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A review of the Income Tax Act related to non-corporate real estate holdings McAfee, Michael Britton 1975

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A REVIEW OF THE INCOME TAX ACT RELATED TO NON-CORPORATE REM, ESTATE HOLDINGS by MICHAEL BRITTON MCAFEE B.Comm., U n i v e r s i t y o f A l b e r t a , 1968 C.A., C a n a d i a n I n s t i t u t e o f C h a r t e r e d A c c o u n t a n t s , 1970 A T h e s i s S u b m i t t e d i n P a r t i a l F u l f i l m e n t o f t h e R e q u i r e m e n t s f o r t h e D e g r e e o f Master of Science i n Business Administration i n t h e F a c u l t y o f B u s i n e s s A d m i n i s t r a t i o n a n d Commerce We a c c e p t t h i s t h e s i s a s c o n f o r m i n g t o t h e r e q u i r e d s t a n d a r d The U n i v e r s i t y o f B r i t i s h C o l u m b i a April 1975 In p r e s e n t i n g t h i s t h e s i s i n p a r t i a l f u l f i l m e n t o f t h e r e q u i r e m e n t s f o r an advanced degree a t the U n i v e r s i t y o f B r i t i s h C o l u m b i a , I agree t h a t the L i b r a r y s h a l l make i t f r e e l y a v a i l a b l e f o r r e f e r e n c e and s t u d y . I f u r t h e r agree t h a t p e r m i s s i o n f o r e x t e n s i v e c o p y i n g o f t h i s t h e s i s f o r s c h o l a r l y p u r p o s e s may be g r a n t e d by the Head o f my Department o r by h i s r e p r e s e n t a t i v e s . I t i s u n d e r s t o o d t h a t c o p y i n g o r p u b l i c a t i o n o f t h i s t h e s i s f o r f i n a n c i a l g a i n s h a l l n o t be a l l o w e d w i t h o u t my w r i t t e n p e r m i s s i o n . Department o f F a c u l t y of B u s i n e s s Admini st-.rati nn a n d Commerce. The U n i v e r s i t y o f B r i t i s h Columbia Vancouver 8 , Canada Date A u g u s t 2 9 t h , 1973 i ABSTRACT The purpose of t h i s thesis i s to examine the impact of the new Canadian Income Tax Act on r e a l estate investments and r e a l estate investors. E f f e c t i v e January 1, 1972, t h i s new Act i n s t i t u t e d many changes to provisions of the old Act which had been i n e f f e c t for twenty years, and introduced substantial new tax provisions which w i l l have a s i g n i f i c a n t influence on the o v e r a l l p r o f i t a b i l i t y of most r e a l estate investments. Those provisions of the new Income Tax Act which w i l l have the greatest e f f e c t on r e a l estate investments are examined i n t h i s t h e s i s , and, wherever possible, these provisions are contrasted with those of the old Act. Also, numerous examples are presented to demonstrate the impact of the various provisions on r e a l estate investments and investors. Each chapter i n t h i s thesis examines, analyzes and makes a conclusion as to the e f f e c t of the various income tax provisions on r e a l estate investments and r e a l estate investors. Chapter 1 provides a background of the history, structure, and administration of the income tax system i n Canada. Who i s taxable, what income i s taxable^ and how i s t h i s income taxed are questions answered i n t h i s chapter. Chapter 2 examines the tax treatment of income derived from the ownership and operation of r e a l property. Capital cost allowance, tax shelters, disallowable expenses and hobby farms are discussed. Chapter 3 i s devoted to an examination of the most revolutionary new income tax provision -- the taxation of c a p i t a l gains. The new rules are discussed which categorized the property y i e l d i n g the c a p i t a l gain into c a p i t a l property, depreciable property, or personal-use property, a l l of which have d i f f e r e n t rules for the computation of the taxable gain or loss. Included