Many people have misunderstanding about property sale.
Many taxpayers are under the misconception that if he/she lives in a property at some point in time, upon sale of the property, one doesn’t have to pay taxes on the gain from the sale of property.
Even my mom was misinformed by her previous real estate agent…
Well, it isn’t true because:
There are elections available to allow you to shelter the gain from the rental years, provided that you meet certain criteria.
But…
Just because you live in a property for a period of time, it does not mean that you are able to shelter all the gain from the sale of the property.
But how do CRA determine if your intention is to flip property?
I could easily claim that my intention was to live in the property, and circumstances changed so it forced me to sell.
The responsibility is on the taxpayer to prove his/her “claim”.
Previous court cases have set out some criteria/guideline for CRA and taxpayers to follow.
If you have the intention to flip, then the property purchase and sale is considered part of a course of a business. When you are considered conducting a business, the profit you made from the sale is 100% taxable.
It gets worse if the taxpayer demolishes the house and builds a new one.
On top of the potential income tax payable, the taxpayer is also considered a builder in the eyes of Excise Tax Act.
If you’re considered a builder building something new, you’re required to charge HST on the sale of the property.
HST on sale of a new build home … can be substantial.
In a recent Federal Court of Appeal case, the taxpayer, who’s a real estate agent for over 20 years, was caught building 3 houses in Vancouver in 2006, 2008 and 2010 without reporting the profit from these 3 flips on his personal tax returns.
This resulted in a total of $2.1M unreported income in the year 2006, 2008 and 2010…
AND…
GST assessments totalled $578K from these transactions…
This could easily be a combine total of $1.5M of tax liability that the taxpayer would have to bear. ☹
The decision factors undertaken by the tax court judge are the following:
This taxpayer did not report these transactions on his tax returns, citing that he lived in all three properties.
The judge went through each criterion one by one based on the taxpayer’s testimonial and the evidence presented. In particular…
The taxpayer moved in and moved out, purchased and sold these three properties within a short period of time. First property was sold within 16 months, second property was sold within 21 months and third one was sold within 16 months again.
Taxpayer bought the first property in 2006, tore the existing home down, build a new one.
He listed the property before he obtained occupancy permit. Sold it immediately afterwards.
Same thing happened to the 2nd and 3rd property in 2008 and 2010.
He also did similar transactions in his corporation as a property developer.
The number of transactions lead to the conclusion that he profits from sale of these three homes were on the income account.
It was obvious that there was a lot of work done in these properties.
In addition, the taxpayer reported moderate income in these years, ranging from $15K to $20K annually, showing that he spent majority of his time working on building these properties.
The taxpayer cited that he didn’t want to take on so much debt and hence why he had to sell all these homes shortly after completion of the construction.
The tax court judge didn’t find this statement to be credible.
The taxpayer bought the first property and took on $812,500 mortgage.
He then took on a mortgage of $1.125M for the second property and $2.1M with the third one.
The claim made by the taxpayer was inconsistent with the facts surrounding the case.
Based on all the analysis done above, the court did not find that the taxpayer’s stated intention (i.e. to live in these properties as his primary residence with his son) to be credible or plausible.
All evidence proved that he acquired each property with the intention of reselling them for a profit.
Well, the Tax Court Judge concluded that the taxpayer was trading these properties on income account. Meaning that he’s conducting a business and hence 100% of his profit was taxable.
He could not qualify to claim primary residence exemption if the transaction was on income account. ☹
The story didn’t end there. We’re talking about $1.5M tax liability here.
Taxpayer appealed. Federal Court of Appeal kept the original ruling.
Lessons learn?
Just because you claimed you lived in the property does not necessarily mean that you don’t have to pay tax on sale of the property…
Until next time, happy Canadian Real Estate Investing.
Cherry Chan, CPA, CA
Your Real Estate Accountant
Happy Canada Day.
I’ve lived in two different places in the world.
July 1 is a special day. It is also the anniversary that my hometown, Hong Kong, was handed over to China.
