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
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:
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:
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.
“The person who signs your paycheck controls your life. Shouldn’t that person be you?” ~ Robert Kiyosaki
I just saw this quote from Robert Kiyosaki’s facebook page today. Many of us know him as the author of “Rich Dad Poor Dad”. I am one of the millions of people who got inspired by his book “Rich Dad Poor Dad”.
I am almost embarrassed to admit that I had no idea what asset meant at one point, even though I was professionally trained to understand what assets and liability mean in school! Asset, according to Robert Kiyosaki, is something that generates cash flow and returns on a monthly basis.
Looking back in the last few years, this book, together with a few other things, had transformed my life entirely.
I left my 6 figure cushy corporate job, refinanced my principal residence and purchased a student rental the same year. Now we have a few of more investment properties, generating passive cash flow and steady return monthly. We even turned our principal residence into a partial asset – we are generating sufficient cash flow to pay off a big chunk of expense of our house.
The journey wasn’t always easy. There were moments I questioned why I left the cushy corporate job, especially when I was pregnant without mat leave pay and when I had to pay for my own prescription drugs.
At the most recent Mr Hamilton Inner Circle meeting, Quentin of Durham Real Estate Investing spoke about his property management philosophy and his new book. As always, he gave away so many great tips on dos and don’t on managing property. Even Robin got to learn a lot from him!
Quentin was a teacher before. He left his job, and big pension, to become a full time real estate investor.
He mentioned in his speech that there were so many benefits of owning your own business. One of the biggest advantages is the tax write-off you get.
If you use a portion of home to operate your business, you can write off that portion of the home office expense, subject to certain criteria set out in the Income Tax Act.
If you use your car to meet your clients, sometimes you may get reimbursed by the company for the mileage, but for the most part, the cost can’t be written off. Going to office everyday isn’t an allowable deduction in your tax return unfortunately. As a business owner, mileage for the purpose of earning business income is deductible.
Most importantly, for small business owners who do not need every penny from the business to support their daily lives, we leave as much earning within the corporation as possible and enjoy the low tax rate of 15.5%.
If you earn $250K with a job, you pay $96,610 tax, roughly 39% of tax in 2015. If you own your business, you pay $38,750 within the corporation.
There isn’t much of a difference, just $57,860 more if you leave the income in the corporation. Imagine what you can invest in using this additional $57,860 within the corporation!
It is a tax free and interest free government subsidized investment that all small business owners qualify for.
With a corporate job, the person who controlled my life had usually been my direct boss. Today it is myself.
The benefit of owning a business just outweighs all the employment insurance benefits and dental care benefits I missed.
Until next time, happy investing.
Cherry Chan, your real estate accountant
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.
I was at the Real Estate Investment Network (REIN) annual Authentic Canadian Real Estate (ACRE) event last month. One veteran investor said that she would not touch any real estate investment if it doesn’t provide at least 30% return annually.
30%! You heard me right!
Probably the only way to achieve this type of return is to invest in a highly leveraged investment vehicle (like real estate or margin account) or have your own business.
Even with a 30% return investment, you don’t really get a 30% return! Let’s remember we have an often forgotten investment partner – Canada Revenue Agency (CRA).
If you earn over $89K job income and above in 2015, CRA takes away about 43% and more on any of your return on investment. This leaves you with 17% after tax return.
17% after tax return is an awesome return, don’t get me wrong! But if there is a way to even lower the tax man’s share, wouldn’t it be great?
Most investors, who make over $89K annually, want to have their lower income spouse to report all these investment income. Since the lower income spouse makes little or no income, the marginal tax rate can be as low as 0% (if the investment income is below the personal tax exemption), leaving the full 30% return in your pocket!
This idea is wonderful but CRA doesn’t really like it. There’s something called Attribution Rule that can “attribute” all these investment income back to the higher income spouse – Meaning that the higher income spouse would still have to report all the investment income in the tax return. CRA imposes this based on the fact that the high income spouse is the one who makes the money for the downpayment and hence the income on the investment property should belong to the higher income spouse.
But there is a way out!
If the lower income spouse “borrows money” from the higher income spouse and pays the higher income spouse interest at a rate at least at the prescribed rate or an arm’s length rate (commercial rate), attribution rule will not apply.
Prescribed rate is a rate calculated by a formula in the Regulations under the Income Tax Act. Currently the prescribed rate is 1%. If you require expert legal advice from a Canadian income tax lawyer for analysis on the CRA’s tax collection powers, you may want to head to taxlawcanada.com and speak with their professionals about your concerns.
