How to calculate capital gains and losses on rental property

Q.  I am selling my rental property, which I lived in for six years before renting it out the last five years. I do not own another home and I am selling this one for less than market value because some horrible renters caused the property to become run down. My mortgage principal is $263,000 and I am selling privately (to avoid real estate commission costs) for $325,000. What do I need to know in regards to capital gains reporting and taxes?
– Chris

A. When you convert a home that is your principal residence into a rental property, this is considered a change in use. You are deemed to dispose of the property at the fair market value at that time, and immediately reacquire it. Future capital gains may then apply based upon subsequent growth in the property’s value.

Under subsection 45(2) of the Income Tax Act, it’s possible to continue treating a principal residence converted to a rental property as your principal residence for up to four years. There are, however, several conditions:

1) You must report the subsequent rental income;

2) You cannot claim depreciation (capital cost allowance) on the property as a tax deduction;

3) You cannot designate another property as your principal residence;

4) You must be a Canadian resident.

There may be situations where the four-year limit can be extended if you, or your spouse or common-law partner, have relocated for work.

In order to make a 45(2) election, you must send a letter to their Canada Revenue Agency tax centre, either attached to your tax return, or mailed after filing your return electronically. The letter should confirm that you wish to make an election under subsection 45(2) of the Income Tax Act, and describe the property.

If you choose not to make a 45(2) election, the sale of your rental property will result in either a capital gain or a capital loss, and possibly an income inclusion called recapture.

If your property is sold for less than the purchase price, you will have a capital loss. A capital loss can be deducted against capital gains for the current year. If you have no current year gains, you can carry a current year capital loss back to any of the three previous years if you had capital gains reported on your tax return. Otherwise, you can carry capital losses forward indefinitely to use against future capital gains.

If you were claiming depreciation (capital cost allowance) as a tax deduction against your net rental income, Chris, these previous deductions are added to your income in the year or sale. This is called recapture, as I mentioned above. Having to pay tax despite a loss on the sale may seem like adding insult to injury, but remember these previous deductions saved you from paying tax on your net rental income in previous years.

Your question suggests that you are worried about paying capital gains tax because the expected sale price is higher than your remaining mortgage principal; this is a common misconception with rental properties. The capital gain has nothing to do with the mortgage. Whether you have a mortgage or not, the capital gain is based primarily on the original purchase price. I say “primarily” because there are some adjustments that apply, which will either reduce your capital gain or increase your capital loss.

When you acquire a rental property, there may be acquisition costs such as legal fees and land transfer tax. These costs are added to your adjusted cost base or tax cost for capital gains purposes. In your case, Chris, these wouldn’t apply, as your adjusted cost base would just be the fair market value when you converted your home from a principal residence to a rental property.

Renovations and capital improvements made over time would also increase the adjusted cost base of a rental property, if applicable.

When selling a property, the selling costs like legal fees and real estate commission, would all be deductible expenses, also reducing the capital gain or increasing the capital loss.

In summary, Chris, it sounds like you may have a capital loss to claim against current, past or future capital gains on other investments. You may have to pay tax on recapture of depreciation (capital cost allowance) claimed while you rented out your home.

It also sounds like you have a rental horror story to tell, and one that aspiring landlords should consider as an often-overlooked risk of owning a rental property.

Jason Heath is a fee-only, advice-only Certified Financial Planner (CFP) at Objective Financial Partners Inc. in Toronto, Ontario. 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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