Hope you guys enjoyed the last weekend of August.
It’s hard to believe that we’re already in the middle of September and my kids are expected to go back to school next week.
We managed to spend the last weekend hanging out with friends and their kids. We rode our bike along Hamilton Beach Trail – yes, there’s a beach in Hamilton and the trail is awesome! 😊
We learned from our kids that happiness can be super simple, it can be as simple as finding rocks and throwing them into Lake Ontario. (They spent at least an hour throwing rocks into the water… 😉)
Sometimes, I wish Income Tax Act can be as simple as kids’ happiness.
Oh well, it surely isn’t the case for this real estate investor in Quebec.
He’s the main character in this court case 9229-2987 Quebec Inc. v. The Queen (2019TCC 281) that I found. His case can be relevant to all Canadian real estate investors out there.
Many real estate investors believe that when a property is sold, you pay tax on capital gain tax. The truth is a property sale can be treated as income OR capital gain.
When your intention is to flip a property, profit from flipping the property is considered income, 100% taxable.
When profit is reported as capital gain, 50% of the profit is taxable. If you have $100K profit made, only $50K is taxable. At 50% personal income tax rate, you are liable for $25K of tax payable.
When profit is reported as income, 100% is taxable. $100K profit at 50% tax rate means that you are liable for $50K of taxes.
If you flip a property inside a corporation, it is considered active business income and therefore it is only taxed at 12.5% in Ontario before accounting for any personal income tax impact.
Most real estate investors would be biased to report a sale as capital gain, since 50% of the gain is taxable if a transaction is reported as capital in nature.
The tax impact is simple, but how doses CRA or the tax court decide whether a property sale is considered business income or capital gain?
Well, Income Tax Act does not have any rules to measure whether “the gain from disposition of a building is attributable to income or considered business income or attributable to capital and considered capital gain,” according to this court case.
The term “business” … includes “an adventure or concern in the nature of trade”.
(If you’re lost because you don’t understand what “an adventure or concern in the nature of trade” is, it’s okay. I read this term over 100 times, and I am still having trouble understanding it. 😉)
The court and CRA are relying on judgements from prior court cases and an Interpretation Bulletin IT-218R developed by CRA to analyze whether a transaction is considered business or not.
Particularly, the court case called out paragraph 17 of this bulletin to analyze the case facts (and yes, these are the criteria you use to apply to your situation):
- The taxpayer’s intention with respect to the real estate at the time of purchase and the feasibility of that intention and the extent it was carried out. An intention to sell the property for a profit will make it more likely to be characterized as an adventure in the nature of trade.
- The nature of the business, profession, calling or trade of the taxpayer and associates. The more closely a taxpayer’s business or occupation is related to real estate transactions, the more likely it is that the income will be considered business income rather than capital gain.
- The nature of the property and the use made of it by the taxpayer.
- The extent to which borrowed money was used to finance the transaction and the length of time that the real estate was held by the taxpayer. Transactions involving borrowed money and rapid resale are more likely to be adventures in the nature of trade.
The most important factor to determine whether a transaction is business or capital in nature is the intention of the taxpayer at the time of acquiring the property.
Also, if, at the time the property was acquired, you also have the secondary intention that if the long-term investment project could not be worked out, you can sell the property at a profit. This profit would be attributable to income, and not capital. ☹
So…how do you determine intention?
Intention isn’t just what we say our intention was at the time of acquiring the property. Your stated intention must also be corroborated with surrounding evidence.
CRA and the court both look at evidence such as:
- What did you do to the property?
- If you buy, renovate, sell immediately after within a short period of time, it’s more likely the transaction is considered to be a flip.
- If you buy, renovate, rent for a long period of time, sell it after you retire in 10 years, sale is likely attributed as capital transaction.
- How often do you do these transactions?
- When you operate a business, you tend to transact more. You do not stop at one. You buy, renovate, sell a few. The more often you do these transactions, the more that you look like you are considered conducting a business and the more likely the transactions are treated on business account, therefore 100% taxable.
- Agreement of purchase and sale
- Conditions in the agreement sometimes include vacant possession. If the intention is to flip the property, as a real estate investor, you want to ask for vacant possession.
- Some agreement of purchase and sale requires the seller not to rent out the vacant unit. This can also be viewed by court that your intention
- As a buyer, when you agree to take over the existing tenants, it is more likely that the transaction is viewed as long-term investment (on capital account and only 50% taxable upon sale).
- Mortgage terms
- Short-term financing can generally be viewed as a support that the transaction is a business and therefore profit from the sale of the property is 100% taxable. If you intend to flip, you tend to sign up for short term mortgage to avoid the large mortgage penalty.
- Long-term financing, a five-year fixed interest closed term mortgage, gives support that you intend to hold the property long-term.
- Other factors
- Did you hire a property manager? Assumption is that you would only hire a property manager if you intend to hold the property long-term and you intend to earn rental income.
- Are you an insider? Are you a real estate agent/broker? Are you a property manager by trade yourself? Are you a real estate lawyer/developer? If you’re in one of these professions, the transaction is more likely to be viewed as business transaction.
It isn’t black and white, as you can see. Hence why there’re court cases after court cases that I’ve been reading about these transactions.
In the next week’s blog post, we will dive deep in this 2019 court case to get a better grasp at how these principles are applied in real life. 😊
Stay tuned, happy Canadian Real Estate Investing.
Cherry Chan, CPA, CA
Your Real Estate Accountant
