Cutting down capital gains tax on real estate sales

Capital gains tax on real estate

One of the biggest complaints I’ve heard from real estate investors is the dreaded capital gains tax hit, Dennis.

Stock market investors don’t seem to be nearly as patient. Real estate is generally a long-term hold, while stock turnover tends to be more frequent. Real estate investors often end up with larger capital gains as well because real estate is such a large investment, with a market value worth more than many investors’ stock portfolios.

If a rental real estate investor has claimed depreciation, also known as capital cost allowance (CCA), all past CCA gets “recaptured” and taxed in the year of sale in addition to capital gains tax payable.

How much is capital gains tax in Canada?

A capital gain, Dennis, is 50% taxable. I want to clarify this because you referred to paying 50% capital gains tax. The tax rate for capital gains isn’t 50%. The income inclusion is 50% of the capital gain, with the gain taxable at your marginal tax rate. Even someone with a high income will only pay 27% tax at most on their capital gains (54% top tax rate in Nova Scotia times 50% inclusion rate). Many taxpayers will pay much less than 27% tax, depending on their other income for the year, tax deductions, and province of residence.

As an example, someone with a $25,000 income and a $100,000 capital gain in British Columbia in 2022 will pay about $12,616 of tax–less than 13%–on their capital gain. A $100,000 capital gain for someone with $75,000 of other income in Ontario will generate about $18,930 of tax payable–under 19%. And in Quebec, someone with $150,000 of income will pay about $24,981 of tax or about 25% on a $100,000 capital gain.

I don’t know if I’d call this robbery, Dennis, at least not in a Canadian context. Employment income, interest income and foreign dividends are all taxed at twice the tax rate of a capital gain. Capital gains also benefit from being deferred, whereas other income sources are taxable annually. So, on that basis, capital gains on real estate are pretty tax-efficient.

The main difference between gains on real estate and investments

One drawback with investing in real estate is that it’s all or nothing. If you want to sell $5,000 worth of a mutual fund, stock or an exchange-traded fund (ETF), you can do it. You can split your capital gains over two tax years by selling half one year and half the next. When you sell real estate, though, you generally have a large capital gain all in one year because it’s all or nothing. 

There is an exception. if you are paid over a number of years for the sale proceeds by the buyer. In this case, you can claim a capital gains reserve, but it must bring at least one-fifth of the capital gain into income each year, even if you are paid less than one-fifth of the proceeds. 

The problem with this strategy is that it is pretty uncommon to sell a property and not get paid 100% of the proceeds on closing. So, in practice, most real estate investors can’t claim a capital gains reserve. 

The transfer of a family farm or fishing property to a child can have a capital gains reserve over nine years to split the capital gain over a 10-year period. This is a more feasible capital gains reserve strategy.

How capital gains works for Canadians

Many other countries around the world tax capital gains more favourably. Some countries, like Chile, index your cost base over time, so that your capital gain is based on the inflation-adjusted capital gain. Other countries, like Singapore, don’t charge capital gains tax at all. Canada does exempt certain assets from capital gains tax, most notably qualified small business corporation (QSBC) shares and farm properties, subject to certain conditions.

You can claim capital losses on other investments against your capital gains, but that might not help you, Dennis, if you don’t have other non-registered investments with losses.

One good way to mitigate tax on a real estate sale is to defer registered retirement savings plan (RRSP) contributions or deductions in anticipation of a large income inclusion from the sale of real estate, especially if your tax bracket will be much higher in the year of sale. Or, if you’re like most people and have plenty of accumulated RRSP room, real estate proceeds provide plenty of cash to make RRSP contributions. Keep in mind that net rental income creates RRSP room, so even a retiree can accumulate RRSP room to be used against a sale (though they or their spouse must be 71 or younger to contribute).

Exemptions for capital gains tax

You mentioned, Dennis, an exemption on capital gains for commercial real estate. To clarify, there is a capital gains tax exemption for real estate used by a taxpayer to earn income from a business, but rental real estate does not qualify as a “business.” A better example might be a widget maker who sells a warehouse to buy a larger warehouse to build their widgets.

The U.S. has a capital gains exemption for “like-kind exchanges” that I won’t go into here, but the exemption can exclude a rental property from U.S. taxation if the proceeds are reinvested into another rental property, subject to conditions.

A common error made by people who opt for DIY tax advice is to do research on the internet and stumble upon outdated advice or, more commonly, U.S. advice. I’ve had a couple people ask me the same question recently about reinvesting their rental property proceeds–à la U.S. like-kind exchange–to avoid capital gains.

Another consideration for real estate investors who have real estate they want to pass along to the next generation is the potential of an estate freeze. There are ways to lock in a parent’s deferred capital gains and have future growth accrue to children.

Capital gains tax is payable eventually, Dennis, even if you don’t sell, as you are deemed to sell all your capital assets, including real estate, on your death. Death and taxes, as they say. So, eventually, your capital gain will be triggered, one way or the other.

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.

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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