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?
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
Tony Ruggiero
Hello Cherry.
I cannot overstate how much impressed I’m by your web site (accidentally found when Googling for Capial Gain tax reduction tips). I found the blend of professional content and the family touch as impressive as humble.
My wife and I are selling a real estate property and will have capital gains.
I’m planning to use a captial gain reserve over a periof of four year to defer the taxable portion of the gains as you outlined on your above article.
My plan is…
2016-Year of sale-Receive 40% with sale & 60% VTB (Vendor Take Back)mortgage.
(File reserve amount of 60%
2017-1st year after sale-receive 20%of proceeds (file reserve amount at 40%)
2018-2nd year after sale- receive 20% of prodeeds (file reserve amount at 20%)
2019-3rd year after sale-receive 20% of proceeds (no more reserve required)
Questons: what do I do with interest reveneu generated our of the VTB each year?
Is this considered interest income earned, reportable and taxed ever year from 2016, 2017& 2018 at 100% or can it be in someway rolled in as capital gain income at only 50% tax. Can it be accumulated and paid at the end of each 20% instalment payment every year or even can it be paid with the 3rd and final 20% instalment on 2019.
We do not need the interest payment income now and neither do we need to report it as taxable income for the next three years since both my wife and I are working full time and this income would be taxed at a much higher rate.
I’ll retirre in late 2018 and any income in 2019 woul attract the last amount of taxes.
Could we offer a VTB to the purchaser at zero interest rate for some other concession such as increasing the purchase price which would equate to a higher capital gain ony 50% taxable or would the CRA still take to position that a VTB must recognize a certain amount of interest payment/income at some prescribed standard rate.
Lastly can my wife &I roll in any left over taxable capital gains each year as show above agains RRSP -we both have lot’s room to cover most if not the entire taxable capital gain.
In this case we would defer the payemnt of taxes to later years when our income would be less and attract less taxes.
Any comments on this matter will be very valuable to us and mostly appreciative.
with deep gratitude.
Thank you an congratulation on your perfect,ideal family – girl / boy.
What Every Real Estate Investor Ought to Know About Repairs & Maintenance Expense (Part 1) - Cherry Chan, Chartered Accountant, Your Real Estate Accountant
[…] When the property is sold at a gain, these “wear and tear” you have taken over the year would have to be taken into income. This is called recapture. You can find my discussion about capital cost allowance in this previous blog post. […]