Tax Treatment for Investment Properties and Primary Residences
Most people are aware that the sale of an investment property is generally subject to capital gains tax on disposition and that the sale of a principal residence is generally tax free. What a lot of taxpayers don’t realize is that when you have a change in use from personal property to income producing property or vice versa, the property is deemed to have been disposed of at fair market value and acquired immediately after for the same price. This can result in unwanted tax consequences in many cases and there are two optional elections that can be made that in many cases are very beneficial to the taxpayer. The problem is that most taxpayers are not aware of these elections and they cannot be made retroactively.
Exception #1: change in use from principal residence to income producing property:
When you change your principal residence to an income producing use such as a rental or business property, you can make an election not to be considered as having started to use your principal residence as a rental or business property. This means, if you make this election, you do not have to report any capital gain when you change its use. However:
- you have to report the net rental or business income you earn; and
- you cannot claim capital cost allowance (CCA) on the property.
While your election is in effect, you can designate the property as your principal residence for up to four years, even if you do not use your property as your principal residence. However, during those years: - you cannot designate any other property as your principal residence; and
- you must be a resident or deemed to be a resident of Canada.
- You can extend the four year limit indefinitely if all of the following conditions are met:
- You live away from your principal residence because your employer, or your spouse’s or common-law partner’s employer, wants you to relocate.
- You and your spouse or common-law partner are not related to the employer.
- You return to your original home while you or your spouse or common-law partner are still with the same employer, or before the end of the year following the year in which this employment ends, or you die during the term of employment.
- Your original home is at least 40 kilometres (by the shortest public route) farther than your temporary residence from your, or your spouse’s or common-law partner’s, new place of employment.
Exception #2: change in use from income producing property to principal residence:
When you change your rental or business property to a principal residence, you can elect to postpone reporting the disposition of your property until you actually sell it. However, you cannot make this election if you previously deducted CCA on the property for any tax year after 1984, and on or before the day you change its use. If you make this election, you can designate the property as your principal residence for up to four years before you actually occupy it as your principal residence.
Exception #3: partial change in use from principal residence to income producing property – eg. Basement Apartment Rental
You are usually considered to have changed the use of part of your principal residence when you start to use that part for rental or business purposes.
You are not considered to have changed its use if all of the following conditions apply:
- your rental or business use of the property is relatively small in relation to its use as your principal residence
- you do not make any structural changes to the property to make it more suitable for rental or business purposes
- you do not deduct any CCA on the part you are using for rental or business purposes
Taxation of Rental Income
Calculating rental income is fairly straight forward, you would take your gross rental income and deduct your eligible expenses. Some of the common expenses are, mortgage interest, property taxes, condo fees, utilities, insurance, management fees, etc. The area that requires the greatest amount of judgement is determining if renovations are a current expense that is deductible against rental income or if it is a capital expense that gets added to the capital cost of the property and is not deducted until the property is sold. A current expense is one that generally reoccurs after a short period. For example, the cost of painting the exterior of a wooden property is a current expense. A capital expense generally gives a lasting benefit or advantage. For example, the cost of putting vinyl siding on the exterior walls of a wooden property is a capital expense. Renovations and expenses that extend the useful life of your property or improve it beyond its original condition are usually capital expenses.
Rental income in a corporation:
Rental income in a corporation is essentially taxed at the same rate as if it were held by the individual, so there is no significant tax advantage to having a corporation in this case. Where there is a big advantage is if you have an operating business that generates excess cash and you wanted to use these corporate funds to invest in real estate. Active business income earned in a corporation gets taxed at 13.5% on the first $500k of income. Let’s say we have a company that has earned $500k of income. After corporate tax, the company is left with $432,500 to invest in real estate. If the company buys the real estate, they would have the full $432,500 to invest. If the owner were to purchase the rental property in his personal name, he would have to declare a dividend to get the funds out of the company. The personal tax on the dividend would cost him approximately $180k in personal tax and therefore he would have slightly less than $250k to invest in the property so in this case there is a significant advantage to owning the property through the company.
Income Taxation on Assignment Transactions
The 2019 federal budget announced that CRA will be devoting significant resources to pursue and investigate real estate transactions as the Department of Finance feels that this is a significant area of non-compliance. What that means is that if you are involved in a pre-construction assignment sale, there is a high likelihood that you will be subject to CRA scrutiny, so it is important that taxpayers understand the rules for both income tax and HST relating to assignment sales.
Many taxpayers assume that the sale of real estate results in a capital gain, but what they don’t realize is that it is not the nature of the property but the intent of the buyer at the time of purchase that determines if the property is capital or inventory. If it is determined that the intention of the taxpayer at the time of purchase was to resell the property for a profit then the proceeds would be considered business income which has a 100% inclusion rate as opposed to a 50% inclusion rate for capital gains. CRA has been attacking assignment sales on the basis that they are short-term transactions that are often undertaken by individuals looking to make a quick profit on the “flip”. Taxpayers who have a history of flipping properties in a short time frame will have a difficult time justifying that their investment is capital property and will likely be reassessed quickly by CRA. If you plan to treat your assignment sale as a capital gain, you should ensure that the facts support your claim that you intended to hold on to the property long-term, either as a personal use property or as an income producing property. There have been recent tax court cases where the judge dismissed the taxpayers claim that the real estate was capital property because the facts did not support their claim and they were assessed taxes on the sale as business income.
Some taxpayers also make the mistake of assuming that because they originally purchased a pre-construction unit with the intention of living in it as a principal residence it qualifies for the principal residence exemption (PRE) and therefore is not taxable. This is not the case in an assignment sale because the rights to the property has been sold prior to closing so the property was never inhabited as a principal residence, and therefore cannot qualify for the PRE. We have seen several cases of CRA applying gross negligence penalties to unreported real estate transactions so with the increased attention that assignment sales will be receiving, it is important to be getting proper tax advice on how to report these types of sales.
The bottom line of all of this is that you should make sure that you keep your eye on the tax consequences of anything you are doing and seek the appropriate advice before doing so. We would be happy to help you with any such matters or direct you appropriately as required.