i n t h i s chapter, also i s the examination of the t r a n s i t i o n a l provisions for c a p i t a l gains on property owned p r i o r to the enactment of the new Income Tax Act. Chapter 4 examines the s p e c i a l provisions r e l a t i n g to involuntary d i s p o s i t i o n s , options, non-arm's length transactions and tax free r o l l o v e r s . O v e r a l l , the conclusion of the thesis i s that the new Income Tax Act has eliminated or greatly r e s t r i c t e d many of the tax provisions which provided great benefits to r e a l estate investors i n the past. The tax shelter aspects of the c a p i t a l cost allowance provisions have been mainly eliminated. C a p i t a l cost allowance that i s recaptured on rental buildings costing $50,000 or more can no longer remain tax free i n c a p i t a l cost allowance pools. The new c a p i t a l gains provisions have made gains on property appreciation no longer free from income taxes. These gains are frequently substantial i n a country where continual i n f l a t i o n and population growth have stimulated a rapid r i s e i n r e a l property values. Provisions which enabled a taxpayer to transfer property, which has appreciated i n value, to related persons, without incurring tax on the c a p i t a l gain or on p r i o r c a p i t a l cost allowance claimed, no longer e x i s t except for transfers by a taxpayer to his spouse. A taxpayer can temporarily defer the taxation of c a p i t a l gains by tra n s f e r r i n g h i s property to a co n t r o l l e d corporation or h i s spouse, however a l l c a p i t a l gains and c a p i t a l cost allowance recaptures w i l l eventually be subject to income taxes upon the death of the taxpayer or his spouse. Under the new Income Tax Act, the r e a l estate investor must face fewer deductible expenses, fewer tax s h e l t e r s , and eventually much higher taxes. i i i TABLE OF CONTENTS CHAPTER 1: INCOME TAXES IN CANADA 1 H i s t o r y 1 A d m i n i s t r a t i o n of the Income Tax System 3 S t r u c t u r e of the New Income Tax Act 5 L i a b i l i t y f o r Tax 7 Taxable Income 8 Business and Property Income 10 Taxable C a p i t a l Gains 11 Summary 15 CHAPTER 2: INCOME PROPERTY INVESTMENTS 16 Property Income 17 An Important C a p i t a l Cost Allowance R e s t r i c t i o n 21 Real E s t a t e Investments as a Tax S h e l t e r 2 9 Recaptured C a p i t a l Cost Allowance 35 Land vs. B u i l d i n g s Controversy 41 Property Taxes and I n t e r e s t on Undeveloped Land 44 Hobby Farming 4 7 C o n c l u s i o n 51 CHAPTER 3: CAPITAL GAINS AND THE REAL ESTATE INVESTOR 54 C a p i t a l Gains Terminology 55 Non-Depreciable C a p i t a l . P r o p e r t y 57 Adjustment to c o s t base 61 Property owned a t December 31, 1971 61 Tax f r e e zone method 62 F a i r market value method 65 De p r e c i a b l e Property 6 8 Cost base . 70 Property owned a t December 31, 1971 71 Personal-Use Property 75 Change i n use e l e c t i o n 77 Non-taxable c a p i t a l gains 80 C o n c l u s i o n 87 i v CHAPTER 4: SPECIAL CASES 9 0 Involuntary Dispositions 90 Options . 95 Non-Arm's Length Transactions 99 Depreciable property 103 Tax-Free Rollovers 107 Property transfers by individuals to corporations 107 Property transfers by taxpayer to spouse 113 Property transfers by individuals to t h e i r heirs 116 Conclusion 123 V LIST OF TABLES CHAPTER 1 1. Structure of the new Income'Tax Act 2. Basic Flow Chart for Determining Taxable Income v i L I S T OF EXAMPLES CHAPTER 2 1. C a l c u l a t i o n o f C a p i t a l A l l o w a n c e 18 2. P a c i f i c A p a r t m e n t s : S t a t e m e n t o f Income f o r Tax P u r p o s e s 20 3. A c c o u n t i n g f o r C a p i t a l C o s t A l l o w a n c e u n d e r t h e O l d A c t 