For most Canadians, the new requirement to report the sale of a principal residence will be nothing more than a compliance exercise—but one shadowed by the threat of unrestricted audits and sizeable penalties. To help you negotiate through the new reporting rules, please see the 8 questions you have about principal residence tax rules. But for families with more than one property as well as real estate investors, this new requirement may introduce a few wrinkles into the more common capital gains strategies used to minimize the amount of tax owed to the CRA.
To help you maximize the capital gains tax strategies under this new reporting requirement, here are eight tips and suggestions.
Tip #1: You must remember to report each sale
The new rules, announced in early October 2016, will require you to report every single property sale on your tax return. That means in your 2016 income tax return (due sometime in April 2017) you will need to report the sale of property, even if you don’t end up owing tax on the sale.
Fail to report the sale—whether intentionally or unintentionally—and you risk an audit, penalties and interest charges and the ability to shelter future home sales through the principal residence exemption (PRE).
Tip #2: A change in use is also considered a sale
Even if you haven’t actually put your home up for sale, the CRA will deem it to be sold if you change the use of the property. Take, for example, you decide to buy a new, larger home for your growing family but want to hold onto your current property and rent it out. The CRA considers this a “deemed disposition”—you haven’t actually transferred the ownership to another person, but you have changed the primary use of the property, from your family home to a rental property. As such, the CRA will consider the home sold, for tax purposes, at the current fair market value.
Thing is, there are a number of ways to trigger a deemed disposition. The most common way is to change the use of a property—from a family home to a rental property. Another way to trigger this type of taxable disposition is to gift the property to a third party. Do this and the property is deemed to have been sold at its fair market value, at that time. One final way to trigger a deemed disposition is when the taxpayer ceases to be a resident of Canada, for tax purposes. In all cases, the owed tax can be delayed and deferred until the property is actually sold, but for specific advice always talk to a tax specialist.
Tip #3: You can still use strategies to minimize taxes
For years, many Canadians minimized the amount of capital gains tax owed by strategically designating when each property was their principal residence, for tax purposes. To make this strategy work, however, the properties can not be income-producing during the years they are designated as a principal residence.
“Canadian families with a home and a cottage owned personally will be impacted by these new rules, as they’ll need to report the sale of each property,” explains John Sliskovic, private client services tax leader at EY LLP. “A family could still optimize the benefit of the principal residence exemption by designating the property with the greatest accrued gain as the principal residence.”
To see how this strategy is used to pay less capital gains tax, let’s look at an example. Say you and your spouse bought a home in 2001 for $250,000. In 2002, you received an inheritance and bought a cottage about two hours away from Toronto for $200,000. For the next 14 years, until 2016, you and your spouse lived full-time in your city home and spent summers and holidays at the cottage. In that time, your family home appreciated and is now worth $650,000. During the same time period, the cottage’s fair market value rose to $725,000. Now you want to retire and part of that transition is to simplify your life by selling both properties and downsizing. If you needed to sell both properties this year, you’d end up having to pay capital gains tax on at least one—designate your city home and the exemption would save you from paying $60,000 in tax*; designate your cottage and the exemption would save you from paying $78,750 in tax. Already strategically choosing to shelter the property with the highest appreciation would save you $18,750 in tax. That’s not chump change. Talk to a tax specialist and you could further fine-tune this strategy to save even more on your taxes.
Remember, there are no changes to the current requirements of the principal residence exemption. “There are no proposed changes to this rule,” says Sliskovic.
Tip #4: But now you have to keep much better records
While the new requirement to report all property sold in 2016 and in future years won’t impact strategic tax planning, it will put more onus on property owners to establish and keep better records. It will mean diligently keeping all receipts and invoices—an important aspect of real estate investment, particularly if you want to increase your adjusted cost base (ACB) on the property, and save tax later on when you go to actually sell the property.
