Capital gains tax lifetime exemption

A large part of business succession planning is about tax. A business owner selling his business (whether by outright sale or by estate freeze) wants to make sure that he or she has set up a plan that minimizes the tax that will have to be paid.

For sellers of small businesses, a useful thing to keep in mind is the capital gains exemption that is available. A Canadian business owner can over a lifetime shelter up to $750,000 realized from the sale of the business.  I believe this particular exemption is best explained by an accountant, so I'm linking to a site by Janet Nixon, CGA, which has a good discussion of the exemption. Click here to read it.

The principal residence exemption

This post from the Canadian Tax Resource Blog has a very good explanation of the principal residence exemption to the capital gains tax rule, and how to apply it in your case. Click here to read it.

Is there capital gains tax when I sell an inherited property?

The following is a question I received from a reader. It's a variation on a question that I hear a lot, so I thought I'd address it here. Just a caveat - when you ask me questions here on this blog, I don't get to know the whole picture, so my answers are necessarily general. You should always back up this information by talking to a lawyer or accountant in person.

"My father died this past November and left everything to myself and sister, including his house/property. If we sell this property this summer, do we have to claim a capital gains? If so, on what part?"

On the transfer of the property from you to a third party, you are probably going to be liable for capital gains tax. The period that you're on the hook for is from the date you acquire it to the day you sell it. Since this period of time will be only a matter of months, the property might not incur too much of a gain in that time, and therefore your tax will be small. You and your sister can split the tax between you as you are both inheriting the property.

Note that if the property in question is your principal residence (which doesn't seem to be the case here), the tax is not payable on your sale of it, because this is an exception to the general rule of capital gains.

Now let's look at the first transfer - that of the property from your father to you. Since you describe it as "house/property" rather than just "house", I'm assuming there is something more than just a house. When these items transfer to you, there is no tax for you personally to pay. However, there certainly may be taxes that must be paid by the estate.

When your father passed away, there would have been no capital gains tax payable on his home (principal residence). Note that only 3 acres of property can be included in the principal residence exemption. If there was an additional property, such as a cottage or revenue property, there is capital gains tax payable on that property. Keep in mind that if the property sits in the name of the estate for a long time, there may also be tax payable on the increase in value while it's in the estate name.

As you can see, it seems a simple question but the answer is complicated. This is why I recommend that you sit down with an accountant to figure out the tax details.

Spousal rollover on death

If you're an executor wondering about dealing with assets that may be eligible for rollover to a spouse, read this article from All About Estates before making a decision.

Small business capital gains exemption

Taxation is a big factor in any business succession plan. It's important that someone selling or otherwise transferring a business understands how the tax arising from the transaction will affect everyone involved. I've found an article by Mark Borkowski that discusses how a seller can use the lifetime capital gains deduction. Click here to read it. This is really well-explained and readable, so I suggest that any business owners who are contemplating an estate freeze or who want to know more about taxation in business succession planning should read this article.

The basics of capital gains tax and the principal residence

As I've mentioned several times in previous blog posts, Canada doesn't currently have any direct death or inheritance federal taxes. But when a person passes away, his or her estate must pay income tax outstanding as well as capital gains tax.

Capital gains tax is the tax paid on the increase in value of certain assets known as capital property. The type of capital property dealt with by executors most often is real estate, though other assets such as the shares of a privately-owned corporation are also capital property.

Capital gains tax works like this. On the day you first acquire an asset, it has a value (called the adjusted cost base). If we are dealing with real estate, the value is normally the price you paid for the property. Over the time that you own that property, it gains in value. The longer you own it, the more likely that the value will increase. On the day you get rid of the asset - by selling it or transferring it under your Will when you die - it therefore has a greater value than it did when you got it. The difference between the value on the day you got it and the value on the day you dispose of it is known as the capital gain. You have to pay tax on one-half of that increase in value.

As an example, let's say Leia buys a house for $150,000. She owns it for many years and when she dies, her executor is going to sell the house. Now it's worth $550,000. The capital gain on the property is $400,000. Leia's estate has to pay tax on half, or $200,000. This doesn't mean that there is $200,000 in tax owing. It means that $200,000 is added to income for that year on the tax return, and the executor will use as many tax deductions, exemptions etc as he or she can to reduce how much tax must be paid.

If the property was worth less at the date of her death than it was when Leia acquired it, she would instead have a capital loss that she could apply to her return.

This is triggered by Leia's death because in law you are deemed to have sold everything you own one minute before you died. This means that even if your executor is not selling the house but is transferring it to a beneficiary, you are still deemed in law to have sold it at fair market value.

There are some exemptions to the rule about capital gains. The one that is important to most executors is that a person does not have to pay capital gains tax when he or she disposes of his or her principal residence. So if the house Leia owned was her principal residence, the $200,000 would not have to be added to her income.

On the other hand, if the house Leia owned was a summer cottage or a rental property, the tax would be owing.

Your principal residence doesn't necessarily have to be the house you live in most of the time. If you happen to own another house that is worth more, you could designate that more expensive one as your principal residence (don't do this without talking it over with your accountant first!).

A married couple only gets one principal residence between them.

Before taking any steps to avoid capital gains tax by setting up trusts or joint ownership or other ideas, you absolutely must speak with an accountant or estate planning specialist about your specific situation. Often people set up schemes to avoid one thing but they haven't looked at the whole tax picture, such as potential tax hits when a property is transferred from an individual to a trust or to joint owners. There may also be other tax solutions available that you hadn't thought of.