Sometimes I wonder how my life would have turned out if my dad didn’t make the bold move to migrate to the greatest country in the world. 😉
We have freedom of speech. We can say pretty much whatever we want, without interference by our government.
We have free health care system. It is not perfect by any means, at least no one has to choose to leave the hospital because they cannot afford to pay for medical care.
We have a strong real estate market. Our government policies and banking system allow us to borrow 80% loan to value for the most part. Investments are much easier here.
Sadly enough, it is getting more difficult for the millennials to get to home ownership these days without some creative strategies.
When I bought my very first townhouse in Toronto 10 years ago, it was not easy either. I lived paycheck by paycheck just to pay for the mortgage and afforded my expensive taste in car.
The house was an executive townhouse, 3 bedrooms and 3 bathrooms. I was single at the time, didn’t really need to live in such a big house.
It never dawned on me that I could have found a roommate to share some of the house expense.
If I could go back in time, I would find a roommate. A few hundred dollars a month of extra rent would have gone a long way.
This is called house hacking, renting out a portion of your own home.
As Canadians, we have to report worldwide income.
When we house hack to earn extra income, we’re also required to report the rental income in our tax return.
What are the tax implication of house hacking?
There’re two major tax implication:
Rental income reporting
Death and taxes are the two inevitable things in life, especially as Canadians.
It should not come in as a surprise that we have to report rental income received from renting out a portion of your home.
The Income Tax Act also allows taxpayer to deduct the expenses incurred to earn the income.
If I were to rent out 1 bedroom of my townhouse and my tenants and I shared all common area including kitchen and bathrooms, I would have been eligible to claim at least 1/3 of the house expenses against the rental income I were to earn.
This means that I could have deducted 1/3 of my mortgage interest, property tax, insurance, utilities, repairs and maintenance, and maybe internet and cable as well against the rental income I received.
Capital gain tax on sale
One of the biggest tax free investment you can get in Canada is our own home.
If you sell your primary residence for capital gain, you can shelter your entire capital gain under primary residence exemption.
So no tax is charged on the money you made from your primary residence.
If you were to rent out a portion of your home, can you still call your entire property as your primary residence and apply the primary residence exemption on the entire capital gain when you sell the property?
The answer isn’t as simple as you think.
In my Toronto townhouse example illustrated above, if I were to rent out one of the bedrooms and claim 1/3 of the house expenses against the rental income, chances are, I would still be able to call my entire house as my primary residence.
So no tax on sale of my property.
Why?
But… if I bought a property and converted it to a legal duplex, the result could be very different.
Well…
In this case, upon sale of this property, I would be able to shelter the capital gain on the portion that I live in. However, I would have been liable to pay capital gain on the rental unit.
Everyone’s situation is different. Good luck househacking.
Until next time, happy Canadian Real Estate Investing.
Cherry Chan, CPA, CA
Canadian tax system is a complicated tax system.
Hence, we routinely do internal and external training so that our team can have the most up to date tax knowledge.
One of the court cases that was brought up by our tax instructor was a court case that happened in 2014 in BC about a storage facility owner who reported all the income as active business income in his corporation.
If you own a small business, net income generated is taxed at a much lower rate in a corporation. In Ontario, the small business tax rate is 12.2%.
This is only applicable if your business is earning active business income.
Active business refers to “any business carried on by the corporation other than a specified investment business…”
“Specified investment business” is defined as “a business carried on by a corporation in a taxation year the principal purpose of which is to derive income (including interest, dividends, rents and royalties) from property…”
In another words, the rental income and interest income you receive in your corporation are not considered as active income and they are not taxed at 12.2%.
It is taxed at the more complicated system, the refundable dividend tax system.
Specified investment business income first gets taxed at 50%, with 30% refundable if the corporation pays its shareholder a taxable dividend. So net tax payable in the corporation is roughly 20% afterwards.
But… who wants to pay 50% upfront anyway – even though after the refund, you pay 20% in your corporation.
Definitely not with this storage facility owner in BC back in 2006 to 2009.
