Tax when Selling Real Estate: The Law (Simplified)
If a person sells a property, the tax treatment of any resulting gain (or loss) depends on whether the property was what tax professionals call “income property” or “capital property.”
An income property is generally a property purchased with an intention to resell it for a quick profit or, as some people in the real estate industry would say, “flip”. The sale produces business income (or loss) and is taxed at a full tax rate. If a new or substantially renovated property is involved, there may also be harmonized sales tax (HST) implications.
A capital property is a property purchased with the intention to hold it as a capital investment and earn income from it. A sale of your capital property results in a capital gain (or capital loss). Capital gain is taxed at one half of regular tax rates.
In simple terms, your intention at the time of purchase is key when determining whether the property is your business or capital property.
If you sold your capital property that was also your family’s personal residence, the gain may be exempt from tax by the so-called “principal residence exemption”.
While many people claim to be familiar with the law, the following are the common misunderstandings about its application.
Misconception #1: “I lived in the house, so any gain from its sale must be tax-free.”
Contrary to popular belief, it is not enough to simply live in a property to qualify for the “principal residence exemption”. Principal residence exemption will not be available if the property was not your capital property, even if you lived in it. If you purchased a property with the intention to resell it for a profit, the resulting gain is taxable as business income, regardless of whether you lived in the property or not.
If, however, you purchased a property with the intention to live in it for a long period of time, the property is your capital property, and a principal residence exemption may be available if all other requirements of the exemption are met.
Misconception #2: “It sounds like my intention is very important, but how would CRA know what it was? Only I know what my intention was.”
The CRA will make an assumption of what your intention was based on how, when, and why you purchased, held, and sold the property. The CRA will look at your occupation, your financing arrangements, how long you held the property, how you used the property, your history of similar transactions, reason for sale, and many other factors.
If the CRA finds that your intention was to resell the property for a quick profit, and you disagree, the burden is on you to prove your position using your evidence. Simply declaring one’s personal intention is usually not enough to change the CRA auditor’s mind.
Misconception #3: “I only had one real estate property during this period, so if I sell it, the gain must be exempt from tax. Where does CRA think I lived if I only had one property?”
Having only one property does not guarantee that the property would be your capital property or your principal residence. This mistake is connected to Misconception #1 (see above): living in a property does not necessarily entitle you to the principal residence exemption.
For example, let’s say a house renovator purchases a house with the intention of making improvements to it and then selling it at a profit. The person decides to live in the house while he is doing the work on the house. After all, he does not own any other properties during the period and has no other place to live.
As soon as the renovations are completed, he sells the property at a profit. The person will not be eligible for the principal residence exemption, because the property is not his capital property. He will pay tax on business income at full rates.
Misconception #4: “If I hold my property for more than one year, the property automatically qualifies as capital property and I only have to pay tax on capital gain.”
There is not a bright-line rule in the law that would guarantee a certain tax treatment based on the number of years a person holds a property. In general, a long holding period indicates that a property is a capital property, whereas a short period indicates a business transaction. However, there are exceptions to every rule.
For example, a person can sell his house after four months of ownership because of an unexpected job relocation and qualify for the capital property treatment and a principal residence exemption.
On the other hand, a person may purchase a property with an intention to resell and renovate it for three years before selling. The property is income property and any gain is taxed as business income despite the three-year holding period.
Misconception #5: “If I sold my principal residence, I do not have to declare the sale on my tax return because there is no tax to pay.”
Individuals who sell their principal residence in or after 2016, have to report the sale on Schedule 3, Capital Gains of the T1 Income Tax and Benefit Return. For dispositions in 2017 and later years, in addition to reporting the sale and designating your principal residence on Schedule 3, you also have to complete Form T2091(IND), Designation of a Property as a Principal Residence by an Individual (Other Than a Personal Trust).
If you forget to make a designation of principal residence in the year of the sale, it is very important to ask the CRA to amend your income tax and benefit return for that year. The CRA accepts a late designation in certain circumstances, but a penalty may apply.
Misconception #6: “I sold my condo on an assignment. Why would I pay any tax? The condo is not even built yet.“
“Selling on an assignment” is a phrase used in the real estate industry to describe an assignment of an agreement of purchase and sale for a property that is still under construction by the original purchaser to a new purchaser, prior to closing.
As an assignor, you are selling something very valuable: your right to a contract that allowed you to purchase the property for a specific price. Any income you earn is subject to income tax and, in certain cases, may have HST implications too.
The tax treatment, again, depends on your intention at the time of entering into the agreement of purchase and sale. If your intention was to resell the property for a quick profit, the gain from an assignment is treated as business income. If your intention was to purchase a long-term investment, the gain from an assignment is a capital gain.
Misconception #7: “My neighbour Bob has been flipping houses for years and brags about not paying any taxes. The CRA is not doing their job.”
The CRA has been working very hard, employing the latest technology to identify people like Bob. The audits in the real estate sector resulted in over $1 billion in additional tax revenues from 2015 to 2018 alone. The 2019 federal budget proposed providing the CRA with $60 million over five years to create a Real Estate Task Force focused on identifying non-compliance behaviour.
If Bob is audited he will likely face serious consequences. He should talk to a tax lawyer.
Misconception #8: “I will save time and money by handling communications with a CRA auditor by myself.”
We generally do not recommend it. Anything you say to a CRA auditor can be used against you. Let a tax law professional handle your audit correspondence with the CRA or, at the very least, obtain a consultation. DIY audits often result in unnecessarily difficult and expensive tax litigation matters.
This blog post is written by Anna Malazhavaya, is a tax lawyer and co-founder of Advotax Law who has successfully represented a number of homeowners, real estate investors and builders who were reassessed after selling their properties. Contact our tax lawyer for a free no-obligation 20-minute phone consultation.
