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Capital gains tax when selling a rental property

MoneySense logo MoneySense 2018-02-09 Romana King
Click here to see more personal finance questions answered.© Used with permission of / © Rogers Media Inc. 2018. Click here to see more personal finance questions answered.

Q. For the moment it seems that capital gains are taxed at 50% of the value. My parents own a rental property. Would it make sense to “buy them out” now and pay the capital gains at 50% rather than wait for the inheritance and risk being taxed at 75% in the future? I assume that this is done at fair market value (FMV), but can I buy the property at less than FMV to save on capital gains tax now or are we forced to pay the 50% at FMV? I have no plans of selling the rental property in the future.

— Gary

A. Great question! First, let me just run through how capital gains tax works.

This tax is charged on all assets that appreciate in value over time. This includes property but also applies to stocks, artwork, even collectibles. The estate or the seller is responsible for paying the tax once the asset is disposed of and that can include the sale of the asset or the gifting or giving of the asset. Capital gains tax is calculated by taking half of the appreciated earnings and charging the asset-owners’ marginal tax rate. What does this mean? It means that when making decisions about selling capital assets it’s best to try and time the sale of these assets in years when income is lower. Why? Because the more income you earn, the higher your marginal tax rate and that means you’ll pay more capital gains tax in those years.

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OK, now that we are clear on the basics of capital gains tax, let’s get down to the heart of your inquiry: When is the best time to transfer the asset from parents to their chosen heir?

Quite often, this decision is clouded by an overwhelming desire to avoid probate tax. In Canada, there is no estate or inheritance tax. However, there are probate fees. These fees—often misinterpreted as taxes—are administered by the provincial courts. They pay for the standard court services that help verify and legally transfer a person’s estate to a chosen heir (and certain assets are exempt, such as property held as joint tenants or registered accounts with designated beneficiaries).

In the grand scheme of things, probate fees are relatively small. For instance, if your parents lived and died in Ontario as the executor of their estate, you would be responsible for paying probate fees of $250 plus $15 for every additional $1,000. This would result in forking out less than $13,585 to cover inherited assets worth $250,000.

Yet, probate fees aren’t the only factor to consider. When an entire estate is left to an heir the final tax bill can be quite significant. All unregistered assets in all accounts are considered to be sold and the final sum of all these assets is then taxed, typically at the highest marginal tax rate. One option is to transfer ownership of the property to an heir before parents die. This means the deemed disposition (the taxman’s way of saying you basically “sold” the property to your heir) of the property is taxed using their current capital gains marginal tax rate. To illustrate, let’s assume your parents earn about $75,000 in annual household income (money from government plans, small pensions, and rental income). Their marginal tax rate is 31.48% (if they lived in Ontario), which means they’d pay 15.74% in capital gains tax (half their marginal rate). Wait until they pass away and the entire value of their estate pushes the marginal tax rate up to 53.53%, meaning you’d have to pay close to double, or 26.76%, in capital gains tax.

It’s one reason why parents often choose to transfer ownership of the property to their heirs before their death. That said, your assumption is correct: You must use the property’s fair market value. The CRA defines FMV as “the highest dollar value you can get for your property in an open and unrestricted market, between a willing buyer and a willing seller who are acting independently of each other.” Even if you end up paying less than FMV for the property, your parents will still be required to pay capital gains tax on the profit of the rental property using the FMV.

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