In Part I of Everything Tax When Purchasing or Selling a Property, we discussed Land Transfer Tax (LTT), Municipal Land Transfer Tax (MLTT), Harmonized Sales Tax (HST) and Non-Resident Speculation Tax (NRST) all of which are levied on a buyer of real property in various circumstances in Ontario.
In part II, we will discuss property tax, capital gains tax and business income tax which are taxes levied against the owners or sellers of property in Ontario.
1. PROPERTY TAX
If you own property in Ontario, you receive a property tax bill each year. Typically, your property taxes are determined by your municipality, based on your property value, the applicable municipal tax rates and education tax rate. Municipalities will use the assessed tax to fund water and sewer improvements, provide law enforcement and fire service and other items deemed necessary services within the local municipality.
Property tax is the main revenue source for municipalities in Ontario. It generates approximately $19 billion annually for municipalities.
Municipal tax rates are set by each municipality based on their own individual tax revenue needs as part of their annual budget process. The Fair Assessment System is Ontario’s method of property assessment.
The Fair Assessment System taxes properties based on what is called their current value, which may not necessarily be the amount paid to purchase the property. The assessment values are reviewed yearly.
The Municipal Property Assessment Corporation (MPAC) determines the current value assessments and classifications for all properties in Ontario. MPCA is a non-profit agency that assesses your property and sends the owner a notice of its assessment. The assessment is supposed to reflect the price the property would garner if you put it up for sale, however an MPAC valuation is often far from its market value.
Property tax rates will be set by the municipality based on its need and budget. Municipalities can also choose to tax different classes of properties at different rates. Some of these classes include: residential, farming, commercial, and industrial. If your property falls within two or more classes for tax purposes, and the rates for the classes are different, the property may be assessed based on what percentage of the property falls into each class.
Failure to Pay Property Taxes
If you don’t pay your property tax, there are several punitive remedies available to the municipality. First, the municipality can levy late payment charges, penalties and interest on the outstanding balance. The late payment charge in the City of Toronto is set at a rate of 1.25% on the first day of default and on the first day of each month thereafter as long as taxes or charges remain unpaid.
Penalties and interest charges will be levied over and above the late payment charge, and cannot be waived or altered by the municipality whatsoever.
Second, if you continue to fail to pay property taxes, the municipality could seize your property. In the City of Toronto, once final notices for unpaid property taxes have been sent, the city will assign your matter to a Bailiff. A Notice of Issuance to Bailiff will begin the proceedings for the seizure of your property. If you continue to fail to pay the outstanding property taxes, the City will commence a Municipal Tax Sale Proceeding. In this proceeding, the City will first register a Tax Arrears Certificate on title to the property as an encumbrance. You have one year from the date of this registration to pay the outstanding property taxes. Failing which, the Treasurer is required to proceed with a sale of the property through the Sale of Land by Public Tender process. For more information on this process, click here.
In many cases, a mortgage lender will collect property taxes as part of the monthly mortgage payment and pay the taxes on the homeowner’s behalf. This is because the failure to pay property taxes could result in the forced sale of the property which is the lender’s security for the loan.
All in all property taxes must be paid by the owner of real property in every circumstance without exception.
2. CAPITAL GAINS TAX
Capital gains tax arises from the disposition of an asset. For instance, if you sell a stock on the stock market for more than you paid to purchase it, the amount of the profit will be considered and taxed as a capital gain.
Real estate is a difficult area for the determination of capital gains taxation. This is because if you are purchasing real estate to hold the property as an investment asset for a large period of time, then the profit you derive from its sale will likely be characterized as a capital gain. However, if you are in the business of purchasing and selling real property, or buying, renovating and flipping properties for a profit, then the CRA will deem the profits you accrue to be business income, as opposed to capital gains tax.
