There’s a good cross-section of real estate investors who invest in both the United States and Canadian markets. And while they have many similarities, there are also key differences. One of the most important to get familiar with is the difference between U.S. IRC §1031 and Canada’s ITA §44.
Table of Contents - Finance Corner: Clearing up Confusion Between U.S. IRC 1031 and Canada’s ITA 44
The distinction boils down to this. In the United States, a real estate investor can sell a property and avoid capital gains tax if they use their earnings to purchase a “like-kind” property. Canadian investors don’t have this option. While they can avoid capital gains on a “replacement” property, the stipulations don’t apply to real estate investments.
A look at U.S. IRC §1031
According to the United States Internal Revenue Code (IRC), section 1031, investors can defer capital gains on the sale of a property by rolling those gains into the purchase of a new property, so long as it meets the following criteria:
- There is an exchange of property “solely” for a like-kind property;
- Exchanged properties are used for trade/business or investment; and
- The exchange takes place within 45 days, with ownership transferred within 6 months.
Realistically, this simply means that U.S. real estate investors can sell a property at a profit and use that profit to purchase another investment property without triggering capital gains. This is useful for investors who want to get out of a saturated market or who may find a better rental opportunity elsewhere.
Comparing ITA §44
Due to the language of Section 44 of Canada’s Income Tax Act (ITA), many investors often confuse it with the benefits offered by U.S. IRC §1031. ITA §44 states that capital gains can be avoided by rolling them into a “replacement” property. Replacement is the objective term, and it differs substantially from “like-kind.” Replacement also connotes that the original property is no longer available to the investor. That’s the rub.
To take advantage of deferred capital gains from ITA §44, the property has to be subject to “involuntary disposition.” That means stolen, destroyed or forfeited to the government by way of an easement. Moreover, the property itself has to have been used to generate income for a business—rental property is specifically excluded (subsection 248.1 of the Act).
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What’s the purpose of ITA §44?
If it can’t be used in instances of rental properties, why should real estate investors care about ITA §44 at all? Well, for starters, because it does have a role in mitigating your tax burden in certain situations. Here’s an example:
You own a small duplex you use as an office. It’s your base of operations—where you do your prospecting, meet with your investment team, and where you keep your tools and other materials. No one rents there, but it’s part of your real estate portfolio nonetheless. One day, it burns down. You use the insurance money to purchase a similar property for the same purpose. Instead of paying capital gains tax on the insurance payout, you’re able to avoid that tax burden by purchasing replacement property.
In other situations, properties you own with business ventures operating on them are also eligible for ITA §44. For example, if you own farmland that’s seized by the government as part of municipal development.
The stipulations for ITA §44 are narrow and sometimes confusing, but that doesn’t mean they should be ignored. If you’re focused on pure rentals, ITA §44 might not be worth worrying about. However, if you’re putting your real estate to work in other ways, it’s important to know the law.
Income tax in Canada for Real Estate Investors
How to shelter against capital gains?
There’s no avoiding the taxman. Benjamin Franklin had it right when he said, “the only things certain in life are death and taxes.” Do what you might, you’ll eventually end up paying some form of capital gains tax if you sell a property that has substantially appreciated over the years.
Canada’s capital gains are taxed as income, which means you’ll pay a rate between 0% and 33%, with most cases trending toward the higher end of the scale. Thankfully, there are ways to reduce this burden. Here are a few tips for reducing capital gains:
- The longer you hold the asset, the lower the capital gains tax tends to be. Holding for longer than a year could be enough to cut your effective tax rate from 33% to 15%, thereby reducing the amount owed.
- Did you lose money on investment this year? Capital losses offset capital gains. If you’re underwater on investment and it’s time to cut your losses, time the sale near the sale of a profitable property to mitigate your tax burden.
- Sell properties when your income is low to cut your effective tax rate. For example, if you recently quit your job to invest full time, you might drop down a couple of tax brackets. The lower your income, the lower your effective tax rate on capital gains.
It’s a good idea to have an accountant or tax professional on standby as part of your investment team. They’ll be able to look at your financial situation and pinpoint ways to offset capital gains.
Know your position before you sell
If you’re used to investing in U.S. real estate markets and taking advantage of U.S. IRC §1031, be warned that Canada doesn’t have any similar programs. ITA §44 may have similar language, but the circumstances are entirely different. It’s easy to make a mistake and land yourself in a tricky tax situation if you don’t know the difference.
One of the smartest things you can do before selling a property is to evaluate your position. How would the sale affect your taxes this year? Are there ways to offset capital gains? Do you qualify for ITA §44 based on the loss of property? Every situation is different, and different solutions apply. Recognizing your situation and the options in front of you will help you buy and sell with confidence.
How To Avoid Capital Gains Tax When Selling Real Estate
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