22 4. A c c o u n t i n g f o r C a p i t a l C o s t A l l o w a n c e u n d e r t h e new A c t 2 6 5. Tax S h e l t e r P r o v i s i o n s u n d e r t h e o l d a n d new A c t s 30 6. A p p l i c a t i o n o f . R e n t a l L o s s e s t o R e n t a l Income 32 7. R e c a p t u r e o f C a p i t a l C o s t A l l o w a n c e 36 8. I n t e r e s t a n d P r o p e r t y T a x e s on U n d e v e l o p e d L a n d 45 9. Farm L o s s e s o f a Hobby Farm 50 CHAPTER 3 1. T a x a b l e C a p i t a l G a i n s 58 2.. A p p l i c a t i o n o f N e t C a p i t a l L o s s e s 60 3. C a l c u l a t i o n o f C a p i t a l G a i n s ( L o s s e s ) : Tax F r e e Zone - M e t h o d 6 3 4. A p p l i c a t i o n o f t h e Tax F r e e Zone M e t h o d 6 4 5. C o m p a r i s o n o f t h e F a i r M a r k e t V a l u e M e t h o d a n d t h e Tax F r e e Zone M e t h o d 6 6 6. C a l c u l a t i o n o f C a p i t a l G a i n on D e p r e c i a b l e P r o p e r t y 69 7. C a l c u l a t i o n o f C a p i t a l . G a i n on D i s p o s a l o f D e p r e c i a b l e P r o p e r t y owned December 3 1 , 1971 74 8. P e r s o n a l - U s e P r o p e r t y : C a l c u l a t i o n o f C a p i t a l G a i n s 76 9. Change i n Use E l e c t i o n 79 10. N o n - T a x a b l e C a p i t a l G a i n s : $1,000 R u l e 82 11. Calculation o f t h e - T a x a b l e C a p i t a l G a i n o n t h e D i s p o s i t i o n o f a P r i n c i p a l R e s i d e n c e 86 v i i CHAPTER 4 1. D i s p o s i t i o n by E x p r o p r i a t i o n 91 2. Tax Treatment of Insurance Proceeds on Damaged Pro p e r t y 92 3. F o r e c l o s u r e s 94 4. Summary of Tax Treatment of Options 9 8 5. Non-Arm's Length T r a n s a c t i o n : Proceeds l e s s than F a i r Market Value * 100 6. Non-Arm's Length T r a n s a c t i o n : Proceeds i n excess of F a i r Market Value 102 7. D e p r e c i a b l e P r o p e r t y : Comparison of Non-Arm's Length P r o v i s i o n s of the o l d Act and the new A c t 105 8. Tax Free P R o l l o v e r s : I n d i v i d u a l s to C o r p o r a t i o n s 108 9. R o l l o v e r s of C a p i t a l L o s s e s : I n d i v i d u a l s to Co r p o r a t i o n s 110 10. Tax Free R o l l o v e r s and R e a l i z e d C a p i t a l Gains: I n d i v i d u a l s to C o r p o r a t i o n s 112 11. Tax Free R o l l o v e r s o f D e p r e c i a b l e P r o p e r t y : I n d i v i d u a l s t o C o r p o r a t i o n s 114 12. Tax Free R o l l o v e r s : Bequests of D e p r e c i a b l e Property 118 13. Comparison of the R o l l o v e r P r o v i s i o n s Governing Bequests of D e p r e c i a b l e Property under the o l d and new Acts 121 CHAPTER 1 INCOME TAXES IN CANADA HISTORY Canada's f i r s t introduction to income tax l e g i s l a t i o n at the federal l e v e l occurred i n 1917 with the passage of the Income War Tax Act designed p r i n c i p a l l y to a s s i s t the country to finance the war e f f o r t . P r i o r to that time, the federal government was r e l y i n g upon customs and excise taxes to provide taxation revenue. Under the provisions of the Income War Tax Act, corporations were taxed at 4% and personal income was taxed on a graduated scale of 4% to 25%. By 1919., the rates had ris e n to 10% for corporations and 4% to 65%, graduated, for indi v i d u a l s . Each year various modifications were added, creating an unwieldy body of amendments, so that by 1945 the need for revised tax l e g i s l a t i o n was recognized. In 1948, Parliament passed the Income Tax Act which c o d i f i e d the old act as well as introducing major amendments. Modifications to the new act continued each year and in 1952 the Income Tax Act was revised again. By 1962, with the recognition of continuing defects i n the income tax system, a