COMMON CENTS
Buying and Selling Real Estate?
Consider These tax Implications First.
By Bo Mocherniak & Jeanne Cheng
When contemplating a purchase or sale of real estate in Canada, taxation is a common concern for both residents and non-residents alike. Whether the profit from the eventual sale of a property will be taxed as a capital gain or as business income can have a significant impact on the decision to buy or sell.
On the surface, this seems like a relatively straightforward issue. But as any real estate investor can attest, deciphering between the two is often a complex process—and the results can be subject to varying levels of risk.
Capital Gains vs. Business Income
Many real estate investors assume that their profits from the sale of real estate will be taxed as a capital gain—which is perceived as the lesser of the two evils. This is because capital gains taxed in Canada are given preferential tax treatment, with only 50 percent of the gain on sale subject to taxation. If the capital gain is incurred by a corporation, the other 50 percent of the gain is added to a corporation’s capital dividend account, which can be paid out tax-free to its shareholders.
On the other hand, if the profit on sale is taxed as business income, 100 percent of the gain is subject to tax, which typically results in a much higher tax liability, reducing the ultimate return on investment. In addition, if the real estate was sold by a corporation, the after-tax funds would likely be extracted by way of a taxable dividend, adding another layer of tax.
The CRA Definition
Although most investors would prefer to have the gain on sale taxed as a capital gain, the Canada Revenue Agency (CRA) may assess it differently. The CRA uses a number of different factors to determine whether a gain is on account of income or capital.
The factor the CRA typically considers first involves the primary intent of the investor upon the purchase of the property. Was the investor hoping to generate a steady income by renting out the property on a long-term basis? Or was the taxpayer’s primary intent to purchase the property and resell it at a profit?
Other important questions that the CRA might ask include:
• Is the investor in the business of buying and selling real estate at a profit?
• Was borrowed money used to finance the purchase and, if so, what were the terms of financing?
• What was the length of time that the real estate was held?
• What factors motivated the sale of the real estate?
• Are there other persons who share an interest in the real estate?
Get It Right (the First Time)
The CRA is devoting significant audit resources to this area of taxation. Many taxpayers, particularly those who have bought and sold condominium units and townhouses, are being targeted by the CRA—even if they have no prior history of buying or selling properties. In many of these situations, the CRA is not only re-characterizing the gains as business income, but it’s even adding hefty penalties to the final tax bill.
Similarly, the CRA is on the lookout for builders who are claiming principal residence exemptions on homes they build for themselves then sell. Historically, such sales have not been reported since the capital gain on the sale is considered to qualify for the principal residence capital gains exemption. The CRA is starting to challenge this—particularly in situations where builders have claimed the principal residence exemption on multiple properties. If the CRA is successful, the gain on the sale will be fully taxable as income.
For this reason, it’s important to analyze the tax implications and associated risks before purchasing or selling real estate in Canada. If, however, you find you are already at the stage where the CRA is auditing you—or, even worse, has already reassessed you—give your tax advisor a call. Not only can they help you get through the process today, but they can prevent you from repeating the same mistakes in the future.
With over 30 years experience with audit, acquisitions, divestitures and valuations, Bo Mocherniak, CA, CBV, provides services to both public and private companies in Canada and the United States. Bo is National Sector Leader for the Real Estate and Construction Group of Grant Thornton Canada, a member of the Grant Thornton International Real Estate Sector Group and past Chair of Grant Thornton LLP. He can be reached at bo.mocherniak@ca.gt.com.
Co-author Jeanne Cheng, CPA, CA, provides tax services to a wide variety of clients including real estate developers and builders, professionals, technology companies, foreign investors and private investment funds. Jeanne’s expertise includes the taxation of partnerships and trusts, succession and estate planning and tax considerations for real estate operations. She can be reached at jeanne.cheng@ca.gt.com
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