He reported all his income as active business income, on the basis that he provided many additional services, such as providing a full-time staff on site regularly, provide access to staff on call 24 hours a day, 7 days a week, delivering reusable storage boxes to customers and pick up and storage when the customer packed the boxes, helped loading and unloading customer property, snow removal, receiving shipments on behalf of customers, and even providing shuttle services to customers and more…
The taxpayer argued that his customers were paying for the bundle of services, not rental space.
If the customers were paying for bundle of services, the income wasn’t derived from property. So, his income received would have been classified properly as active business income, taxed at the low small business rate.
Unfortunately, the judge didn’t agree with this argument.
The tax court judge was in the opinion that there was only one business. If one took away the storage units there would be no business. If one took away the services provided there would still be a storage business.
The judge was in the opinion that the customers were paying rent, not services.
The taxpayer’s lawyer then brought up the similarities between this storage facilities operation and a hotel operation.
CRA’s administrative policy treats a hotel operation as active business, paying 12.2% income tax rate.
If a hotel operation can be treated as active business, why can’t storage facilities operation be treated as active business?
The judge sighted many differences between a hotel operation and what the taxpayer provided in his storage facility operation.
Hotel operation provides fully furnished room, linens, daily cleaning service, concierge services, kitchen furnishing, room service, or even some level of food service, etc.
Hotel customers buy the bundle of services, but not with the storage facility service.
The provision of services in a hotel operation overcomes the provision of property.
If we go back to the definition of Specified Investment Business, you could see that “Specified investment business” is defined as “a business carried on by a corporation in a taxation year the principal purpose of which is to derive income (including interest, dividends, rents and royalties) from property…”
Principal purpose of hotel operation is NOT to derive income from property but rather, derive income from provision of services.
Storage facility, at least according to this judge, is to derive income from property (that is to collect rent).
Unfortunately, storage facility income is still considered as specified investment business income in a corporation.
Until next time, happy Canadian Real Estate Investing.
Cherry Chan, CPA, CA
Your Real Estate Accountant
Recently I saw a question on social media about borrowing money from your small business corporation to purchase your primary residence.
“I run a small business in my corporation and have accumulated a large amount of savings in the corporation. Can I take money out as an employee home purchase loan to purchase my primary residence?”
If you are a small business owner, many accountants often suggest you leave as much money in the corporation as possible to achieve maximum tax deferral.
After all, qualified small businesses in Ontario pay as little as 12.2% tax.
And highest personal marginal tax rate in Ontario is 53.5%.
When money is drawn out from your corporation via dividend or salary, you, as the shareholder or employee, would have to pay tax in your personal name. Depending on what you do and how much you report, you can pay as much as 53.5% tax on the money you take out.
Many business owners opt to leave as much money as possible in the corporation, keeping most money in their pocket paying 12.2% tax.
As a result, many small business owners have a lot of money saved up in the corporation.
When they decide to buy their primary residence, can they take this saving out from the corporation to fund the purchase?
Can you really use something called an employee home purchase loan to help you purchase your primary residence?
Do you have to repay the money back into your corporation?
Typically, when you borrow money from the corporation for no specific reasons, the amount of shareholder loan you have drawn out from the corporation would have to be reported as income on your personal tax return.
In other words, if you borrow from your corporation to purchase your primary residence, you have to report the amount you borrow as income on your personal tax. The highest marginal tax in Ontario is 53.5%. Yikes!
The good news is that there are some exceptions:
If you are a shareholder of the corporation that owns over 10% shares of the company, you are considered as a “specified employee”.
If you are a specified employee, for you to qualify for the exception mentioned above (so you don’t have to be dinged on the 53.5% personal tax), you have to make sure you comply with the following:
If you are the sole shareholder of your business and sole employee of your business, chances are, it would be difficult to prove to CRA that you are receiving the loan in the capacity of employee unless you can provide proof to CRA that other businesses are offering their arms’ length employee the same type of loan.
Understand your risk, speak with a professional accountant to structure it right.
Until next time, happy Canadian Real Estate Investing.
Cherry Chan, CPA, CA
Your Real Estate Accountant
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