine how much to sell your home for, I would suggest that readers use figures like these when setting their expectations for real estate growth for investment or retirement purposes.

For example, investors thinking about going “all-in” on real estate (and forgoing registered retirement savings plans (RRSPs), tax-free savings accounts (TFSAs) and the stock market) should keep in mind that in a 2%-inflation environment propped up by low interest rates, appreciation on residential properties should probably be 2% to 4%. 

The same goes for those who are buying or already own a rental property where the annual rental income is only 2% to 3% of the property value, since they’ll need a heck of a lot of appreciation to make that investment pay off. 

When it comes to selling a real estate property, I would focus much more on considerations like that than on what I paid for the property in the first place. In your case, Yan, if you want to sell, you should base your target price on what you hope buyers will pay, instead of what you have paid into the property over the years. 

Ask a Planner: Leave your question for Jason Heath »

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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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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