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How to avoid capital gains tax on rental property

Many Canadians invest in rental property to earn income and build wealth. When you sell a rental property for more than you paid for it, you usually owe capital gains tax on part of the profit.

Rental properties are not automatically exempt from tax like your home.

However, there are legal ways to reduce or avoid tax on capital gains in certain situations.

What Is Capital Gains Tax on Rental Property in Canada?

Capital gains tax applies when you sell capital property such as a rental house or condo. The gain is the profit after subtracting your adjusted cost base and selling expenses from the sale price.

In Canada, only 50 percent of your capital gain is taxable. You report that amount on Schedule 3 of your tax return.

If you claimed capital cost allowance (CCA) while renting the property, part of that amount may be taxed as ordinary income when you sell.

This recapture is separate from capital gains tax and is fully taxable.

What Is the Principal Residence Exemption?

The principal residence exemption (PRE) can shelter all or part of the capital gain when you sell your home. If a property was your principal residence for every year you owned it, you do not pay tax on the capital gain from its sale.

You must report the sale and designate the property as your principal residence on your tax return (Schedule 3 and Form T2091(IND)).

A principal residence can be many types of housing units such as a house, condo, or apartment.

The land is included as part of the principal residence if it is up to one-half hectare (about 1.24 acres) and is necessary for the use of the dwelling.

Can a Rental Property Ever Qualify for the Principal Residence Exemption?

Yes, but only under specific conditions. A rental property can qualify for the principal residence exemption if you convert it to your principal residence before selling.

This means you must actually live in the property as your main home for it to qualify.

When you change a rental property to personal use, the Canada Revenue Agency (CRA) may consider that a change in use has occurred.

A change in use can trigger a deemed disposition of the property at its fair market value, which may create a capital gain at that time.

How to Use the Principal Residence Exemption After Renting

If you plan to make your rental property your home, the CRA allows you to choose not to trigger a deemed disposition when you change its use. To do that, you must make a 45(2) election on your tax return.

Making this election means you are not treated as having sold the property when its use changes. That allows the years you live in the property to count toward the principal residence exemption.

To benefit from this strategy:

  • You must actually move into the property and make it your main home.
  • You must file the election in the year of the change in use.
  • You cannot claim CCA after the election.

This can reduce the capital gain attributable to rental use and shelter more of the gain when you eventually sell.

Partial Principal Residence Exemption

You do not have to live in a home for all the years you owned it to claim some principal residence exemption. If you lived in it for part of the time and rented it for the rest, only the years it was your principal residence count toward the exemption.

You will have to prorate the gain between tax-exempt and taxable years when you sell.

For example, if you rented the property for five years and then lived in it as your home for three years, the exemption applies only to the portion of gain related to the three years it was your principal residence.

Electing Principal Residence for Multiple Years

When you sell, you must include the sale on Schedule 3 and designate the property as your principal residence for all qualifying years.

The CRA requires this reporting even if the gain is fully exempt. Failing to report can result in penalties and loss of the exemption.

Limitations of This Strategy

There are some limits to using the principal residence exemption with rental properties:

  • You can only have one principal residence per family unit per year. This rule means if you or your spouse owns another home, only one can be designated as principal residence for that year.
  • If the property is treated as inventory or you bought it with the intention to resell, the exemption may not apply. In that case, profits could be treated as business income and taxed differently.
  • Past use as a rental means that only years you lived in the property count toward the exemption. Years it was rented will likely produce taxable capital gains.

Reporting the Sale of a Former Rental Home

When you sell a property that was once a rental home, you report the sale and include any capital gains on Schedule 3.

If part of the gain is sheltered by the principal residence exemption, you must complete Form T2091(IND) and indicate the years the property qualified as your principal residence.

Other Ways to Reduce Capital Gains Tax

If the principal residence exemption does not apply, other ways to reduce tax include:

  • Using capital losses from other investments to offset gains.
  • Timing the sale in a year when your income is lower.
  • Spreading gains through a tax plan with a professional advisor.

While not a tax shelter, planning your sale and reporting can reduce or manage capital gains tax legally.

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