Tax Attack

1. Revenue Canada is not allowing me to claim capital gains because it says it''s a business income. Is this correct?

This is a classic argument with the Canadian Revenue Agency (CRA) and certainly one of the most litigated areas in tax. The answer is far from clear in many cases. The CRA will be looking to a variety of factors in judging what an investor''s primary and potentially even their secondary intention is with a property.

Generally speaking, where an investor is looking to earn ''reasonable'' profits through renting a property, they are more likely to be considered earning a capital gain on ultimate disposition. Alternatively, where the primary motive of owning the property is to subsequently sell it for a profit, this is more likely to be considered on account of income.

Proving your intention can be a little more complex, of course.

A big mistake that we frequently see is investors have documentation and agreements outlining the fact that they intend to sell the property at a specified point in time. This pretty much creates a "slam dunk" for the CRA. For example, if you enter a joint venture with another individual and agree that in five years you will sell the property and split the proceeds, you''ve basically admitted that your intention is to sell the property in five years. Thus, welcome to the world of "income."

A large fallacy that we encounter is the belief that if someone holds a property for a certain period of time (often two, three or five years is suggested), they will be considered to have earned a capital gain, regardless of the particular situation. There are plenty of examples of court cases where holding periods are shorter than this and still generate a capital gain, and alternatively much longer while generating income.

A small amount of preparation and planning while buying the property can greatly enhance your chances of influencing how the property will be taxed. Knowing the various factors the courts look to in deciding these issues goes a long way.

2. When does it make sense to incorporate? We own three rental properties but would this strategy make sense for us?

The final answer is - it depends! There are no boilerplate solutions and a host of factors to weigh. What may be right for one person could be completely opposite for another with exactly the same fact scenario. Largely the reasons for the discrepancies in our mind are different people will have different priorities. Further, there is a significant amount of disinformation available, which simply confuses and generates incorrect analysis.

When we assist clients with the analysis, first we need to remind them that there are different professionals whose opinions are relevant from a legal, insurance and financing perspective, for example. Further, even amongst a particular profession there will be plenty of disagreement. In our analysis, we categorize factors into five major groups for consideration:
* Flexibility
* Legal considerations
* Tax implications
* Financing considerations
* Marketing and organizational issues

We find that the vast majority of accounting advisors recommend personal ownership. We do not typically share this opinion and personally use corporations and other entities.

It''s not enough to know what your advisor suggests, it is important to understand the basic reasons for the recommendations.  Often asking questions related to the pros and cons of specific factors will help you in gauging the professional''s comfort with this speciality area of real estate.

3. When should an investor consider depreciating a property and what are the advantages and disadvantages?

Taking depreciation on a property (or capital cost allowance in tax terminology), where permitted, allows an investor to shelter taxable income from immediate taxes. Ultimately, these taxes will likely be repaid when the property is sold (termed a "recapture"). Generally though, at the time a property is sold, an investor is likely to have cash available in order to pay taxes, as compared to years when an investor''s income (or ready cash) is lower.

So, in effect, often the question should be rephrased to ask, "Would you like an interest-free loan from the government for a number of years or not?"

Caveats exist. One common exception is where the property may be used as your principal residence, which could be ultimately disposed tax-free. An important point for investors to note is that by claiming capital cost allowance, you typically remove the possibility of receiving any proceeds tax-free.

Alternatively, it may be that in a particular year(s) you will have lower amounts of income than in other years. These are the years you''re better off not claiming depreciation and instead just paying the smaller amount of tax you''re liable for. It''s in the years that you earn a high income that depreciation comes into its own, helping you reduce your tax burden.  

George Dube is a chartered accountant at Dube & Associates Professional Corporation in Kitchener, Ont.

From the November 2009 issue of CRE

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