The higher income spouse has to report the 1% interest income on the personal income tax return. The lower income spouse can report this as a corresponding deduction against the property income.
So long as the property can provides more than 1% return, it is almost always worthwhile to setup the prescribed rate loan.
It’s also important to note that the interest must be paid within 30 days after the year end. If the taxpayer fails to do so, this loan will lose the status of the prescribed rate loan forever.
Let’s use a quick example to illustrate.
Say Spouse A earns $150K job income a year and Spouse B stays home to take care of the kids and has no income.
They purchase a student rental, which generates $10K of net income a year.
If Spouse A has to report the $10K in his tax return, he pays 48% tax on it. Leaving $5,200 after tax money.
Since Spouse B doesn’t have any other income, it will be ideal if she reports the entire income.
Using the Prescribed Rate loan strategy, Spouse B pays 1% of the loan to Spouse A. Say the property is purchased at $300K, downpayment 20% is $60K. 1% interest on the $60K is $600.
Spouse A reports $600 as income (instead of $10K), pays $288 tax ($600 * 48%).
Spouse B has no other income and reports $9,400 as income ($10,000 – $600). Pays no tax.
Combined tax liability from the investment = $288 + $0 = $288.
Tax savings = $4,800 (if reported 100% by Spouse A) – $288 (using Prescribed Rate Loan strategy) = $4,512 annual savings.
After tax cash = $10,000 – $288 = $9,712
Not bad, isn’t it?
This article is for information purpose only. Consult a professional accountant and lawyer before setting this up.
Until next time,
Cherry Chan, Your real estate accountant
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.
A couple days ago when I was driving to Toronto to visit a client, I heard Justin Trudeau’s radio comment about how much he doesn’t like the new Family Tax Cut and how it makes the rich richer. And he will definitely cancel this Family Tax Cut program as soon as he becomes the Prime Minister.
A quick disclaimer – I am not a political person at all. I don’t know much about Canadian politics. But I can tell you with my first hand experience from this tax season – majority of my clients get some tax benefits out of this program.
2014 was the first year Canadian families get to enjoy the newly introduced Family Tax Cut. Harper Government allowed families who have children under the age of 18 to split income between the higher income spouse with the lower one, up to a maximum of $2,000.
This brings an unexpected smile to many of my clients when they see their tax returns.
Like any government programs, it is not a one size fits all solution. Some get the benefit and some do not. Equality may be the priorities for some, but to an accountant, after seeing how much people have to pay to the government, I am just happy to see any tax cut!
We are almost down to the last stretch of the tax season and the 2015 federal budget was just announced today.
Contribution limit to Tax Free Saving Accounts (TFSA) is increased to $10,000 for 2015, from the current $5,500. If you have never contributed to your TFSA before, you can now contribute up to $41,000 cumulatively and accumulate your wealth tax free in your TFSA.
If you can invest in something that gives you 10% return a year, compound annually (meaning reinvesting what you earn back again to earn an additional 10%), this $41,000 you invest in today will make you a millionaire in 35 years.
Many people may disagree – the way I see it is that the government is encouraging us to take control of our own financial lives and put our retirement savings in our own hand.
This blog post entitled Where Do Your Tax Dollars Go? basically explains it all. 15 cents out of every $1 our Federal government spends go into Old Age Security and Guaranteed Income Supplement. “Increased spending on support for the elderly has been the largest single increase under the Conservatives and that is unlikely to change regardless of which party is in power.”
15.3% of our population was seniors in 2013. By 2030, the most conservative studies show that this figure will be 23.6%.
Who’s going to support the growing senior population? These numbers just go to show us that it is irresponsible to put our financial future in the government’s hands. Of course, that’s why we are real estate investors, taking control of our own financial future!
As a small business owner, I smile when I see the Federal tax rate on small business corporation going down from 11% (15.5% combined with Ontario tax) to 9% (13.5% combined with current Ontario tax rate) over the next few years. J More reasons to own your small business. And more reasons for our real estate investors to use appropriate tax strategies to minimize their tax liabilities.
One last item to us, real estate investors specifically, if your goal is to give a part of your wealth to a specific charity, now the Federal government offers more incentives for you to do so! If you donate your real estate investment gain to a charity, you get a tax break!
Until next time, happy real estate investing.
Cherry Chan, Your real estate accountant
P.S. If you are interested in making a great return in your TFSA account, send me an email.
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.
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