Tax profit as income or capital gains?

Your home can be an effective tax shelter, but if you use the wrong strategy, your plan can backfire.

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From the June 2013 issue of the magazine.

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Moncton (A-)Recently, I chatted with a couple who, after seven years, sold their century-old row house in Toronto’s Trinity-Bellwoods neighbourhood. With grins plastered on their faces, they happily declared the best part was their sizeable profit—they sold for $300,000 more than they originally paid—was completely tax-free.

This got me thinking. Every week we get questions from readers regarding capital gains taxes as they apply to the sale of property. Most people are aware there’s an exemption for your principal residence, but the nuances muddle us up. And let’s face it, when it comes to taxes, there are a lot of nuances.

Is it a capital gain or income? When you buy an asset—whether a house, art, or a stock—you expect it to appreciate in value. If you eventually sell the asset for more than you paid, that increase in value is normally considered a taxable capital gain by the Canada Revenue Agency (CRA). Capital gains are taxed at only half your marginal rate. But not every sale gets this treatment. Remember those nuances?

For example, if a nurse buys a condo, rents it out for four years, then sells it for a net profit of $100,000, she would pay capital gains tax. That’s because being a landlord was not her primary source of income. However, what if that same nurse bought several pre-construction condos and sold them before taking possession? According to the CRA, that’s a different story. If a person “habitually does a thing that is capable of producing a profit,” then that profit is considered business income, which is taxed at twice the rate of capital gains.

The bottom line: profits from the sale of real property don’t immediately qualify for preferential capital gains tax treatment.

Residence rules. For most of us, the real concern is how to use the principal residence exemption (PRE) effectively when it comes to selling property. To qualify for the PRE the property must be a house, cottage, condo or trailer (other categories qualify, but check first with CRA), and you or your family must have “ordinarily inhabited” the property. “This doesn’t mean you live in the property 365 days of the year, but you can’t be a visitor either,” explains Albert Luk, lawyer with Devry Smith Frank LLP, a Toronto law firm.

If you have more than one property that meets these criteria, you have a good problem, says Luk. “Deciding which to designate as a principal residence can be complicated, but it can also produce significant savings.”

For instance, if you’re in a 21% tax bracket in retirement and sell your cottage for a net profit of $400,000 and your principal home for a net profit of $250,000, you would pay approximately $42,000 in tax. Yet if you designated your cottage (rather than your house) as your principal residence, you could save close to $16,000 in tax.

Leave it to your kids. “Capital gains and property rules sound simple,” says Luk, “but in practice they get very complicated the more you drill down.” One such complication occurs when parents decide to give title of their home to an adult child.

By adding your child to the deed you’re initiating a “deemed disposition,” says Luk. That’s another way of saying the CRA considers the change in ownership to be a sale: by making your child a co-owner you have effectively sold 50% of the property at fair market value. While you will qualify for the principal residence exemption—meaning you don’t have to pay tax on the deemed disposition—your child will be on the hook for any capital gains from the time he or she is added to title until the home is sold. (This assumes they already own their own principal residence.)

Another option is simply to leave your home to your children in your will. Your estate won’t pay any capital gains taxes on this transfer, and your children will be responsible only for any capital gains from the date they inherit the property to the time they eventually sell it.

Flipping out. Creative armchair accountants may see the PRE savings and wonder, “If one is good, maybe more is better.” But think hard before you try to exploit this tax rule. In a recent case, decided last September, the CRA forced a taxpayer named Sylvie Giguère to fork out $11,400 in penalties and tens of thousands in back taxes for trying to game the system. Giguère and her spouse had bought, renovated, lived in and sold seven homes within six years, and claimed the PRE on each. The CRA denied the exemptions, stating that the profit was actually business income. “The CRA is cracking down on people who are moving away from simple capital gains to producing income by flipping real estate,” says Luk. “You can’t have your cake and eat it, too.”