Where the CRA has determined the profits to be business income, the rate of tax is typically higher than capital gains tax, and additionally, HST will be exigible on the income. Business income taxation will be discussed in greater detail below. For our purposes now however, it is important to understand that capital gains tax does not arise on the disposition of all real property: capital gains tax will arise on the disposition of investment property only, or in other words, for single properties held for long periods of time.
Rate of Capital Gains Taxation
The rate of capital gains tax is first determined by the inclusion rate. The inclusion rate in Canada is presently 50%. The inclusion rate is how much of the gain is included in your income for income tax purposes.
For example, if you have a gain of $125, only $62.50 is included in your income (inclusion rate of 50% x $125.00), which means you are only paying tax on one-half of the gain, being $62.50. The remaining $62.50 flows to you tax free.
The rate of tax that you pay on the amount that is included in your income is your marginal rate of tax depending on your level of income. For example, if you earn $85,000 a year, your top marginal tax rate is 31.48%. Using the above simple example, if you had a gain of $125.00 then you will pay tax on $62.50 at the rate of 31.48%, which means you will pay $19.67 in tax on a gain of $125.00. Taking all of that together, that’s approximately a 15% tax rate.
For this reason, capital gains tax is typically a lower rate of tax that business income tax, as business income tax is levied on 100% of the income (as opposed to only 50%). As a result, sellers of real property will continue to wish to characterize their profit as a capital gain, as opposed to business income.
Capital Gains Tax Levied on Sellers
If you sell real property in Canada which was held for a long period of time or for investment purposes, the tax levied on the seller will likely be capital gains taxation. This tax is required to be self-assessed and claimed on the seller’s personal income tax return, whether the seller is an individual or a corporation.
3. THE PRINCIPAL RESIDENCE EXEMPTION TO CAPITAL GAINS TAX
Paragraph 40(2)(b) of the Income Tax Act provides that a Canadian resident is not taxable on a capital gain from his principal residence; essentially the entire amount of the profit from the sale of a personal principal residence is exempt from taxation.
Principal residence is defined in Section 54 of the Income Tax Act. For a property to qualify as a principal residence, it must satisfy three basic requirements:
- the property must be “owned, whether jointly with another person or otherwise … by the taxpayer”;
- the property must be “ordinarily inhabited” in the year by the taxpayer or the taxpayers spouse (or former spouse) or child; and
- the property must be designated by the taxpayer to be his or her principal residence for the year.
The term “ordinarily inhabited” is not defined in the Act. The position of the Canada Revenue Agency with respect to the ordinarily inhabited rule is found in Section 2.11 of Income Tax Folio S1-F3-C2:
“The question of whether a housing unit is ordinarily inhabited in the year by a person… must be resolved on the basis of the facts in each particular case.
“Even if a person inhabits a housing unit only for a short period of time in the year, this is sufficient for the housing unit to be considered ordinarily inhabited in the year by that person. For example, even if a person disposes of his or her residence early in the year or acquires it late in the year, the housing unit can be considered to be ordinarily inhabited in the year by that person by virtue of his or her living in it in the year before such sale or after such acquisition, as the case may be.”
Since 2016, and pursuant to section 2301 of the Income Tax Act Regulations, a taxpayer’s designation of a property as a principal residence for one or more tax years is to be made in the person’s income tax return for the tax year in which he or she has disposed of the property. This designation can be achieved by completing Form T2091 (Ind) found here.
Change of use of principal residence
Under the Income Tax Act, you can be considered to have sold all (or part) of your principal residence even though if you didn’t actually sell it. This can occur if you convert all or part (e.g. the basement) of your principal residence to a rental property or conversely, decide to move into a property that you formerly rented out.
The tax rules state that each time you change the use of a property, you are considered to have sold the property at its fair market value and to have immediately reacquired the property for the same amount, which becomes your new tax cost of adjusted cost base. As a result, the general rule is that upon such a change in use, you are required to report the resulting capital gain (or, in some cases, capital loss) in the tax year this change of use occurs.
Not to fret however. If the property was your principal residence prior to the change of use, you don’t have to pay tax on any accrued gain.
