If you own a rental property in Canada and plan to sell it, you will be subject to capital gains tax on any profit you make from the sale. However, there are ways to minimize the capital gains tax liability on rental property. The following will discuss strategies to help you minimize or avoid capital gains tax on rental property in Canada.
Tax Avoidance Versus Tax Evasion
It is important to point out that in Canada, tax avoidance refers to the legal use of tax planning strategies to minimize one’s tax liability within the boundaries of the tax law. Tax avoidance strategies typically involve taking advantage of tax deductions, credits, and exemptions available under the tax law. Tax avoidance is legal if the strategies used comply with the tax law and are not intended to deceive or defraud the government.
On the other hand, tax evasion is the illegal act of intentionally not reporting income, hiding income or assets, or providing false information on tax returns to pay less tax than is owed. Tax evasion is a criminal offence and can result in fines, penalties, and even imprisonment.
The key difference between tax avoidance and tax evasion is that tax avoidance is legal and involves using legal methods to reduce one’s tax liability, while tax evasion is illegal and involves intentionally breaking the law to avoid paying taxes.
Methods to Minimize Capital Gains Tax on Rental Properties
Following are a few ways to minimize the capital gains tax liability on rental property.
Take Advantage of the Principal Residence Exemption
If the rental property was your principal residence for some of the time you owned it, you might be able to take advantage of the principal residence exemption. This exemption allows you to claim the property as your principal residence for up to four years, even if you did not live there for the entire time you owned it, significantly reducing or eliminating the capital gains tax liability on the property. You should consult with a tax professional to determine if you are eligible for this exemption.
Make a Gifted or Inherited Property Your Principal Residence
If you have received a rental property as a gift or inheritance, you may be able to avoid or minimize the capital gains tax liability by making the property your principal residence. To do this, you must live in the property for at least one year and meet the other requirements for the principal residence exemption.
Incorporate Your Rental Property Business
Incorporating your rental property business can provide several tax advantages, including reducing your capital gains tax liability. When you incorporate, you transfer property ownership to the corporation, and the corporation becomes the legal owner. When you sell the property, the capital gain is taxed at the corporate tax rate, which is generally lower than the personal tax rate. You can also take advantage of other tax deductions and credits available to corporations.
Move Your Earnings to a Tax Shelter
Moving your earnings to a tax shelter, such as a Registered Retirement Savings Plan (RRSP), can help you reduce or avoid the capital gains tax liability on rental property. You can use the earnings from the property sale to contribute to your RRSP, which will reduce your taxable income and, therefore, your tax liability. You should consult a tax professional to determine if this strategy is appropriate for your situation.
Utilize the Capital Gains Reserve
Utilizing the capital gains reserve can help you reduce your capital gains tax liability on rental property. The capital gains reserve allows you to spread the capital gains tax liability over several years, which can help you reduce your tax bill. You should consult a tax professional to determine your eligibility for this strategy.
Offset Capital Losses
Offsetting capital gains with capital losses can help you reduce your capital gains tax liability on rental property. If you have incurred capital losses from other investments, you can use those losses to offset the capital gains from the sale of the rental property. You should consult a tax professional to determine your eligibility for this strategy.
Carry Your Losses to the Following Year
If you have incurred a capital loss from the sale of a rental property, you can carry that loss forward to the following year and use it to offset any capital gains you may incur. You should consult a tax professional to determine your eligibility for this strategy.
Understanding the Capital Gains Tax in Canada
What Is Capital Gains Tax In Canada?
Capital gains tax is a tax on the profit from selling an asset, including rental property. The capital gain is the difference between the original purchase price and the selling price of the property.
How To Calculate Capital Gains Tax On The Sale Of Property
To calculate the capital gains tax on the sale of rental property, you will need to follow these steps:
- Calculate the adjusted cost base of the property, which includes the property’s purchase price, the cost of any improvements you have made to the property, and any selling costs.
- Subtract the adjusted cost base from the sale proceeds to determine the capital gain.
- Calculate 50% of the capital gain.
- Add 50% of the capital gain to your annual income and pay tax on it at your marginal tax rate.
How Capital Gains Tax Works
When you sell a rental property, you must report the capital gain on your income tax return. The capital gain is calculated by subtracting the property’s adjusted cost base from the sale proceeds. The adjusted cost base includes the purchase price of the property, the cost of any improvements you have made to the property, and any selling costs.
You must pay tax on 50% of the capital gain at your marginal tax rate. So, for example, if your marginal tax rate is 35%, you will pay35% on half of the capital gain (or 17.5% tax on the full capital gain).
Rental Property Capital Gains FAQs
How much tax do you pay when you sell a rental property in Canada?
When you sell a rental property in Canada, you must pay tax on 50% of the capital gain at your marginal tax rate.
How long do I have to live in my rental property to avoid capital gains in Canada?
To minimize capital gains tax in Canada, you must designate the property as your principal residence for each year you own it. The number of years that you can claim the principal residence exemption is limited to four years.
Can you have two primary residences?
You can only have one primary residence at a time. However, you may be able to claim a second property as your principal residence for up to four years if you meet the requirements for the principal residence exemption.
What is the six-year rule for capital gains tax?
The six-year rule for capital gains tax in Canada allows you to claim the principal residence exemption for a property you did not live in for the entire time you owned it. To do this, you must designate the property as your principal residence for each year you own it and meet the other requirements for the principal residence exemption.
There are several strategies that you can use to minimize the capital gains tax liability on rental property in Canada. However, the effectiveness of each strategy will depend on your specific situation. Therefore, consult a tax professional to determine which strategy is right for you.
Use The Smith ManoeuvreTMto Reduce Your Tax Bill
This article discusses ways to minimize or legally avoid taxes upon selling an investment property. However, while you own the rental, consider using it to significantly reduce the time it takes to pay off your expensive principal residence mortgage. Via cash damming, or the Cash Flow Dam accelerator, you can use your rental revenues to cycle through your mortgage, significantly reducing your tax bill and taking 10, 15 or more years off the time you have to make mortgage payments