Romana King is a senior editor at MoneySense. To order the MoneySense Guide to Buying & Selling a Home, go to moneysense.ca/books

Read more from Romana King at Home Owner on Facebook »

25 comments on “Tax profit as income or capital gains?

  1. I don’t understand. How come the couple in the example profited 300k tax free??? Was it not a capital Gain or Income? #newbie

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    • because the house they sold is their principle resident. So it it tax free according to PRE.

      Reply

      • Henry:
        Should be that simple, right? Unfortunately, the CRA is clamping down on what it deems as real estate investors: People who earn an income by buying and selling real estate. The problem is not everyone that’s coming under the CRA’s scrutiny IS earning an income this way, however a great deal are and these are the taxpayers that are not claiming the profit as income, but as capital gains. The CRA clearly states that real estate appreciation is considered a capital gain IF it is not part of your primary income stream. This is one situation where a good accountant really is worth their fee.

        Reply

  2. I purchased a home in April of last year. It has been my principal residence since, and I have done a lot of renovations. I recently took a great opportunity for a new job that was unexpected, but It’s about 60kms from my home. Now I want to sell my house and move closer to work, and with all the renovations I expect to make a profit when I sell. Will I need to claim capital gains? Or would I be exempt?

    Reply

    • just make sure you have a copy of the letter of employment to prove to CRA the reason you sold the house. You will be fine.

      Reply

  3. MY PARENTS PURCHASED A HOME TO LIVE AND RAISE THEIR FAMILY IN 1976 (AS ANY NORMAL FAMILY) WITHOUT ANY THOUGHT AS AN INVESTMENT,OR EXPECTING HOME PRICES TO GO UP.IN THEIR MIND.JUST A HOME AS A RESIDENCE FOR PRIDE AND HAVE A PLACE TO LIVE AND RAISE FAMILY.
    THIS IS A PRINCEPLE RESIDENCE..
    HOW WOULD THIS EFECT US UPON SELLING THIS HOME IN TORONTO.

    Reply

    • If you are not in the business of buying and selling homes, than there is no need to worry, the house would be considered a principal residence (granted that they do not own other homes and have already placed the principal residence on one of them) and there is no need to worry. Just make sure you are very clear and have the appropriate proof (paper work) for anything you do.

      Reply

  4. How the real estate or the lawyer report the capital gain from the sale of the house? Is there a form (what number) for reporting?

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  5. I lived in my house prior to getting married for over 20 years. (I then moved into my husband’s house.) I kept My house and rented it out. What happens if I decide to move back into my house? Would it now become my principle residence and be exempt from capital gains if it gets sold?

    Reply

    • Hi Claudette,
      Yes. If you own a home, live in it as your principal residence, then move out and rent it out before moving back in and making it your principal residence you will be subject to capital gains tax throughout this time. But you’ll be able to shelter the gains from tax while the home was your principal residence. Say, for example, you bought your home in 1975 and lived in it until 1995, at which time you got married and moved into your husband’s home, before renting out the home you bought in 1975. You would have a deemed disposition in 1995 and would owe tax, but you’d be sheltered from the tax because it was your principal residence. If you rented out this home from 1995 to 2000, and then moved back into the home in 2000, you would owe capital gains tax (tax on the appreciated value of the property based on the rising value from 1995 to 2000), however you would not actually owe this tax until you sold the house. If you then lived in this home from 2000 to 2015, as your principal residence, and then sold it this year, the capital gains from 2000 to 2015 would be sheltered from tax based on the principal residence exemption.
      Hope this helps.

      Reply

  6. My parents bought a four units town house for $210000.00 and now the price is about $700000.00. My parentes lived in one unit and rented the other three units. My parents had put my name and one of my seven brothers name on the deed of this property when they first bought it. My mother had passed away in 2013 and my father passed away last month. My father had paid of the property two months before he passed. Now I would like to buy the property and have my brother’s name remove from the title. since we must share equally with all eight of us… Who will have to pay for the capital gain tax and how much? Please help.

