The right time to sell a rental property

Consider the tax liability currently versus in the first year of retirement

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Q: We have a rental property that provides a decent return, but we are tired of the responsibility and wish to sell it. I am still working for another few years and there will be sizable capital gains. My questions are: Should we sell the property while the market is hot (and before interest rates climb) or wait until I retire? And what could we invest in with the equity?

 – Sydney

A: I’m afraid there is no one-size-fits-all answer in your case, Sydney, but I’ll try to provide some issue identification and discuss some potential solutions for you.

First off, the tax on the sale of the property will come from two sources: capital gains and recapture. It’s clear that the property has gone up in value, so there will be a capital gain on sale. The gain is determined based on the sale price, less selling costs (like real estate commissions and legal fees), less the adjusted cost base (ACB) of the property. The ACB isn’t necessarily just the original purchase price – it may be that you have made capital improvements or renovations over the years that have increased the cost of the property for tax purposes. Eligible closing costs on the initial purchase will also add to the ACB.

One-half of a capital gain is taxable and could be taxed at over 50% depending on your province of residence and other sources of income in the year. No doubt your income is likely to be higher during the next few years while you are working, so that needs to be taken into account as far as determining the timing. You might want to look at the tax liability currently versus in the first year of retirement, for example, to see if it’s compelling enough to hold off, Sydney.

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In addition, recapture may apply if you were claiming depreciation on the property over the years. Depreciation provides a 100% deduction against net rental income when claimed, but on sale, all accumulated depreciation is 100% taxable. It too may be taxable at a tax rate of over 50% depending on your income sources and where you live.

You raise a good point, Sydney, about interest rates. You are concerned about the impact on real estate prices if and when interest rates rise. There’s not much room for interest rates to fall and eventually they will increase again, but it may be some time yet. All assets prices are at risk when rates rise and the cost of borrowing is higher and fixed income investments like bonds and GICs are more competitive. I personally think that the low rate environment and the real estate market may still have some legs.

As far as how you invest the proceeds if you sell the property, you could consider other types of real estate investments if that’s an area of interest for you. There are a wide variety of publicly traded and private options ranging from owning real estate indirectly through real estate investment trusts (REITs), various funds and limited partnerships (LPs) to loaning on real estate in the form of mortgage funds or mortgage investment corporations (MICs).

I think you really need to look at your overall investments to see how the proceeds best fit into your portfolio. And with retirement approaching, Sydney, a retirement plan can help you project and determine your required rate of return in retirement, your income needs and how much of your capital you need and when.

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Jason Heath is a fee-only, advice-only Certified Financial Planner (CFP) at Objective Financial Partners Inc. in Toronto, Ontario. He does not sell any financial products whatsoever.

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