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Protect Your Profit from Capital Gains Taxation


Tax-free profit on the sale of your principal residence is alluring, but it can be elusive. Under the federal Income Tax Act, property owners are entitled to tax-free profit on the sale of their principal residence, provided they follow the Canada Revenue Agency (CRA) guidelines.

Capital gain is the net difference between the cost of a property and the sale price.

Many Canadians take the tax-free status of their home for granted. To protect your principal residence exemption from capital gains taxation, seek professional advice before you act. For instance, if you made a profit on the sale of your cottage, but did not report it on your tax return, the CRA may consider the cottage as your designated principal residence and disallow tax-free status for your home.

You can also lose the exemption if you move frequently since that may be considered a business activity which does not qualify.

"Capital gains are the second least taxed type of income after the principal residence tax-free exemption," said Louis J. Sapi, CA, MBA, a founding partner of Toronto-based Hinchcliffe Sapi LLP, who agreed to participate in a Q & A session, drawn from reader queries and common concerns. Sapi stressed that the information provided in his answers does not replace professional advice and is not intended to provide a professional opinion or advice for a specific tax issue.

Contact professional tax and legal advisors to assess your particular situation and needs.

Question:

I lived in my home for 10 years then rented it out for 3 years while renting another place. What would the tax consequences be if I now decide to sell my home?

Answer:

If you move from your home, rent it out and then decide to sell after several years, tax rules permit you to designate your home as a principal residence for four years after a change of use. Write the Minister of Revenue a letter to "elect" to designate your home as a principal residence at change of use.

You must not claim any capital cost allowance or depreciation on the home while it is rented during the election period. The same rule would apply if you bought another home.

In that case, during the first four years, the new home would not be designated a "principal residence" if you elected your former residence (rental) property as your principal residence for those same years.

You and your significant other (including common law or same sex partner) cannot own two principal residences at the same time for tax purposes.

You must choose one during the over-lapping period after 1981. Professional advice will help you optimize tax benefits.

Question:

I used part of my home as an office and part as a principal residence. Will this impact on my claim for tax-free status if I sell my home?

Answer:

If you also use your home as a place of business and claim capital cost allowance, you would need to assess that portion of the home used for business and prorate the capital gain between the tax free principal residence portion and the business portion.

The business portion would be taxed at the current capital gains inclusion of 50 percent of the gain taxed at your marginal tax rate. If you use one room in your home as an office or nominal use of your home and do not claim capital cost allowance, you may be able to avoid any capital gains tax on the sale of the home.

The particulars of your case would need to be assessed by your tax advisor to ensure that you could avoid capital gains tax on the sale of this home.

Question:

I have a family cottage that I inherited while I owned a principal residence. The cottage has sky-rocketed in value since I got it and now I want to sell. Do I need to pay tax on this property and, if so, how much?

Answer:

The cottage property was inherited at its fair market value at the time of title registration in your name. If you renovated the cottage, additional costs would be added to the fair market value at inheritance.

The cottage value and costs of renovation would be the tax cost of the cottage for purposes of capital gains tax. In certain circumstances, you may also add property taxes paid for the cottage.

The proceeds you receive are reduced by the legal fees/disbursements and sales commission to the real estate agent, if any, and the tax cost of the property. Fifty percent of the capital gain is included in your income and taxed at your marginal tax rate. Contact a tax advisor to evaluate the net after-tax result before you sell.

Question:

What if I move back into the cottage? How long would I need to wait before I could sell it as my principal residence tax free?

Answer:

It does not matter if you move back in. The tax rule requires you to allocate the number of years that you held the cottage as your principal residence. Remember that only one principal residence can be owned after 1981.

If you own two residences during the same or part of the time, you will need to prorate the capital gain on the sales of each residence to the extent the residence sold was designated your 'tax free' principal residence. The necessary calculations are best carried out by those well versed in the tax rules.

Question:

I want to buy properties, rent them out and have the tenants pay the mortgage and expenses while I write-off net rental losses against my other income. Is there any tax problem with this plan?

Answer:

The properties need to be available for rent during the tax period. The tenants should be paying rents at prevailing market rates. Your children or relative tenants renting at discounted rates would increase net loss and raise a flag with tax authorities. You must add the costs of renovation to the value of the building during the period the rental unit is not available for rent.

The value of land, if any, is separated from the building value that is subject to capital cost allowance. You may reduce rental profit by the capital cost allowance for that particular rental property.

You may not increase a rental loss by capital cost allowance. Mortgage interest, not mortgage principal, would be tax deductible expense. Net rental losses would be deducted against other income.

Question:

I want to give my home to my son and his wife. What are the tax issues?

Answer:

If you give your home to your child, there would be a deemed disposition and capital gains tax would accrue only to the extent that the property was not your principal residence.

This is determined by counting the years you claim the gifted property as your principal residence plus 1 year, then divide this number by the total number of years you owned a principal residence. The prorated gain, if any, would be included in your taxable income at the current inclusion rate of 50 per cent and taxed at your marginal tax rate.

Complications could include the following:

  • Issues that may arise under family law that could result in the donated residence being attached by your former daughter or son in-law upon dissolution of your child's marriage. 
  • If your child is spend-thrift or possibly insolvent and subject to creditors, they may attach liens on the property that you donated. 
  • Transferring the property to a family trust may prove wise. Your tax and legal adviser and an estate planner can help you to decide on the best way to gift property to your children or to provide financial support to relatives and avoid unexpected disappointment. Yes, capital gains issues are complex, but the right professional advisor will help you find the best tax strategy to achieve your real estate and related goals, short- and long-term. Ask a lot of questions before you act.

Written by PJ Wade

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