To Exempt Or Not To Exempt – Tax Treatment On The Sale Of A Rental Property

As will be detailed, effective tax planning strategies surrounding the sale of a rental property should focus on proper compliance with the Income Tax Act (“ITA”). A seller who ensures ITA compliance will avoid a substantial fine and sanctions from the Canada Revenue Agency (“CRA”).

Tax Consideration for the Sale of Property: Capital Gains

The focus of this article is on the capital gains tax payable on the sale of a property. Although other considerations, such as real estate commission, legal fees, and moving expenses, are important, they have little to no tax implications beyond sales tax.

Capital Gains Defined

Capital gains on the sale of property can be defined as the difference between the property’s cost to the seller (broadly, the amount the seller paid to acquire the property) and the proceeds of sale. As a result, 50% of the profit made from selling a home will be subject to taxation, otherwise referred to as taxable capital gains, with the remaining 50% categorized as non-taxable gains.

Capital Gains: Individual vs. Corporation

For individuals, taxable capital gains on the sale of property are added to the seller’s taxable income and effectively taxed at the seller’s top marginal rate. For corporations, taxable capital gains are treated as passive income, which may be taxed at a higher rate when the corporation is a Canadian-Controlled Private Corporation (“CCPC”). However, corporations may add the non-taxable portion of capital gains to their Capital Dividend Account (“CDA”), allowing tax-free capital dividends to be paid to shareholders and partially offsetting the tax paid.

Capital Losses

Although real estate is generally expected to appreciate, property can still be sold at a loss. In such a scenario, 50% of the total loss becomes an allowable capital loss, which may be used to offset taxable capital gains in the same year, carried back three years, or carried forward indefinitely. Importantly, these allowable capital losses can only be applied against taxable capital gains, not employment income or other investment income. This treatment applies identically to both individuals and corporations.

Strategies to Minimize Capital Gains Taxes

There are two core strategies to consider for the minimization of taxes payable on the sale of a rental property:

(1) Capital Gains Reserve Deferral

Rather than receiving the entire sale price up front,  the sale can be structured so that the buyer pays over time. The ITA then allows the seller to spread the taxable gain over up to 4 years, with the first year used to claim the initial reserve amount. Through this deferral, the seller only has to include 20% of the taxable capital gains in their income each year, which can keep them out of the higher marginal brackets and reduce their total tax bill.

However, a reserve deferral arrangement is atypical in property sales: purchase prices are typically paid upfront, as sellers may not be comfortable absorbing the risk of default. Therefore, to ensure buyers do not skip out on their payments, a vendor take-back mortgage is commonly registered on title to provide a method of enforcement in the event of default.

(2) Expense Inclusion

The formula for calculating capital gains when selling a property is proceeds less adjusted cost base (“ACB”) less expenses incurred to sell. Every dollar added to your ACB is an untaxed dollar of gain. The ACB is the price paid to acquire the property plus capital costs (additions, acquisition costs, etc.), less any reductions such as capital cost allowance. Determining whether a cost is a capital cost or a regular maintenance expense typically requires considering whether the addition improves the property’s value or leads to a sale. As such, keeping records of any improvements made may be surprisingly beneficial for reducing capital gains, especially if sellers are spending tens of thousands of dollars on property improvements.

Tax Planning Misconceptions

Calling a Rental Your Principal Residence: Principal Residence Exemption

Some property owners may consider purchasing a rental property under their name, generating income from it, and designating it as a principal residence to take advantage of the principal residence exemption (“PRE”) to avoid all capital gains at the time of sale. As a tax planning strategy, this approach is erroneous, as the PRE is granted on a year-by-year basis. Since the PRE is annualized, a seller cannot take full advantage of the designation when it is time to sell their rental property if they have lived elsewhere for years.

In addition to the PRE’s year-by-year application, there is a physical component: the owner must reside in the property at least occasionally throughout the year. The CRA factually interprets whether this requirement was met. The PRE also includes provisions regarding the use of the property that may trigger tax consequences. If a seller moves into their own rental property, there is a deemed disposition of the property, triggering capital gains due to a change in its use. However, this does not occur when a rental property ceases to produce income, and the seller leaves it vacant.

Section 45(3) of the ITA may allow a taxpayer who converts a rental property into their principal residence to defer the deemed disposition that would otherwise arise on the change in use until the property is sold. In certain circumstances, the taxpayer may also designate the property as their principal residence for up to four years before they began ordinarily inhabiting it, provided that no other property was designated as a principal residence by the taxpayer, their spouse or common-law partner, former spouse or common-law partner, or child for those years. The election must be made by the taxpayer who owns the property.

Putting the Property in a Corporation to Avoid the Tax

Another potential approach a seller may take to avoid tax liability upon sale is to designate a rental property as a corporation’s principal residence. Whether the seller already oversees a corporation or incorporates a company for the designation, misuse of the principal residence designation is erroneous and can lead to additional taxes.

However, per sections 40(2)(b) and 248(1) of the ITA, a corporation does not count as an individual for the purposes of claiming the PRE. Therefore, when it comes time to sell a property, the corporate seller will be liable for the full amount of the taxable capital gains, if applicable, at a higher tax rate due to the general classification of capital gains as investment income. Otherwise, from a practical perspective, lenders may be generally more reluctant to provide mortgages to corporations due to their limited liability. In turn, this may require accepting higher interest rates and providing personal guarantees.

Therefore, using a corporation for rental property endeavours is typically only beneficial for those with multiple rental properties (and need liability protection against potential lawsuits), those with complex estate planning aspirations, and those who employ more than five full-time employees to manage the rental properties.

Conclusion: Tax Treatment of Rental Properties

There is no universally “best” approach to selling a rental property. There is only the approach that fits the unique circumstances, tolerance for risk, and timeline of each individual. What remains consistent across every case is that the ITA is unforgiving of after-the-fact improvisation. What may seem like a great decision that defers or minimizes taxes devolves into a poor decision that leads to fines and stress. Decisions about when to sell, how to structure payments, what to claim, and what to designate all have to be locked in before proceeding. For most sellers, consulting a tax-focused lawyer is beneficial. Structuring a plan with a lawyer based on logic and legislative foundations can lead to less time worrying about whether the CRA will send you a reassessment letter and more time on the things that matter.