Are you a landlord looking to sell your rental property? If so, you might wonder if there are ways to minimize the capital gains tax, which can take a massive bite out of your profit.
Generally, there’s no way to avoid paying taxes on capital gains from rental properties. However, you can employ a few legal strategies to lower your tax bill.
In this guide, we’ll explain how the capital gains tax works, how it impacts your tax liability, and what you can do to keep more of your money from the CRA’s clutches.
What are capital gains?
A capital gain on a rental property occurs when you sell it for more than you originally paid for it. In Canada, you pay tax on 50% of the capital gain you realize on the sale of your rental. The other half you can keep tax-free.
For example, if you bought a property to earn rental income for $400,000 and five years later sold it for $475,000, your capital gain would be $37,500. You would have to disclose this amount on your tax return and add it to all the other income you earned during the year. The CRA will tax 50% of the gain, which is $18,750.
When are capital gains triggered?
A capital gain is triggered when you sell your rental property. That means you’ll incur a tax liability only in the year you realize a profit from its sale. If you hold onto the property instead of selling it and its value appreciates, your gain is considered “unrealized,” so you don’t pay a dollar in tax.
If you rent out the home you live in, you may be exempt from paying the capital gains tax should you make money upon selling it. That’s because you can claim a generous tax break called the principal residence exemption.
Provided you periodically lived in the rental property during the year, and it functions as your main home, you’re entitled to the principal residence exemption for the whole property, including the section you rent out.
In addition, you must meet all the following conditions:
- Your rental portion of the property is secondary to its use as a principal residence
- You don’t perform any structural changes to your property to make it suitable for tenants
- You never deducted capital cost allowance for the rental portion of the property
If you don’t meet the above criteria, the part of your home used as a rental will be subject to the capital gains tax.
What influences the amount of capital gains tax owed?
Your federal income tax bracket is the primary variable that determines how much capital gains tax you’ll owe when you sell your rental property.
Under the Canadian tax system, the more money you make, the higher the tax bracket you fall under. That means you’ll pay increasingly more tax with each dollar you earn. And since the taxable portion of the capital gain from a rental sale counts as income for tax purposes, it can significantly impact your tax liability.
You could face a steep tax bill if you sold your rental during a year when you earned a lot of money, whether through your job, investments, or other sources. The taxable capital gain can push you into a higher tax bracket.
Of course, there are also provincial taxes to consider. Tax rates are the same for all Canadians at the federal level but vary at the provincial level. Some provinces impose higher rates than others, so the amount you pay will partially depend on where you live.
Tips to reduce capital gains tax on rental property sales
If you expect to earn a profit on your rental property’s sale, there are tactics you can use to minimize your exposure to the capital gains tax. Here are some to consider.
Sell your rental property at the optimal time
The higher the income you report for a given year, the more tax you can anticipate paying, given the progressive nature of Canada’s tax code. As a result, a massive profit on the sale of your rental could bump you up to a higher tax bracket, which means you’ll owe the CRA a sizable chunk of money.
Therefore, a financially savvy move is to delay the sale of your property to a year when your overall earnings are low, especially if you experience erratic swings in income. You’ll pay less tax overall, as your depressed earnings will place you in a lower tax bracket.
Contribute your earnings to your RRSP
Do you have ample contribution room available in your RRSP? If so, consider depositing some of the earnings from your rental’s sale in this tax-sheltered account.
Since you can deduct RRSP contributions on your tax return, you’ll reduce your taxable income, which means less of your profit will be up for grabs by the CRA. You can conduct this transaction provided the rental property was held in your name.
Remember that there’s a cap on how much money you can put in your RRSP each year. If you have little room left in the year you dispose of your rental, this strategy won’t do much to ease your tax burden.
Maximize key rental property tax deductions
The lower the capital gain following your rental’s sale, the fewer taxes you’ll pay since there’s less income to tax. As a result, it’s wise to report the lowest capital gain possible to the CRA while complying with tax regulations.
You can shrink your capital gain by decreasing your sales proceeds and increasing your adjusted cost base (ABC).
Sales proceeds are easy to comprehend: it’s simply the money you receive from the buyer. However, you can deduct any costs you incur from this amount to facilitate the sale of your property. These can include the realtor’s fee, legal fees, and a mortgage penalty charged by your lender. You can claim these costs as tax deductions, reducing the sales proceeds and resulting in a lower capital gain.
In addition to the original amount paid to purchase the property, the ABC includes related closing costs (legal fees, land transfer tax, etc.) and capital improvements you’ve made over the years. Adding these expenditures to your ABC will lower your overall tax liability, so don’t miss them.
Offset your profit using capital losses
A capital loss is the opposite of a capital gain. It occurs when you sell an asset you own, including a rental property, for less than you paid to acquire it. While not valuable on its own, a capital loss can be tremendously helpful in minimizing your capital gains tax.
You can use a capital loss to offset the capital gain on your rental in the current tax year down to zero.
For example, assume you earned a capital gain on your property’s sale of $70,000. Ordinarily, $35,000 of this gain would be taxable. But if you incurred a loss of $30,000 on another real estate property, you could apply it against the gain, which would leave you with a taxable capital gain of $20,000 ($70,000 – $30,000 x 50%).
Here’s a neat little feature of capital losses: you can carry them back to the previous three taxation years and forward indefinitely. In other words, you can use them to reduce a capital gain you realized three years ago or one that may occur in the future.
Use the capital gains reserve
The capital gains reserve allows you to spread out your capital gain over five years. Since it’ll be taxed over time instead of all at once in the current year, you’re less likely to be pushed to a higher tax bracket. As a result, you can avoid a potentially colossal tax payment in the year of sale.
However, you can use this option only if the buyer spreads their payments over several years. In most cases, you’ll receive the entire lump sum upfront. Learn more about claiming a capital gains reserve and whether you qualify.
Our final thoughts
If you profit from selling your rental property, you could face a tremendous tax bill, as you must pay tax on half of what you earn. Luckily, there are ways to minimize your tax liability, such as sheltering your profit in an RRSP, utilizing capital losses from other investments, and selling your property in a year where you expect to earn little income.
However, depending on your financial situation, some options may work better for you than others. If you’re contemplating selling a rental property, consult a tax specialist to help you choose the right strategy.
To learn more about how taxes impact your rental property and ways to minimize how much you pay, visit our Finance Management page
