Canada does not have a 1031 Exchange like the US.
Property investors in the United States use the 1031 like-kind exchange as a tax advantage to reduce their capital gains taxes.
If you are wondering whether Canadians enjoy a similar tax deferral benefit like the 1031 like-kind exchange, here’s what you need to know.
What is a 1031 Exchange?
The 1031 exchange originated from Internal Revenue Code (IRC), section 1031 in the U.S.
The 1031 exchange enables investors to defer taxes on capital gains from property disposal when they exchange property held for productive use or investment.
Typically, if the sale proceeds from an investment property are reinvested into another property that is like-kind in nature, an investor can avoid paying taxes subject to fulfilling the rules of the 1031 exchange.
The tax advantage with a 1031 exchange is a ‘deferral’; this means that when the reinvestment property is sold, the deferred capital gain from the disposed property plus any additional gain from the replacement property would be subject to tax.
Canadian Equivalent of a 1031 Exchange
There is no equivalent to the 1031 exchange in Canada.
Your capital gains on property disposal are subject to tax in the year that you realize the gains.
However, the Canada Revenue Agency (CRA) allows Canadians to defer capital gains on capital property sale using the capital gains reserve discussed below.
Canadian Owning US Property
As a Canadian, if you own an eligible property in the US, you can leverage the 1031 exchange for US tax purposes.
However, Canadian residents are also subject to tax in Canada.
You will need to report your capital gains to the Canada Revenue Agency.
When you eventually sell the reinvestment property, you may be able to claim the foreign tax credit to make up for double taxation.
The Capital Gains Reserve Mechanism
While Canadians do not have the liberty to defer taxes on property sale using the 1031 exchange, the CRA allows capital gains tax deferral through a capital gains reserve.
Typically, when you sell a property for a higher price than the base cost —usually the purchase cost, plus selling and other outlay costs, you will have a capital gain on your property sale.
When filing your tax return for the applicable year, you need to report this gain.
The CRA will tax half (50 percent) of your capital gains.
To claim the capital gains reserve, you need to fill and submit Form T2017, Summary of Reserves on Dispositions of Capital Property.
Generally, you can claim a capital gains reserve for a maximum period of four years; exceptions apply.
Here’s how you can defer and spread your capital gains tax using the capital gains reserve.
If you receive installment payments for your property sale, you can defer the tax on other partial payments until you receive them.
For example, suppose you sell a property with a purchase cost of $50,000 for $150,000.
In that case, you will have a capital gain of $100,000.
You receive $50,000 upfront and $25,000 equal installment payments for four years.
With partial payments, you can calculate a capital gains reserve, which you will apply to reduce your capital gains.
A simple calculation to determine the maximum capital gains reserve you can claim in the year is:
Capital gain × (Amount payable after the end of the year / Proceeds of disposition)
Using the example above, 33.3% of your Capital Gain can be deferred using the reserve.
Maximum capital gains reserve for the year: $100,000 x ($50,000 / $150,000) = $33,333.
While this is only a simple example to guide you, you will need to compare this amount to other calculations that the CRA has provided in Form T2017.
The capital gains reserve you can claim depends on the type of property you dispose of and when you dispose of the property.
Frequently Asked Questions
- Does 1031 exchange exist in Canada?
The 1031 exchange does not exist in Canada. Capital gains on property disposal need to be reported and applicable taxes paid in the year the property is sold.
- Can you defer capital gains tax in Canada?
Yes, you can defer capital gains in Canada using the capital gains reserve. The capital gains reserve allows you to receive partial payments for your property sale and spread the capital gains over a few years.