It also means that you will have to establish the fair market value of a home whenever you have a deemed disposition. The easiest way to do this would be to pay about $500 for an accredited appraisal report. You’d then need to keep this on file until you actually transfer ownership of the property to another person, thereby triggering capital gains tax that needs to be paid to the CRA. That’s because under the new rules, the CRA will have the information it needs to figure out whether tax might be owed on a property.
Tip #5: Big changes if you own property through a trust
Families that own a home or cottage through a trust may be impacted in a different way. “The proposed changes limit the types of trusts that are eligible to designate a property as a principal residence,” says Sliskovic.
For example, a trust that is no longer eligible to designate the property as a principal residence under the new rules, but owns that property at the end of 2016, must separate its gain into two components: The gain accrued to 31 December 2016 may potentially be sheltered by the principal residence exemption, and the gain accruing from the beginning of 2017 to the date of disposition that will be subject to tax.
“Families that have utilized trusts to hold principal residences will need to carefully review the amendments and make any necessary changes to ensure that their estate planning is still appropriate,” explains Kim G. C. Moody, director, Canadian Tax Advisory at Moodys Gartner Tax Law LLP, in a recent legal brief.
“Non-residents who utilized trusts to acquire property and claim the principal residence exemption will also be greatly affected,” explains Moody. With these new rules the strategic use of such trusts and similar “planning is now effectively dead.”
Tip #6: House-flippers watch out!
For real estate investors that specialize in buying, renovating and then quickly selling homes—a process known as house-flipping—the new reporting requirements will force you to justify the “ordinarily inhabited” rule.
As Moody explains: “The property also has to be a “capital property” of the taxpayer.” This means that it cannot be part of the trade of the business. This obviously isn’t the case for house-flippers. “House flippers are not eligible for the principal residence exemption since properties that are quickly sold after the acquisition will likely not be considered capital property but rather inventory,” writes Moody. As a result, any profits from selling the house are no longer considered a capital gain but rather as business income and would not be entitled to the principal residence exemption.
Tip #7: Don’t be surprised by these changes
The recent changes to how sold property is reported to the Canada Revenue Agency is not the first time the principal residence exemption has been significantly changed. One of the more significant changes occurred in the early 1980s, when each spouse was no longer allowed to claim a principal residence exemption for different properties (thereby enabling married couples to “double-up” on the benefits of the principal residence exemption). As a result, all family units are restricted to sharing the principal residence exemption for every calendar year for properties disposed of after 1981. While Federal Finance Minister Bill Morneau has stated that the feds are in a holding pattern right now, when it comes to the country’s real estate markets, don’t be surprised if additional changes are announced in the near future. Right now, the Liberal government wants to assess how recent changes have impacted each property market; if the shifts they are anticipating don’t transpire, it’s quite possible the federal government, or other levels of governments, will consider additional measures.
Tip #8: No more 1+ for foreign buyers
Anyone who was a non-resident of Canada in the year a property is bought, will no longer be able to automatically add a year to the number of years the property is considered a principal residence. (Tax specialists often point out that every Canadian is allowed to claim the PRE for each year the property is owned, plus one, effectively decreasing the capital gains taxes owed, where applicable.) This new rule applies to any property sold (or deemed to have been sold) after October 3, 2016.
“In effect, this will prevent a non-resident of Canada from being able to dilute their taxable capital gain on the disposition of an otherwise principal residence in years where they acquire and dispose of properties,” explains Moody. However, he is concerned that non-residents may get around this new rule by gifting funds to their resident spouse or child, who acquires the property on the non-resident’s behalf and allows them to continue to take advantage of the 1+ rule.
Where can I get more information?
Finally, if you want more information on how these recent changes will be applied, the CRA will be providing more detailed instructions in the T4037 Guide: Capital Gains 2016.
Calculations are as follows:
*House sale price of $650,000 – purchase price of $250,000 = $400,000
→ $400,000 divided by 2 = $200,000
→ $200,000 x marginal tax rate (we assume 30%) = $60,000
**Cottage sale price of $725,000 – purchase price of $200,000 = $525,000
→ $525,000 divided by 2 = $262,500
→ $262,500 x marginal tax rate (we assume 30%) = $78,750