Recently one of my blog followers asked me this question: what is the best way to avoid paying tax on capital gain on sale of properties?
Sadly, unless you don’t make any gain on the sale of your real estate portfolio, you will have to pay tax.
Are there ways to minimize the tax on capital gain?
Absolutely, unfortunately there is no way to avoid such taxes. Unlike in the United States, we are not allowed to roll the capital gains into the next property and defer all the gains.
With careful tax planning and ownership structure, you can share the ownership with a lower income spouse or your children or your parents. That way at least a portion of the gain can be taxed at a lower average rate.
Of course, there can be concerns that the gain can be attributed back to the higher income spouse. Consult a professional before making any decision on the ownership structure.
Another way that can help to reduce the taxes is that you can have a vendor take back mortgage. You are allowed to take a reserve, also meaning deferring a portion of the capital gain on the sale of your real estate investment over a maximum of 5 years, if you agree to take on a vendor take back mortgage.
You are allowed to deduct a capital gain reserve in the first four years, so the reserve will be reported in subsequent years as capital gain. The formula to calculate the reserve is below:
This formula is also subject to a cap – which is calculated as a percentage of the capital gain:
Year of sale – maximum amount of capital reserve (deferral) = 80% of capital gain
1st year after sale – maximum amount of capital reserve (deferral) = 60% of capital gain
2nd year = 40%, 3rd year = 20% , 4th year after sale = 0% deferral
Let’s use an example.
Purchase price = $300,000
Sale price = $500,000
Capital gain = $200,000
Initial deposit = $100,000
Outstanding balance = $400,000 repayable at $80,000 per year for five years
So for the year of sale, the capital gain can be deferred is calculated
- Based on the formula: $200,000 x $400,000 / $500,000 = $160,000
- Maximum amount = 80% of capital gain = 80% x $200,000 = $160,000
Capital gain on the sale of property = $200,000
Deferral allowed based on the calculation = $160,000
Capital gain reported = $40,000; net capital gain = $20,000
Year 1 after sale, the capital gain deferral is calculated as follow:
- Based on the formula: $200,000 x $320,000 / $500,000 = $128,000
- Maximum amount = 60% of capital gain = 60% x $200,000 = $120,000
Capital gain required to be reported = ($200,000 – $40,000 (reported in year of sale)) = $160,000
Deferral allowed based on the calculation = $120,000
Therefore, capital gain reported = $160,000 – $120,000 = $40,000; net capital gain = $20,000
Year 2 after sale, the maximum amount of capital gain deferral is calculated as follow:
- Based on the formula: $200,000 x $240,000 / $500,000 = $96,000
- Maximum amount = 40% of capital gain = 40% x $200,000 = $80,000
Outstanding balance of capital gain to be reported = $200,000 – $40,000 – $40,000 = $120,000
Deferral allowed based on the calculation = $80,000
Therefore, minimum capital gain reported in year 2 after sale = $120,000 – $80,000 = $40,000
So on and so forth for year 3 and year 4 after sale.
You may wonder how this would help you save taxes. It will only help you if you are not making more than $220K annually on your personal tax return.
The Canadian personal tax system is a progressive tax system. This means that the more you make, the higher the tax rate and hence the more tax you will need to pay.
Say you make $50,000 job income, you pay about $8,570 tax in Ontario in 2015.
If you report the $200,000 capital gain in 2015, your total tax payable is $48,173, meaning $39,603 belongs to the capital gain.
Now, assuming the tax bracket stays the same for the next five years, every year, the tax payer reports $20,000 of net capital gain in addition to the job income of $50,000, a total of $70,000 taxable income. Total tax payable every year is $14,800, of which $6,230 is related to the net capital gain.
Over five years of reporting total tax payable related to the net capital gain = $6,230 x 5 = $31,150.
Saving is $8,453 ($39,603 – $31,150).
Now, if you own the properties in the corporation, the same deferral is available to the corporation given that the proceeds are being paid over the years. However, the tax rate on the net taxable capital gain you earn is still 46.17%. Whether you pay the tax today or pay the tax over five years, the tax rate is still the same.
Before you proceed to use this strategy, make sure you speak to us positioning yourself properly.
Until next time, your real estate investment accountant,
Cherry Chan, CPA, CA
This site provides general information on various tax issues and other matters. The information is not intended to constitute professional advice and may not be appropriate for a specific individual or fact situation. It is written by the author solely in their personal capacity and cannot be attributed to the accounting firm with which they are affiliated. It is not intended to constitute professional advice, and neither the author nor the firm with which the author is associated shall accept any liability in respect of any reliance on the information contained herein. Readers should always consult with their professional advisors in respect of their particular situation.