How to Report Gain from Property Sale the Right Way Part 2

I just received a couple of emails from clients telling us that they got their CEBA loan approved.

CEBA loan application deadline has been extended to October 31.

It’s always heartwarming to see clients’ messages thanking us for hosting the webinar and sharing what we know from our own application process. 😊

I’m happy to report that many of our clients can get the help from the government they need to continue with their business.

The government has also made it clear that they would make the loan accessible to entrepreneurs who do not have a business bank account. Information on how to apply without one has not been updated as of yet. Stay tuned and we will keep you posted.

Last week, we wrote about the criteria to determine the nature of the property sale.

Let’s continue on to apply to a real court case so you can get a better idea of how it works.

Here’s the background story of the court case 9229-2987 Quebec Inc. v. The Queen.

Taxpayer has been in the property management business during the taxation years at issue (2010 and 2011).
Taxpayer is also a real estate investor and has been one since 2007. He started small, just like you and I, by buying a duplex. He went on to acquire multiple rental properties in different areas of Quebec. Some of them are owned in corporations.
In 2010, he acquired two apartment buildings: Bordeaux 1 and Bordeaux 2.
He stated that he intended to continue to grow his rental property portfolio and increase his income.
He even mentioned that he hired a property management company to manage the properties.
He financed the purchase of the building with a mortgage from a credit union and an interest-bearing promissory note.
He had an engineer friend that came out with him to inspect these properties prior to closing. Only a visual inspection was done and they did not inspect the basement.
Unfortunately, after closing in Feb 2011 of Bordeaux 1, he discovered the extent of the structural problems in the two buildings. The goal of earning rental income from these properties was no longer feasible.
His lawyer also advised him that it was impossible to recover anything from the previous owner, especially because the problem could be easily noticed when an inspection of the basement was done – which taxpayer claimed he didn’t do.
He couldn’t afford to pay for the repairs required. His credit union banker advised him to turn the properties to joint ownership for easier financing.
“He decided to repair the structure, renovate the apartments, place the buildings under joint ownership and sell the apartments individually.”
“He did this to limit his damage”, but ended up making profits.

Analysis by court

Let’s revisit the criteria that the court looks at, specifically from this court case –

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.

Intention

The judge found that the taxpayer had the intention to sell these two buildings for profit at the time of purchase based on the following reasons:

The taxpayer stated that he didn’t inspect the basement or inside of the apartment units, hence did not discover the extent of repairs required.
Based on the Agreement of Purchase and Sale of Bordeaux 1, the taxpayer had an inspection condition stipulated. The taxpayer confirmed that he was satisfied with the condition of the building. It’s not plausible that no inspection was done in the basement to uncover the structural issue, especially since the taxpayer had been a property manager for a number of years.
The Bill of sale of Bordeaux 2 specified that the buyer had examined the building prior to closing, but the taxpayer claimed that he did not inspect the property until after closing. He found out that the floors were sinking in one of units from a property manager walkthrough after closing.
The Judge did not believe that it could be plausible that the taxpayer didn’t inspect the unit, given the amount of structural problems he experienced in Bordeaux 1.
One of the reasons why the taxpayer was forced to sell the property as joint ownership was because he didn’t have the money to finance all the repairs. He issued a termination cheque of $26,000 to one of the tenants to vacate her housing unit.
He also claimed that he realized that he could not sell one apartment individually and rent out the rest of the building to others, therefore, he set up the joint ownership structure and sold the rest of the apartments. The Judge did not understand why he could not continue to rent out the rest of the units.
After closing, when the taxpayer discovered the structural issue, he hired an engineer to inspect the property in April. Two cheques were issued to tenants at two of the units to terminate the lease 5 days after the taxpayer claimed that the engineer told him about the extent of the structural problems.
The deed of Bordeaux 1 had a release clause that required “the seller to agree to release his mortgage on the undivided rights sold to the first 3 buyers, without any repayment. The buyer agrees to pay the full balance due plus interest accrued upon the 5th sale.” – which basically said that the taxpayer had the intention to sell the property at the time of closing.
The judge was not satisfied that the idea of selling the property under joint ownership came from the banker.

Other factors

Ownership period was very short – 6 to 18 months for Bordeaux 1 and 4 to 7 months for Bordeaux 2. The shorter the ownership duration, the more likely that the intention was to resell them at a profit.
Nature of business & taxpayer’s occupation – he’s an experienced real estate businessman and had years of experience working as a property manager. The judge believed that he must have known that he could make a quick profit flipping these properties.
Nature and use of the property – the buildings are located at a highly desirable area in Montreal, which was indicative of an intention to resell at a profit.
Financing – purchase was 100% financed and taxpayer paid off the sale price less than one year of acquisition, which again was indication that the taxpayer intended to resell the property for quick profit.

Now you know, the court goes deep into the details of the agreements, deeds, mortgage terms, ownership period, your profession, as well as the nature and use of the property, to come to an overall conclusion as to whether you’re selling a property for income or capital gain.

It is extensive and all your evidence should support your original intention.

Until next time, happy Canadian Real Estate Investing.

Cherry Chan, CPA, CA

Your Real Estate Accountant