    Reply

  7. MY husband and I separated in 2006. I stayed in the primary home, valued then at $875K. He moved to our rental property, then valued about $300.
    I want to go forward with a divorce.My understanding is that we split based on the 2006 values. He is concerned he will have to pay capital gains based on todays’ values.
    Would the gain not be calculated based on the appraised values during the time it was rented only, . Would property #2 become his primary residence once he was living in it?

    Reply

    • Cathy,
      You will need to talk to a lawyer for specific advice on your situation. I can only offer general advice.

      When it comes to divorce and property ownership there are different rules and laws at play.
      If you and your husband split in 2006, the division of your assets — from a legal perspective — would be based on 2006 values. However, if you go to sell a property or if you have a deemed disposition, you are responsible for the taxes up until the day of the disposition.

      So, if your husband vacated the family home in 2006 and moved into the rental unit that year, he would have a deemed disposition based on 2006 values — meaning any appreciation of the family home until 2006 would be sheltered under the principal residence exemption. However, any appreciation from 2006 to 2015 would NOT be sheltered. Any appreciation on the rental property from 2006 to 2015, however, would be sheltered for your husband, but not for you.

      Of course, this boils down to whether or not you are selling the home or simply settling your finances based on a finalized, legal divorce. A lawyer may have a legal way around the capital gains your husband will owe from 2006 to 2015 on your former marital-home.

      Reply

  8. My daughter and I are co-owners of a trailer which we both live in. She also owns a condo which her mother (who owns 1%) lives in. She, my daughter, is going to sell the condo.
    How does she stand on capital gains?

    Reply

    • Hi Ken,
      It’s always a good idea to talk to a lawyer or an accountant when dealing with real estate and taxes, however, I can provide some general insight.

      First: Your daughter can only claim one residence as her primary residence. The other residence will be considered a secondary or investment property. The primary residence exemption means the CRA will not charge you tax on the profit you made on the sale of a property. For that reason, it’s always a good idea to shelter the property with the greatest appreciation (the greatest profit margin) using the primary residence designation. But be careful: Just because your daughter owns the condo does not make it a primary residence. If the CRA decides to audit your daughter’s paperwork they may ask for proof that the condo was her primary residence — and this would mean she’d have to defend the fact that she’d lived/used the property for a significant portion of every year that she claimed it was her primary residence. There are no time rules (ie: 6 months living in a home makes it a primary residence), just usage rules (you need to use it as your primary living space).

      If your daughter did not use the condo as living space, she would be subject to paying capital gains on 99% of the profit earned on the sale of the condo (while her mom’s 1% of the profit would be sheltered under the primary residence exemption).

      Reply

  9. I am joint tenant with my father on two properties. One is my principal residence. The other was rented out. As my father became a Canadian resident 5 years ago, I was reporting the income on the rental property, trying to be a good tax payer. He has not legally deemed either of the properties as his residential property. He will be moving into the rented property this year. He has no other properties.

    At this point we need to separate my name from the property. Am I on the hook for capital gains on the rental property, even though it will be his principal home. Is he on the hook for capital gains when we remove my name?

    Unfortunately like so many I have now read about, we put both our names on both properties in order to be able to obtain a mortgage and for the purpose of survivorship, without thinking of the tax consequences.

    Reply

  10. Hello,

    Last year of October 2014, my husband and I just bought a new house and we are going to sell our old house so we can pay the new mortgage of the new house. The old house, we bought it in 2004 , paid $118,000. During the time we live in this old house, we did a lot of renovations and improvements roughly spent about $50,000. In 2015, the old house market value went up to %335,000. Basically, $335,000 – $118,000 = $217,000 increase and 50% of that $108,000 would be subject to a capital gain tax based on the rule. Question 1: Marginal Tax — is that a combination of my husband and my marginal tax or is the capital gain amount divided by two? Question 2: If the old house was our Principal Residence before, how does capital gain tax calculation works? Question 3: Can we add the total amount we spent for the home improvement and renovations to the purchase amount of the old house?
    Please explain further regarding capital gain tax as we are worried to pay too much.

