Article: Rental property and the capital gains tax
[ Accounting ]
Rental Property
and the
Capital
Gains Tax
By David Gargaro
Capital gains tax (CGT) is a tax on capital gains, which is the profit that
occurs from the sale of capital property. The inclusion rate (currently 50%)
is the amount of capital gain that is subject to the CGT. For example, if
you purchased a property for $100,000 and sell it for $300,000, then the
capital gain is $200,000 (the original price minus the selling price). Fifty
percent of that amount, or $100,000, is taxable at your specific tax rate.
depreciable equipment (e.g., laundry machines) over a period of several
years at specified rates. This deduction is known as capital cost allowance
(CCA); the amount you can claim will depend on the type of property.
To calculate the capital gains on the sale of your rental property, you must
know three amounts: the proceeds of disposition, adjusted cost base (ACB),
and outlays and expenses incurred to sell the property. The basic formula is
capital gains = proceeds of disposition – (ACB + outlays and expenses).
When you sell the rental property, you might be required to increase
your income by the recaptured capital cost allowance. This can occur
when the proceeds from the sale of the building (and other depreciable
property) are more than the sum of the property’s various undepreciated
capital costs (UCC) (e.g., $80,000 for the building, $5,000 for paving,
$5,000 for equipment). The UCC is the total capital cost of the building
and additions, less the CCA claimed over the years.
Proceeds of disposition is the sale price of the property. ACB is the
actual cost of the capital property, which includes capital expenditures
(i.e., additions and improvements to the property) but does not include
current expenses (i.e., maintenance and repair costs). Outlays and
expenses include amounts incurred to sell the capital property, such as
commissions, surveyors’ fees, legal fees, transfer taxes, and advertising
costs related to the sale process.
Explained Dennis, “Suppose that you purchased a property for $200,000
and the land was valued at $100,000 while the building portion was valued at
$100,000, and the building portion was depreciated (CCA claimed) by $50,000
over ten years. You then sell the property for $400,000. The capital gain is
$200,000, and the taxable capital gain is $100,000. Assuming the portion of
the proceeds allocated to the building exceed the original cost, the previously
claimed CCA of $50,000 must also be included in taxable income.”
“When calculating your capital gains, it is very important to have
maintained receipts for capital additions or improvements made to the
building and property,” said Dennis Anderson, Partner, Tax Services, Ernst
& Young LLP. “Differentiate these expenditures from operating expenses
that have been deducted from rental income annually and are not added
to the adjusted cost base.”
Capital cost allowance
When selling a rental property, you must properly allocate the proceeds
between the land and building. While you own the rental property, you
can deduct the cost of the building (land is not depreciable) and any
18 may / june 2012
Deferring taxes
When selling rental property, you can defer a portion of capital gains
through a vendor-take-back (VTB) mortgage. The vendor takes back debt
when the buyer takes on a mortgage or financing from the vendor to
purchase the property. The vendor can elect to spread the capital gains
over a period of up to five years through claiming a reserve for proceeds
not yet received. The maximum reserve that can be claimed for a year
is determined by formula, where the minimum amount of the gain that
must be reported each year is 20%. Unless there is a lot of VTB debt, the
amount to be reported in the first year would be much higher.
[ Accounting ]
When the seller claims a reserve amount against
the capital gain in the first year, that amount is
brought into income in the following year. The
seller claims a new reserve amount the next year,
and the process repeats until the amount is fully
paid or the five-year period expires.
In a simple example, a rental property sells for
$1 million, and the capital gain is $500,000. The
deal is financed by a VTB mortgage repaid evenly
over five years at $200,000 per year. The reportable
capital gain will be $100,000 per year by claiming
the available reserve for proceeds not yet received.
“A vendor-take-back mortgage allows you to
defer payment of the capital gains tax instead of
taking full payment for the property’s purchase
and paying all the tax at once. You can also earn
interest on the VTB mortgage,” said Dennis.
“However, there is the risk that the buyer will
default on the mortgage.”
prior to the sale. Rental businesses with five or
fewer full-time employees are not considered to
be active businesses under the Income Tax Act.
If the corporation passes the test of running
an active business, the shareholders could
claim the lifetime capital gains deduction
against taxable capital gains by selling the
shares of the company, rather than having
the company sell the rental properties.
“The LCGE is available to a qualifying corporation
that is owned by several family members,” said
Dennis. “When they sell the corporation, they can
potentially each claim the LCGE of up to $750,000
depending on their ownership.” RHB
For more information, contact: Dennis M.
Anderson, Partner, Tax Services, Ernst & Young LLP-
GAIN THE EDGE!
Capital gains exemption
Unlike rental property owners, business owners
can defer the capital gains and taxes on the
sale of business properties for up to one year,
depending on the timing of the sale compared to
the business’s taxation year. Under replacement
property rules, the individual can defer some
or all of the capital gain by acquiring a similar
business property. The amount of gain deferred
depends on the sale price and price paid for
the new building. For example, a person who
owns a building with a restaurant can sell the
property to move her restaurant to a larger
space in a new location, and defer the taxes on
the sale. However, owners of rental properties
do not qualify for this type of deferral.
Owners of corporations that own rental
properties might be able to qualify for the
$750,000 lifetime capital gains exemption (LCGE),
which works out to a $375,000 lifetime capital
gains deduction. They must own shares in a
qualified small business corporation, which the
Income Tax Act defines as a Canadian controlled
private corporation that uses at least 90% of its
assets to carry on an active business in Canada.
The individual or a relative must have owned these
shares for at least 24 months prior to the sale, and
at least 50% of the corporation’s assets must have
been used in the active business for two years
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Rental Housing Business 19
3/27/12 9:11:32 PM