Royal Commission on Taxation (Carter Commission) was established to investigate the entire f i e l d of taxation. The Commission's findings were published i n 1967 i n a six volume report recommending exten-sive revisions to the Canadian income tax structure. Working on the basis of the report and subsequent submissions by the public, the government published the White Paper on Tax Reform on November 7, 1969, which stated the government's proposed changes to the income tax system. Following numerous public hearings and submissions causing modifications to the proposed tax l e g i s l a t i o n , i t was presented to the House of Commons on June 30, 1971 as 2 Tax Reform B i l l C-259, an Act to amend the Income Tax Act. After several l e g i s l a t i v e changes, the b i l l was given Royal Assent on December 23, 1971 and thereby became the new Canadian Income Tax Act. 3 ADMINISTRATION OF THE INCOME TAX SYSTEM In Canada, t h e f e d e r a l government and t h e t e n p r o v i n c i a l governments have been g r a n t e d t h e a u t h o r i t y under the B r i t i s h N o r t h A m e r i c a A c t o f 1867 t o impose a d i r e c t t a x on income. S e c t i o n 91.3 o f the B r i t i s h N o r t h A m e r i c a A c t g r a n t s t o t h e P a r l i a m e n t o f Canada t h e e x c l u s i v e a u t h o r i t y i n Canada on a l l m a t t e r s coming w i t h i n "the r a i s i n g o f money by any mode o r system of t a x a t i o n " . S e c t i o n 92.2 o f t h e same A c t g r a n t s t h e p r o v i n c i a l l e g i s l a t u r e s t h e powers t o make laws i n r e l a t i o n t o m a t t e r s coming w i t h i n " d i r e c t t a x a t i o n w i t h i n t h e p r o v i n c e i n o r d e r t o t h e r a i s i n g o f a revenue f o r p r o v i n c i a l p u r p o s e s " . The p r o v i n c e s have a l l imposed income t a x e s , b u t , w i t h t h e e x c e p t i o n o f O n t a r i o ' s c o r p o r a t i o n income t a x and Quebec's c o r p o r a t i o n and p e r s o n a l income t a x , t h e p r o v i n c e s have d e l e g a t e d t h e r e s p o n s i b i l i t y of a d m i n i s t e r i n g and c o l l e c t i n g t h e i r income t a x e s t o t h e f e d e r a l government. The f e d e r a l government agency w h i c h a d m i n i s t e r s t h e Income Tax A c t i s t h e T a x a t i o n D i v i s i o n o f t h e Department of N a t i o n a l Revenue. T h i s D i v i s i o n w h i c h i s headed by a Deputy M i n i s t e r has i t s head o f f i c e i n Ottawa and has 28 d i s t r i c t o f f i c e s headed by D i s t r i c t D i r e c t o r s a c r o s s Canada. These D i s t r i c t O f f i c e s a d m i n i s t e r - t h e income t a x : r e t u r n s f i l e d i n t h e i r a r e a and n e g o t i a t e w i t h t h e t a x p a y e r s i n t h e i r j u r i s d i c t i o n . The Income Tax A c t c o n s t i t u t e s o n l y p a r t o f t h e law w h i c h governs t h e a p p l i c a t i o n o f income t a x e s i n Canada. S e c t i o n 221.1 o f t h e new Income Tax A c t s t i p u l a t e s t h a t t h e Governor i n C o u n c i l may make r e g u l a t i o n s w h i c h f a c i l i t a t e t h e c a r r y i n g o u t o f t h e purposes and p r o v i s i o n s o f t h e A c t . These r e g u l a t i o n s expand and c l a r i f y t h e s e c t i o n s o f t h e Income Tax A c t . A f u r t h e r i m p o r t a n t 4 body of law r e l a t i n g to income taxes i s j u d i c i a l law embodied i n decisions made by the courts of the land. These j u d i c i a l decisions can not take p r i o r i t y over the statutory law of the Income Tax Act and the Income Tax Act Regulations but they are important i n in t e r p r e t i n g the meaning of these statutory laws. Decisions rendered by the Department of National Revenue - Taxation against a taxpayer must conform to the Income Tax Act and the Income Tax Act Regulations as interpreted by the j u d i c i a l system. 