    Thank you kindly,
    Lynlin

    Reply

    • Hi Lynlin:
      First the good news: If you sold your principal residence you don’t owe a single cent in tax, even if you made a nice, tidy profit.
      But that also means you can’t deduct renovation expenses to offset the profit you made on the sale of your house because you’re not being taxed on that money.
      If you were being taxed on it (say, it was a rental property that you did not live in) than the taxable portion of the profit would be split by whomever was on the deed, and that person’s marginal tax rate would be used. For example, if you sold a rental property and made $100,000 in profit you’d be taxed on $50,000 of that profit (the government only taxes half your profit when it’s a capital gain). If both you and your husband were on title, you would each claim $25,000 as income and pay tax according to your tax bracket.
      Hope that helps!
      Romana

      Reply

  11. We purchased a condo when our daughter’s were attending University. We claimed it as Revenue property even though they weren’t physically paying us rent. We basically showed an income and claimed all the expenses: the condo fees, taxes, power and heat. We never showed a profit in the 10 years we had it. The condo is sitting empty for the past year and we will not be claiming it as revenue property anymore. What happens now when we sell it.

    Reply

  12. My mother sold her principle res. and paid no capital gains. For the last couple of years she has rented, traveled stayed with family and at the cottage . Can she deem the cottage her principle now that she wants to put down roots again? How or where does someone say that a home is their principle res.?

    Reply

  13. I want to sell my rental condo before I reach age 71. Why? Because then I have to convert my RSP to a RIF and take mandatory minimum withdrawals which will put me in a higher tax bracket. The sale of the condo would give me about $250,000 total capital gain over the original price, thus making $125,00 the taxable gain. I read on the CRA web site that one can spread capital gains over 3 or 4 years. How does one do that with a real estate sale?

    Reply

  14. My brother and I inherited a property in Newmarket Ontario. It is in need of repairs, if we put the house in our names to obtain a mortgage to do these repairs, we will increase the selling value by approximately, $200k using about $80K mortgage. My brother is a US resident, we are trying to find out how much funds we would pay in capital gains if we profit $200K… we do not understand the system. Someone told us we would pay $100K to taxes. Please help! Thank you.

    Reply

  15. We purchased a house in another province, with the intent to reside in that house, once we sold in the province we lived in. However, we decided not to leave the house vacant until we could sell and move so we rented it out.

    Once we moved, we didn’t have the heart to evict our tenants to move into the house ourselves, so we bought a different house and let the tenants continue to rent from us. This was over 2 years ago.

    We are now planning a few small to medium renovations on our PRE and are thinking of selling it and moving into the house we had rented out.

    How does this work? I’m so confused from the lingo on the internet. I need it in layman’s terms… will I pay capital gains on the rental house if we move into it and sell it in the future?

    Reply

  16. Hi there, hope you doing well. I have a complicated question want to ask please.
    Originally, I have no property at all and I have a brother who has a townhouse and he is living there with his wife. Then later on, my parents, who owned a house, transferred their house under my name and my brother’s name together. So now me and my brother owned this house together (not anymore for my parents) but my brother still own his townhouse at the same time. My brother keeps living his townhouse as principal residence and for me, of course I am the principle residence of the house. The question is, when we sell this house in future, will it need to be taxed for the capital gain due to the appreciated portion? I am living in the house with parents and there is no rental at all. But the thing is my brother has his own principle resident at his townhouse and own this house at the same time. Will CRA treat this property as his investment as it is not his principle resident? Thank you very very much

    Reply

  17. Hi: My husband had to put his name on title of a condo that was co owned by his Mom. The only reason he did that was she wouldn’t qualify for a mortgage without his name. She died in April after living there for 7 years. We had to put it up for sale or we would have to pay the Mortgage. Will my husband have to pay capital gains. It was not bought as an investment. It was bought so his Mom had somewhere to live.

    Reply

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