With the release of the 2024 Federal Budget, the Capital Gains Inclusion rate is top of mind for many investors, especially those who invest in real estate. This article will be especially important for you if:

• You’ve bought a secondary property
• You are considering buying one
• You have changed how a property is being used
• You are considering changing how a property is being used

Even if you aren’t currently a real estate investor, perhaps you own or could end up with an interest in a vacation property such as a cottage. If this is the case, be sure to read on!

The last section of this article can be EXTREMELY important to minimizing your tax bill.

Principal Residence Exemption

It’s fairly widely known that the sale of a principal residence is exempt from capital gains tax.  

However, what happens if you start renting out the property? Or if you move into a rental property? 

At that point, you’re deemed to have changed the use of the property and if it wasn’t already, it now becomes subject to capital gains tax.

The Capital Gain Tax

The 2024 budget has introduced a higher rate of capital gain inclusion into income for capital gain above $250,000 of 66.67% or two-thirds.

Before June 25, 2024

Properties that are subject to capital gain require 50% of the capital gain to be included in income. Then, that income is taxed at whatever your personal tax rate is.

June 25, 2024 or Later

Properties that are subject to capital gain include 50% of the first $250,000 into your income, and then 66.67% for every dollar of capital gain above $250,000 is included. Then, you are taxed at whatever your normal rate is.

Calculating Capital Gain for Mixed-Use Properties

Sometimes, it’s easier to use an example to explain a concept. For this example:

• The property was purchased 20 years ago
• The property was purchased for $100,000 after expenses
• The property was a principal residence for the first 10 years it was owned
• The property was then rented out for the following 10 years
• The property was sold for $1,000,000 after expenses
• There is one owner of the property who was an individual.

It would be unfair to charge capital gains on the entire amount because the property was a principal residence for the first 10 years. Therefore, there is a formula that can be used to calculate the capital gain that is considered “Fair”.

The number of years the property was a principal residence plus 1 is divided by the total number of years owned. Then, this is multiplied by the proceeds received from the sale (net of expenses) minus the Adjusted Cost Base of the purchase.

Adjusted Cost Base is the price paid for the property plus any closing costs and other costs to make the property habitable.

For simplicity, let’s break this calculation down a bit. The total capital gain from the sale of the property is the selling price net of expenses minus the purchase price net of expenses.

$1,000,000 – $100,000 = $900,000

This is the total capital gain. However, not all of this is included in the income of the taxpayer. It is then prorated by the number of years the property was a principal residence plus 1, divided by the number of years the property was owned.  In this case:

(10 + 1) / 20 = 0.55

Multiplying this ratio by the total capital gain produces the Principal Residence Exemption.

0.55 x $900,000 = $495,000

Taking the total capital gain less the Principal Residence Exemption, we get the Taxable Capital Gain.

$900,000 – $495,000 = $405,000

Now, we apply the Capital Gain Inclusion rate.

Before June 25, 2024

$405,000 x 50% = $202,500

This is the taxable capital gain if the transaction occurred before June 25, 2024.

June 25, 2024 or Later

$250,000 x 50% + ($405,000 – $250,000) x 66.67% = $228,333.33

This means that for disposals on June 25, 2024, or later, the amount included in income is significantly higher. 

When you consider that the marginal tax rate is often quite high in years real estate is sold, this could result in an increased tax bill of up to approximately 54% of the difference, or nearly $14,000.

Implications

The biggest implication of this change is that there is more tax planning required to ensure the taxes can be covered when the property is sold. It’s also important to remember that should you pass away, it is a deemed disposition and capital gains are due at that time.

Unfortunately, this means that some families are forced to sell family cottages and vacation properties in order to cover the tax bill.

One concern that we have is the number of people, now seniors, who have built their retirement and estate planning upon the old inclusion rate of 50%. At this point in life, purchasing life insurance to help cover the tax bill is likely prohibitively expensive, and since the senior is likely retired, they probably have no way to increase their financial assets to sufficiently cover the increase in taxes payable.

This means, they either have less to live on for the remainder of their lives, or they have to leave less to their inheritors.

There is something called the Capital Gain Reserve that can be used to help spread capital gains over a period of time to reduce the overall tax burden if the property is staying in the family – but that’s a topic for another day. Reach out to us if you want to know more.

Register your Change in Use!

It is very important to ensure you make the appropriate election if you’re changing the use of your property. The penalties for failing to make these elections are $100 per month up to $8,000. It’s well worth taking the time to research this a little bit if you’re changing the use of your property.

Changing from Principal Residence to a Rental

To register this change, you need to file a Section 45(2) election with CRA. This essentially tells them that this property is no longer your principal residence, but is now a rental property.

Changing from a Rental to your Principal Residence

To register this change, you need to file a Section 45(3) election with CRA. This tells them that it is no longer a rental property and is now your principal residence.

Why Make Elections?

It’s important to make these elections for a couple of reasons. First, to avoid that nasty penalty of up to $8,000. And second, to lock in the change of use date and reduce your future Capital Gains Tax.

Plan Ahead

Keep in mind that when making important financial decisions, you need to plan ahead. The Section 45 elections are very simple to do, but failing to do so can cost a lot if you don’t plan ahead.

Unfortunately, as we perform tax planning, we don’t know what future governments will do, so those plans can be affected by changes such as increasing the Capital Gain Inclusion Rate.

If you need help with your situation or want assistance making these elections or ensuring you’re paying the appropriate amount of capital gain tax, please reach out to us!