Tax rate on real estate capital gains | Tax impacts on the disposition of a rental property held by an individual

If you are thinking of selling a rental property, there is a good chance that this disposition will result in tax liability. This article will help you determine the tax implications of selling a rental property when it is owned by an individual. 

1.  TERMINOLOGY

§ CCA: Capital cost allowance

§ UCC Undepreciated capital cost

§ ACB: Adjusted cost base

§ Net PD : Net disposal price

2.  ASSUMPTIONS - SALE OF RENTAL PROPERTY

Let's take for example the case of an individual who owns a triplex used solely for rental purposes and whose attributes are as follows

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CAUTION: If you are a co-owner of a building, it is important to consider only your respective share in the building to determine the tax impacts.

You will notice that we have split the initial purchase price to allocate the purchase price between the land and the building. This step is particularly important for determining the tax attributes of the building, and is too often forgotten in practice. To determine the allocation between the land and the building, it is sufficient to opt for a fair and reasonable method, either by looking at comparable, by establishing the prorata yourself according to the facts specific to the building or, in the absence of any relevant information to establish it, by relying on the allocation that is made on the data of the land roll.

CAUTION: Even if a reasonable and acceptable allocation method is used, it will not be possible to make a terminal loss on the building when there is a capital gain on the land.

3. CALCULATION OF TAX IMPACTS

The tax impacts of disposing of a rental property are calculated in two stages:

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   i.     The calculation of recapture of depreciation;

  ii.     The calculation of the capital gain.

3.1 CALCULATION OF RECAPTURED DEPRECIATION

When you sell a depreciable property, a recapture of capital cost allowance can occur if the proceeds of disposition of the property are more than the UCC balance of the class of the property at that time[2]. The UCC is the capital cost of all your depreciable property in a class, minus the total CCA [3]you claimed in previous years.

To calculate the recapture amount, subtract the balance at that time ($192,000) from the lesser of 

             i.     The amount of the capital cost of the building ($224,000); or

            ii.     The net disposition price of the building ($285,000);

In our example, the recapture amount would be $32,000, or ($224,000 - $192,000). If you have a recapture of capital cost allowance on the disposition of a property, you have to add the amount of the recapture to your income for the fiscal period in which the disposition occurred. 

CAUTION: If the proceeds of disposition are less than the UCC balance at the time of disposition, a terminal loss may be realized. This type of loss is deductible against any other type of income (however, see our comment in the previous section on realizing a terminal loss).

3.2 CALCULATION OF THE CAPITAL GAIN ON THE SALE OF THE BUILDING

The calculation of the capital gain realized on the disposition of a building is relatively simple. It is the total amount of the transaction (net disposition price) less the total ACB

In our example, the realized capital gain will be $102,000, i.e. $41,000 for the land and $61,000 for the building:

    Land:Net DP ($143,000) less ACB of land ($102,000) = $41,000;

    Building: Net PD ($285,000) less ACB of building ($224,000) = $61,000.

Note, however, that only 50% of the realized capital gain is taxable. In our example, the total realized capital gain will be $102,000 and therefore the taxable capital gain will be $51,000.

3.3 CONCLUSION: TAX IMPACTS ON THE CAPITAL GAIN FOR A REAL ESTATE SALE 

In conclusion, the taxpayer will have to include in his other income an additional amount of $83,000 in the year of the disposition of the building, namely :

    An amount of $32,000 as a recapture of amortization; and

    An amount of $51,000 as a taxable capital gain.

The taxes payable on this amount will depend on your taxable income bracket in the year of disposition. Below, I provide a summary table of the marginal tax rates for 2021 for an individual earning, among other things, employment income, business income or rental income:

Finally, note that the mortgage balance does not play a role in determining the tax impact of disposing of an immovable. This data is only relevant to determine the net liquidity that will remain following the sale of the building and following the payment of all debts and taxes related to the building: 

The net PD ($428,000) minus the debts ($200,000) minus the estimated taxes (say, $42,000), will leave you with a net cash flow of $186,000.

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4.  OTHER CONSIDERATIONS

The information presented above is intended to be a quick overview of the tax impacts of the disposition of a rental property by an individual. However, certain additional elements may also need to be analyzed in order to properly determine the tax consequences in such a situation. The following elements can have a significant impact on the tax consequences of the disposition of a building:

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i. Did the owner live in any of the apartments as a principal residence?

If so, it may be possible to exempt, in part, the taxes that would be payable in respect of the unit you lived in as your principal residence.

ii. Has there been a partial or complete change of use of the property since acquisition?

In other words, has the purpose of the building changed along the way to become a personal property rather than an income-producing property or, conversely, to convert the personal property into an income-producing property? If a change of use has occurred, certain tax elections may be relevant to minimize the tax consequences of that change of use.

CAUTION: when a change of use occurs, whether partial or complete, you are presumed to have disposed of, at market value, the portion of the building affected by the change of use. If no tax election is made at that time, significant tax charges may result.

iii. Was the property sold to a person with whom you are not at arm's length (children, brother/sister, parents, etc.)?

If so, it will be important to ensure that the transaction is at fair market value in order to avoid unwanted tax impacts on both sides.

iv. Is any part of the building commercial in nature (commercial premises) or have you carried out a short-term rental activity (AirBnB type)?

If so, sales taxes (GST and QST) may apply, in whole or in part, to the sale of your property.

v. Will you finance your buyer?

If so, this may allow you to obtain certain tax benefits[4].

Each situation has its own particularities and, in some cases, certain strategies can be used to minimize the tax impact of the sale of a property. Don't hesitate to contact us for more information.

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vi. What are the five main elements that can be included in the cost base of a CGT asset?

1. The money paid, and the market value of any other property given to acquire the asset.
2. The incidental non-deductible costs of acquiring the asset or of the CGT event, such as remuneration for professional services, transfer costs, stamp duty, advertising costs, and marketing expenses.
3. Capital and non-capital costs of ownership such as interest and rates which are not deductible (for assets acquired after 20 August 1991).
4. Expenditure of a capital nature incurred to increase or preserve the value of the asset, or that relates to installing or moving the asset.
5. Expenditure of a capital nature incurred to the extent to which it was incurred in establishing, preserving or defending the taxpayer's title to, or a right over the asset.

 Learn more about CGT on property development here.

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[1] Capitalizable expenditures represent expenditures that are to be added to the cost of the building rather than expensed. In summary, expenditures that are intended to increase the capacity of the building or its useful life are capitalized (replacing an oil heating system with an electric system is an example). Current expenditures are those that restore the building to its original condition (e.g. same product line).

[2] Generally, each building costing more than $50,000 has its own depreciation class. In this case, this would be the only property included in that class.

[3] If you would like to learn more about CCA, please see our other blog on the subject: https://www.barricad.ca/blog/deduction-pour-amortissement-immeuble 

[4] If you want to know more about this, please visit our other blog on this subject :: https://www.barricad.ca/blog/vente-dun-immeuble-pourquoi-financer-lacheteur