There is some more good news. When you change your principal residence to a rental property, you may be able to make a special tax election to not be considered to have changed your use to rental property. If you do so however, you will lose your ability to claim any depreciation – known as capital cost allowance (CCA) – as a deductible expense.
While your election is in effect, you can designate the property as your principal residence for up to four years, even if you don’t use your property as your principal residence; however, you can only do this if you don’t designate any other property, such as a vacation home or cottage, as your principal residence during this period of time. If you make this election and then move back into your residence, there are no immediate tax consequences as a result of moving back.
Finally, what if you decide to convert only part of your principal residence into a rental property? While technically the change of use rule above applies, the CRA will consider you to have not changed its use if your rental use of the property is “relatively small in relation to its use as your principal residence,” you don’t make any structural changes to the property and you don’t deduct any CCA on the part you are using for rental purposes.
4. BUSINESS INCOME AND HST
As stated above, if you or your corporation is in the business of buying and selling properties, the CRA will deem the profits to be business income as opposed to giving rise to a capital gain. The implication is that you will in essence pay more tax. Business income is taxed as income at your marginal rate of tax, depending on your total income in a given taxation year. This is in contradistinction to capital gains taxation where only 50% of the gain is taxed as income.
The difference between business income and capital gains is that business income occurs on the disposition of a trading assets whereas capital gains occur on the disposition of an investment asset. As previously discussed, investment assets are those held for long periods of time and intended to accrue value and derive investment income during the length of ownership. For example, if you purchase a house as an income property, then you are taxed on the rental income as passive income during the period of ownership. When you sell the house however, any profit you derive will likely be taxed as a capital gain. That is because the purpose for which you held the house was as an investment asset and was intended to be held for a long period of time.
This is in contrast to the circumstance where you purchase a house with the intent to renovate or sell rather quickly in the future (for example, holding property for less than 5 years of ownership). In this instance, you did not intend to hold on to the property as an investment. The profit you derive from its sale will be taxed as business income.
Due to the large disparity in taxation, every seller wishes to characterize a sale as giving rise to a capital gain, and not as business income.
As a result of the increasing housing prices in the GTA, and the ability for large gains, the CRA has cracked down on sellers claiming the profit from a sale was a capital gain. The CRA will audit these transactions by first sending a questionnaire to the seller which questions items such as how much you paid for the property, whether you conducted any renovations to the property, whether you lived in the property and the reason for the sale. Essentially, you will have to establish that you sold the property for a reason other than to give rise to a profit, otherwise, you will not be able to maintain that you are not engaged in the business of buying and selling homes.
Where the CRA has determined the profit from the sale of the house to be business income, you will also have to be concerned about HST. Businesses are generally required to collect and remit GST or HST on its sales.
As discussed, there are various types of tax that arise in various circumstances and at various points in time in respect of the purchase and sale of real property. In Everything Tax When Purchasing or Selling a Property, we discussed Land Transfer Tax (LTT), Municipal Land Transfer Tax (MLTT), Harmonized Sales Tax (HST), Non-Resident Speculation Tax (NRST), property tax, capital gains tax, the principal residence exemption to capital gains tax and business income taxation.
These various taxes are also taxed by different taxation bodies or government entities in Canada. While Land Transfer Tax is collected by the Province of Ontario, property tax is collected by the local municipality and capital gains or business income tax is collected by the Federal Government, or CRA. And finally, of course, there are different rates of tax, even where the collecting body remains the same, such is the case between capital gains and business income tax on the sale of real property.
The various tax obligations in respect of the purchase and sale of real property can be complex. Should you require advise on your particular circumstance, you should consult with a lawyer.
The above provides information of a general nature only. This does not constitute legal advice. All transactions or circumstances vary, and specified legal advice is required to meet your particular needs. If you have a legal question you should consult with a lawyer.
Shira Kalfa – Partner. BA, JD
© Kalfa Law, 2018