In real estate it is important to take the long-range view of property investing. But every once in a while, when the situation warrants, we’ll sell a property. And when we do, just like any other property owner we’re mindful of the tax that we are exposed to (capital gains). Often overlooked or unknown by investors, understanding tax in life and in real estate in one of the key elements and is intrinsic to long term wealth creation.
In Canada, when investors sell capital property for more than they paid for it, Canada Revenue Agency (CRA) applies a tax on half (50%) of the capital gain amount. This is called the inclusion rate.
For example, if a Canadian in the effective tax bracket of 33% bought a piece of real estate for $500,000 and sold it for $600,000, the taxable capital gain amount would be $50,000, and as a result of their marginal tax rate, which is approximately 50% in most provinces they would likely pay half of that in taxes. The amount of tax paid would depend on the person’s total income, personal situation, and their province of residence.
There are ways to minimize capital gains tax when you or a group sells a multifamily property.
Getting Creative on the structure is an opportunity for both the seller and the buyer to maximize their Return!
Vendor Take Back Mortgage, Seller Financing or Balance of Sale
A form of seller financing, a Vendor Take Back mortgage (VTB) is an arrangement whereby the seller (vendor) signs a private mortgage contract with the buyer. No bank or lender is involved. The buyer agrees to make regular monthly payments to the seller until the debt is paid off.
Once the transaction is closed and the title of the property is transferred to the new owner, the seller retains equity or provides a mortgage on the property equal to the amount of the unpaid balance or the mortgage amount. This arrangement continues until the buyer pays off the original amount plus interest. If the buyer defaults, the seller/vendor has the right to foreclose, just like a bank.
A Vendor Take Back VTB or Balance Of Sale can occur in conjunction with a traditional bank mortgage, whereby the buyer borrows a portion of the purchase price from a bank and enters into a vendor take back mortgage with the seller/vendor.
If properly structured a VTB mortgage can be a mutually beneficial opportunity for both the buyer and the seller.
So how can a vendor take back mortgage help the seller with capital gains taxes?
It can help because the seller is spreading out their capital gain over a period of years rather than all at once, in one year. This can affect their tax bracket and lower the amount they pay in capital gains tax. The Canadian personal tax system is a progressive tax system, which means that the more you make, the higher the tax rate and hence the more tax you will need to pay.
In tax year 2020, Canada’s income tax brackets are:
- 15% on the first $48,535 of taxable income, plus
- 20.5% on the next $48,534 of taxable income (on the portion of taxable income over $48,535 up to $97,069), plus
- 26% on the next $53,404 of taxable income (on the portion of taxable income over $97,069 up to $150,473), plus
- 29% on the next $63,895 of taxable income (on the portion of taxable income over $150,473 up to $214,368), plus
- 33% of taxable income over $214,368.
The increase in the rate of taxation is significant. Therefore, if it’s legally possible to get yourself into a lower tax bracket, it’s a good idea.
The advantages for the seller are mainly related to tax on capital gains and income. Further in many cases it enables the seller to receive a higher sale price and receive a secured monthly return above and beyond the sale itself. For the buyer, the main benefit is that this arrangement can reduce or in certain scenarios entirely eliminate the amount of capital required to close a transaction. Using these tax strategies can drastically increase the ROI of a real estate deal.
An example is as follows;
List Price and Purchase Price: 2,000,000$
VTB or balance of Sale: 250,000$
Term: 12 months
Monthly payment: 2,500$
Interest Rate: 12%
Return on VTB: 30,000$
Effective Sale Price: 2,030,000$
Any decisions that you make regarding your taxes should be made only with the consultation of a tax professional but spreading out your income over several years can save you from a big one-year tax hit by timing the year of tax inclusion to your advantage.
Capital Gain Reserve
When you sell a capital property, you can claim a capital gain reserve for the proceeds to the extent that they have not yet been received.
The capital gain reserve reduces the amount of the capital gain you report as income in a particular year. First, you calculate your capital gain. Then you reduce the capital gain with the reserve you would like to claim in the year. In the first year of disposition, not more than four-fifths of the gain can be taken as a reserve. Then, in the year after you claimed a reserve, you need to include the reserve as income.
Interest Vs. Principal Payments on a vendor take back
When structuring a purchase or a sale that involves a VTB, consider the implications of interest versus principal payments. When a borrower repays a loan that you have provided to them, the interest and principal are taxed differently. The interest is calculated as real taxable income, and taxed accordingly, whereas the principal is not. For example, if you loan someone $1000 and they pay you back $1000, it’s not taxed as there was no gain but if they pay you the principal and also $100 in interest, that would be taxable income. Likewise, if you do a vendor take back and charge interest, the interest is real income. (This is entirely distinct from capital gain).
Consider the following; Instead of paying interest, principal payments can be made. This strategy is largely to the benefit of the seller as it will exempt them from having to claim the payments as income as principal payments are not taxable as income. Therefore, you can structure your payment schedule and type of payment to be as tax efficient as possible based on your own personal scenario on a yearly basis. Conversely, from the buyers perspective, it is not overly helpful as interest paid on a mortgage is deductible however the principal payments strategy can simply be used as a bargaining chip to get the deal done and entice the current owner into understanding the value a VTB.
The point of this article is not to provide tax advice. The message is that you, as an investor in multifamily real estate you should be aware of how to structure deals in order to maximize profits and be tax efficient. By using these unconventional and creative transaction structure, there can be great benefits to both the buyer and the seller.