How to Avoid Capital Gains Tax on Rental Property Canada

When a rental property is sold in Canada, the owner may face capital gains tax on any increase in its value. This article outlines strategies for Canadian rental property owners to reduce or defer these tax obligations upon sale.

Understanding Capital Gains on Rental Property in Canada

A capital gain arises when a capital property, such as a rental property, is sold for more than its adjusted cost base (ACB) and associated selling expenses. The gain is calculated by subtracting the ACB and selling expenses from the proceeds of disposition, which is the amount received from the sale.

The ACB includes the original purchase price, acquisition costs like legal fees and land transfer taxes, and capital improvements made over the ownership period that enhance value or extend useful life. These capital expenses differ from routine repairs and maintenance, which are deductible against rental income annually. Maintaining accurate records of eligible expenses and improvements is important for determining the ACB and minimizing the taxable gain.

Only 50% of a capital gain is taxable, meaning half is added to the taxpayer’s income for the year of sale and taxed at their marginal income tax rate. If Capital Cost Allowance (CCA) was claimed on the property, a recapture of this CCA may occur upon sale, which is fully taxable as income.

Applying the Principal Residence Exemption for Rental Property

The Principal Residence Exemption (PRE) allows Canadians to sell their main home without capital gains tax on the appreciation in its value. A property qualifies if it is a housing unit owned and “ordinarily inhabited” by the taxpayer, their spouse, common-law partner, or children at some point during the year. This exemption applies to one property per family unit annually.

When a property’s use changes, such as from a principal residence to a rental, the Canada Revenue Agency (CRA) considers a “deemed disposition.” This treats the property as if sold and reacquired at fair market value, potentially triggering a capital gain. Elections are available to manage these tax consequences.

The Section 45(2) election applies when a principal residence becomes a rental property. It defers the deemed disposition, postponing the capital gain until the property is sold. This election allows the owner to designate the property as their principal residence for up to four additional years while rented. To qualify:
The taxpayer must remain a resident of Canada.
No other property can be designated as a principal residence during the election period.
Capital Cost Allowance (CCA) must not be claimed on the property.
Rental income must still be reported.

The Section 45(3) election applies when a rental property becomes a principal residence. It defers the capital gain triggered by the change in use, preventing immediate taxation upon reoccupation. This election allows the property to be designated as a principal residence for up to four years before the owner moves back in. A condition is that no Capital Cost Allowance (CCA) was claimed during its income-producing period. Both elections require careful consideration and specific filings with the CRA, often via a letter with the tax return.

Additional Strategies to Reduce or Defer Capital Gains

Beyond the Principal Residence Exemption, other strategies can help manage capital gains tax. The Capital Gains Reserve defers a portion of a capital gain if sale proceeds are received over several years, spreading recognition over a maximum of five years. To claim a reserve, the seller must:
Be a Canadian resident.
Not be exempt from tax.
Not sell the property to a controlled corporation.
Each year, a portion of the reserve is brought into income, aligning tax liability with funds received.

Maximizing the Adjusted Cost Base (ACB) directly reduces the capital gain. The ACB includes the initial purchase price and eligible capital expenditures like significant renovations, additions, and legal fees incurred during purchase. Properly adding these costs to the ACB lowers the difference between sale proceeds and cost base, resulting in a smaller capital gain. Similarly, sale-related expenses like real estate commissions, legal fees, and advertising costs are deductible from proceeds, further reducing the gain.

Transferring a rental property to a spouse or common-law partner can defer capital gains. Such transfers can occur at the Adjusted Cost Base (ACB) without immediately triggering a gain for the transferor. This postpones the capital gain until the property is sold by the recipient to a third party. However, Canadian tax attribution rules apply; any capital gain realized by the recipient spouse is attributed back to the original transferor for tax purposes. This rule prevents income splitting for tax purposes.