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In Canada, capital gains tax is a tax levied on the profit made when selling an asset like real estate for more than its purchase price. This tax can take a significant portion of your profits, as 50% of the capital gain is taxable at your marginal tax rate. Fortunately, there are several legal strategies to defer or reduce the amount of capital gains tax owed on real estate. By understanding the tax implications and using the available tax deferral strategies, you can significantly reduce the tax burden.
What is Capital Gains Tax Deferral?
A capital gains tax deferral allows individuals to postpone the payment of taxes on the sale of an asset to a future date. This deferral can be crucial for investors, homeowners, and real estate professionals looking to maximize their financial gains while minimizing the immediate tax impact. In Canada, specific methods exist for deferring capital gains tax when selling real estate, depending on your property type, ownership structure, and investment strategy.
Below, we explore the most effective strategies to defer capital gains tax on real estate in Canada.
Principal Residence Exemption
One of the most well-known and effective ways to defer or avoid paying capital gains tax in Canada is through the Principal Residence Exemption (PRE). When you sell your principal residence, the property where you and your family live most of the time, any profit made from the sale is generally exempt from capital gains tax.
To qualify for the Principal Residence Exemption, the following conditions must be met:
- The property must be designated as your principal residence for each year you own it.
- You must have lived in the home for at least part of the year.
- Only one property per family unit (spouse and minor children) can be designated as a principal residence at a time.
By using this exemption, you can defer paying capital gains tax entirely when selling your principal residence. However, this exemption does not apply to investment properties, vacation homes, or rental properties.
Capital Gains Reserve Provision
Another key strategy to defer capital gains tax is the Capital Gains Reserve. This provision allows you to spread out the capital gains over a period of up to five years, thus reducing the immediate tax liability.
Here’s how it works:
- If you sell a property and receive the payment over several years (for example, through seller financing), you can elect to report the capital gains incrementally over those years.
- The Capital Gains Reserve can be claimed if a portion of the sale price is received in future years, and you report the gain proportionally based on the amount received each year.
This strategy can significantly reduce your upfront tax liability, particularly for individuals who may move into a higher tax bracket due to the capital gain. By spreading the capital gains over five years, you may benefit from lower overall taxes if your income fluctuates from year to year.
Section 85 Rollover for Corporate-Owned Real Estate
For businesses and individuals who hold real estate within a corporation, the Section 85 rollover allows for a tax-deferred transfer of real estate assets into a corporation in exchange for shares. This means that if you want to transfer your real estate holdings to a corporate entity for legal or tax planning reasons, you can defer the capital gains tax that would otherwise be payable on the transfer.
The key benefits of the Section 85 rollover include:
- Deferring the recognition of the capital gains until the shares are sold or the corporation disposes of the property.
- Flexibility in choosing an elected transfer value, which helps manage your tax liabilities.
- Protecting the real estate from personal liabilities by holding it within a corporate structure.
This method is especially useful for investors and real estate developers who want to transfer properties between entities without triggering an immediate tax event.
Using a 1031 Exchange Equivalent
While the U.S. has a 1031 Exchange that allows real estate investors to defer capital gains taxes by reinvesting the proceeds from the sale into another property, Canada does not have an identical program. However, there are still ways for Canadian real estate investors to defer taxes when reinvesting in new properties.
The key strategy in Canada involves rolling over the proceeds of a real estate sale into a replacement property. This strategy applies primarily to small business owners or farmers who sell their business-related real estate and reinvest in similar business properties. The replacement property must be purchased within a specific timeframe, typically the same fiscal year or within a set period after the sale.
Although this option is more limited than the 1031 Exchange in the U.S., it still offers an opportunity to defer capital gains tax when upgrading or expanding a business.
Tax-Free Savings Accounts (TFSA) and RRSPs for Investment Property**
For investors looking to defer or minimize capital gains taxes on real estate investments, using Tax-Free Savings Accounts (TFSAs) and Registered Retirement Savings Plans (RRSPs) can be highly effective.
- Tax-Free Savings Account (TFSA): Although you cannot hold real estate directly in a TFSA, you can invest in real estate investment trusts (REITs) or other real estate-related investments within your TFSA. The capital gains, dividends, and interest earned in the TFSA are tax-free, meaning you can grow your real estate investments without worrying about capital gains tax.
- Registered Retirement Savings Plan (RRSP): Similar to a TFSA, an RRSP allows for tax-deferred growth of investments, including certain real estate investments. You will only pay tax when you withdraw the funds from your RRSP, usually during retirement when you may be in a lower tax bracket.
Using TFSAs and RRSPs strategically allows you to shelter real estate investment returns from immediate taxation and compound your returns tax-free or tax-deferred.
Gifting Property to Family Members
Gifting real estate to family members is another potential way to reduce or defer capital gains tax. While gifting real estate is generally considered a disposition for tax purposes, meaning that capital gains tax would apply, there are strategies to minimize the tax burden in certain cases.
For instance, transferring property to a spouse or common-law partner can be done on a tax-deferred rollover basis, meaning no immediate capital gains tax will be triggered. However, when the spouse eventually sells the property, they will be responsible for paying the capital gains tax based on the original purchase price.
Similarly, parents can transfer farm property or qualified small business corporation shares to their children on a tax-deferred basis under certain conditions. This is especially beneficial for families looking to keep farm or business real estate within the family.
Strategic Estate Planning and Trusts
Incorporating estate planning and trusts into your real estate ownership strategy can also help defer or minimize capital gains tax. One popular strategy is the use of a family trust to hold real estate assets, which allows for greater flexibility in distributing the assets and potentially deferring capital gains.
In a trust structure, the beneficiaries of the trust may eventually inherit the property, and the trust can be structured in such a way that capital gains taxes are deferred until the beneficiaries sell the property. This can be an effective tool for long-term tax planning, especially for high-net-worth individuals with significant real estate holdings.
Conclusion
Deferring capital gains tax on real estate in Canada requires careful planning and the use of strategic tax provisions. From leveraging the Principal Residence Exemption to using Section 85 rollovers, Capital Gains Reserves, and various investment vehicles, there are multiple avenues available to reduce or delay your tax liability. It’s essential to consult with a tax professional or financial advisor to choose the best strategy for your unique situation and maximize the benefits.