Cherry Chan Your Real Estate Accountant

Corporation, Real estate corporations, Real estate investment, Real Estate Investors, Should I incorporate?

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

/2 Comments/by Cherry

Corporation, Real estate corporations, Real estate investment, Real Estate Investors, Should I incorporate?

How to Report Gain from Property Sale the Right Way Part 1

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

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Corporation, Real estate corporations, Real estate investment, Real Estate Investors, Should I incorporate?

4 Reasons Why You Should Set Up a Will Now to Protect Your Love Ones

Life is all about perspective.

Yesterday, I got 4 back to back calls from my tenant in Toronto, while I was having my best round at golf this year. The last time I got 4 back to back calls from this tenant, it was about how the fridge broke down and he couldn’t get the delivery guy to show up on time.

I didn’t give in, didn’t call my tenant back until after the golf game to this seemingly urgent call.

When I finally got to call him back, he apologized for not having sufficient funds in the bank account to clear the pre-authorized debit request. He went on to explain to me how hard he tried to have sufficient money for the withdrawal for 15 minutes.

He was willing to compensate me for the NSF fees.

I laughed.

I told him that I just went to my client’s funeral last week. He died young. He was only 35.

His death changed my life perspective.

A NSF cheque here and there may drive you crazy, but in the grand scheme of things, it’s really no big deal.

When you’re stressing out, step back, take a deep breath. Maybe you can still work it through.

Compared to life and death crises, many of our problems seem small.

Speaking of life and death, I want to take this opportunity to reshare my blog post about drafting up a will.

This exact experience made me realize how important it is to have a will.

You can decide what you want

If you don’t have one already, please get one done. When the unfortunate things happen suddenly, at least you already lay out a plan. You lay out exactly what you want to get done, you lay out how the assets can be distributed.

Estate distribution can be a lot longer

At least, whoever has to take care of the assets and liabilities can do it without going through months of waiting.

When you have no will, the next of kin (spouse or children or parents) has to apply to become the estate trustee. This person has to post a bond to pay the Government. The bond application process is time consuming and difficult.

The government decides how your assets are distributed when you don’t have a will

If you don’t have a will, the first $200K of your assets are first given to your spouse and anything over $300K is shared between the spouse and descendants.

If your kids are minors at the time when the unfortunate event happens, and if you don’t have a will, this automatic allocation can pose problems.

Higher income taxes and higher probate

When a Canadian taxpayer passes away, all your assets are deemed to dispose at fair market value.

You might not have actually sold your properties at that time, but the Income Tax Act still deems the sale have happened.

This means that your estate would need to pay taxes, based on the increased value of the property.

If your families are not prepared for it, they may have to sell a few of the properties to pay for the final tax bill.

If you plan ahead, there are ways to minimize the tax at death.

On top of the income tax liability, the Ontario government also charges Estate Administration Tax at 1.5% on assets over $50K.

If the fair market value of your assets is $3M, you will have to pay $3M x 1.5% tax = $45K.

Can this amount be minimized? Absolutely. This can only be minimized with proper planning.

Here’s the previous blog post about the 8 items you should consider when you set up a will.

Until next time, be grateful.

Cherry Chan, CPA, CA

Your Real Estate Accountant

/1 Comment/by Cherry

Corporation, Real estate corporations, Real estate investment, Real Estate Investors, Should I incorporate?

Smith Manoeuvre: How to Turn Primary Home Mortgage Interest Tax Deductible the RIGHT WAY

A couple of clients recently asked us about Smith Manoeuvre, I would use today’s post to share with you how it’s done and how it can increase your tax deduction.

Step 1: Get a re-advanceable mortgage on your primary residence/personal used properties

The key here is to start with a re-advanceable mortgage. A re-advanceable mortgage is a mortgage that allows you to increase the home equity line of credit as you pay down your mortgage.

As you pay your monthly mortgage payment, your line of credit availability increases.

You can now BORROW MORE from your line of credit.

If you borrow from this line of credit to invest in stock or buy an investment property, the interest on the borrowed fund is tax deductible.

Step 2: Use your after-tax earnings/extra saving to pay down your home mortgage

Generally speaking, your primary residence mortgage interest isn’t tax deductible.

If you have extra cash available for investment immediately, you can first use your extra cash to pay off your primary mortgage, which in turn increases the line of credit available for investment.

Step 3: Use the extra line of credit available to invest in stock and real estate

You borrow against your line of credit to buy a house or invest in the stock market.

Interest from your line of credit is now tax deductible.

Word of caution though – if you borrow to invest in TFSA, RRSP and any registered account, chances are, the interest would not be tax deductible.

The investment you use your line of credit to make must be outside of a registered account.

Step 4: Keep up your paperwork for year-end tax deduction

If you use the extra cash/saving to invest, your primary home mortgage interest would not be tax deductible.

By transferring cash the proper way and taking advantage of what is available from the mortgage terms, you are now making your primary home mortgage interest tax deductible.

Like I said all the time to my clients, in Canada, you need to “earn your deduction”.

Earning your deduction means that you have to keep track of your paperwork, all the transfer slips, deposit details to ensure that you can prove that the funds from your line of credit is used for investment purposes.

Make sure you keep the documents until you fully repay the loan.

Step 5: Rinse and repeat

You can rinse and repeat with your savings – turning your non-deductible primary home interest to deductible investment interest.

Commonly asked questions

1 . Line of credit interest is usually higher than my mortgage interest. Wouldn’t it be beneficial to pay less interest?

It depends on your marginal tax rate.

Marginal tax in Ontario can be as high as 53.5%.

If we round it down to 50% for ease of calculation.

50% tax rate means that if you get to write off your mortgage, you save taxes for approximately 50% of the interest cost.

Your deductible interest cost x 50% tax must be greater than the difference between your mortgage interest and your line of credit interest.

Even if the numbers don’t work out, which is unlikely, you can also restructure your line of credit into a low fixed interest rate mortgage. I’ve heard mortgage rates as low as 1.89% these days. 😉

2 . My mortgage term ended. My banker suggested that I should combine my mortgage and line of credit as one lump sum mortgage. Can I still deduct the interest against my investment?

Absolutely. All you need is to keep all your initial documentation, your paperwork to combine the line of credit with mortgage, until you eventually stop deducting the interest cost.

Remember, paperwork is the key.

Just because CRA says that you are required to keep 7 years of documents do not always mean that you don’t need to keep certain paperwork for longer.

3 . If I combine my primary home mortgage with my line of credit that I use for investment purposes into one giant mortgage, how do I know how much interest I can deduct?

The balance outstanding on the line of credit at the time when you combine it with your home mortgage matters.

Say, at the time when you combine the two, you owe $100K on your LOC and you used the entire LOC for investment purposes. And you also owe about $200K on your home mortgage.

The new mortgage balance is $300K.

1/3 of the interest expense would be tax deductible

= 100,000 (LOC balance before the new mortgage is formed) / 300,000 (new combined mortgage balance x Interest expense

Until next time, happy Canadian Real Estate Investing.

Cherry Chan, CPA, CA

Your Real Estate Accountant

/2 Comments/by Cherry