Capital gain versus income

I find that the majority of investors sell properties and automatically assume a capital gain has resulted. Discussions of an alternative possibility are frequently dismissed as heretical. An inappropriate tax filing position can produce an expensive and unexpected reassessment from the Canada Revenue Agency (CRA), particularly if the transaction is one of several and/or audited a few years after the fact, allowing for the addition of interest and penalties for each transaction. However, preparation and education can help shield you from disaster or at least make you aware of the risks you are assuming.

What is a capital gain or income?

From a tax perspective, we must categorize the profits (or losses) realized on the sale of a real estate investment. Generally speaking, we can think of a capital gain as the profit from selling an income generating asset. On the other hand, income is typically generated where we sell an ‘inventory’ item or asset available for sale.

Why do we care?

In short, only 50% of the profits from a capital gain are taxed. Due to tax rate differences between individuals and corporations, for example, plus the different types of income from a tax perspective, investors may at times prefer income treatment. Examples of other reasons for care include:

* Capital cost allowance (tax deductible depreciation) is available to capital assets but not inventory,
* Differences in the length of tax reserves (a period of time where the profits can be brought into income potentially over 3 or 5 years),
* Restrictions on tax free reorganizations (methods of transferring ownership of properties or corporate shares, for example, without immediately incurring taxes)
* Restrictions on deductibility of certain costs

Telling them apart

The Income Tax Act is of minimal assistance here, so we must look to what the CRA and more importantly the courts see as defining characteristics. The CRA provides an excellent reference as to their opinion of how the Income Tax Act should be read in this regard, Interpretation Bulletin 218R.  

As one of the most litigated areas in tax the courts have had ample opportunity to provide commentary. It often comes down to a ‘question of fact’ which provides a fair deal of subjectivity in how to interpret actual events.

First, the courts look to the ‘primary intention’ of the taxpayer. If you are looking to receive income from the investment itself in the form of rental profits, it is more likely that you will realize a capital gain. Alternatively, where you are trying to generate your profits from the sale of the property itself, this is more indicative of an income intention.

There is a cruel joke in my mind called ‘secondary intention’ which provides that where you have a back-up plan to sell the property if plans go sideways, the profit may be classified as income. I’d suggest that the number of serious investors without backup plans is rather limited. Fortunately, there are a variety of cases which contradict these findings, but attention is still needed.

Points of consideration by the courts

The courts have considered a wide variety of factors which they use to help them interpret the intentions of the taxpayers. No one indicator is by itself determinative. Further, specific indicators can often be interpreted in favour of either CG or income.

* Feasibility (can you realistically do what you say you can?)
* Extent to which plans were carried out
* Geography and zoning (are you purchasing in a speculative area or does the zoning permit your stated intentions?)
* Nature of the property (developed vs. undeveloped or high vs. low income capacity)
* Frustration of primary intent (was there something beyond your control preventing you from implementing your plans?)
* Business organization (do you look like a sophisticated business)
* Efforts made to effect sale (unsolicited vs. MLS listing for example)
* Evidence of change of intention (perhaps intending to convert to condo status)
* Nature of business of taxpayer/associates
* Use of borrowed money and terms (leverage, open/closed, capacity for income, etc.)
* Length of time property held (please please please be cautious of rules of thumb)
* Other participants (you are who your friends are, intentions of controlling party, occupation of others)
* Reasons for sale which may be a gauge as to original intention
* Evidence of extensive dealings with real estate

Planning ahead

Most investors are unaware of the many factors the CRA considers in deciding how to categorize real estate profits. Taking a little time to evaluate your current and future portfolio, plus the legal agreements surrounding your relationships with other investors can save untold grief. Implementing a proactive policy of documenting your intentions and providing copies to your advisors prior to questions coming up, can greatly enhance your credibility and support your position should future questions arise.

Please remember that this article is general in nature and should not be relied upon without first consulting with your qualified tax advisor. George Dube, CA, is a partner in Dube & Associates Professional Corporation, Chartered Accountants, in Kitchener, ON.

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