5 STRUCTURE OF THE NEW INCOME TAX ACT The new Income Tax Act which became e f f e c t i v e January 1, 1972 i s a comprehensive federal statute which i s divided into 17 parts which are i n turn divided into 257 sections as i s shown i n Table 1.1. Part 1 of the Income Tax Act contains the general tax provisions which s t i p u l a t e who i s taxable, what income i s taxable, how income taxes are calculated, and the manner i n which income taxes are paid i n Canada. Parts 11 to IX describe special taxes which are imposed on corporations. Parts X to X l l l describe the tax treatment of sp e c i a l types of income. Provisions for an additional tax on corporations i s contained i n Part XIV. Parts XV to XVII describe the administration, i n t e r p r e t a t i o n and enforcement provisions of the new Income Tax Act. 6 Table 1.1 S t r u c t u r e of the new Income Tax A c t P a r t D i v i s i o n S e c t i o n s S ubject 1 1 - 1 8 0 Income Tax A 2 L i a b i l i t y f o r tax B 3 -108 Computation of income C 109-114 Computation of t a x a b l e income D 115-116 Taxable income earned i n Canada by no n - r e s i d e n t s E 117-127 Computation of tax F 128-143 S p e c i a l r u l e s G 144-148 S p e c i a l income arrangements H 149 Exemptions I 150-168 Returns, assessments, payments, appeals J 169-180 Appeals t o Tax Review Board and F e d e r a l Court 11-1X 181-197 S p e c i a l taxes on c o r p o r a t i o n s X 198-204 Tax on d e f e r r e d p r o f i t s h a r i n g plans and revoked p l a n s XI 205-207 Tax i n r e s p e c t of c e r t a i n p r o p e r t y a c q u i r e d by t r u s t s XII 208-211 Tax on investment income of l i f e i n s u r e r s ' X I I I 212-218 Tax on income from Canada of n o n - r e s i d e n t persons XIV 219 A d d i t i o n a l tax on c o r p o r a t i o n s XV 220-244 A d m i n i s t r a t i o n and enforcement XVI 245-247 Tax e v a s i o n XVII 248- - I n t e r p r e t a t i o n 7 L I A B I L I T Y FOR TAX A c c o r d i n g t o S e c t i o n 2.1 o f t h e new Income T a x A c t , i n c o m e t a x e s s h a l l be l e v i e d u p o n t h e t a x a b l e i n c o m e o f e v e r y p e r s o n r e s i d e n t i n C a n a d a . T h i s t a x a b l e i n c o m e i n c l u d e s i n c o m e f o r t h e y e a r f r o m a l l s o u r c e s i n s i d e and o u t s i d e C a n a d a a n d i n c l u d e s i n c o m e f r o m a l l b u s i n e s s e s , p r o p e r t y , o f f i c e s , e m p l o y m e n t s , and n e t t a x a b l e c a p i t a l g a i n s O)"'". A p e r s o n i s d e f i n e d i n t h e A c t t o i n c l u d e i n d i v i d u a l s a n d c o r p o r a t i o n s a nd t h e l e g a l r e p r e s e n t a t i v e s o f t h e s e e n t i t i e s ( 2 4 8 . 1 ) . A n i n d i v i d u a l i s deemed t o b e a r e s i d e n t o f C a n a d a i f he s o j o u r n e d i n C a n a d a d u r i n g t h e y e a r f o r 183 d a y s o r more o r was an e m p l o y e e o f t h e g o v e r n m e n t o r o f c e r t a i n p r e s c r i b e d i n t e r n a t i o n a l o r g a n i z a t i o n s ( 2 5 0 . 1 ) . A c o r p o r a t i o n i s deemed t o b e a r e s i d e n t o f C a n a d a i f i n c o r p o r a t e d i n C a n a d a a f t e r A p r i l 26, 1965 o r h a s c a r r i e d o n b u s i n e s s i n C a n a d a ( 2 5 0 . 4 ) . A n o n - r e s i d e n t p e r s o n i s s u b j e c t t o C a n a d i a n i n c o m e t a x e s o n h i s t a x a b l e i n c o m e e a r n e d i n C a n a d a i f he was e m p l o y e d i n C a n a d a , c a r r i e d o n b u s i n e s s i n C a n a d a , o r d i s p o s e d o f a t a x a b l e C a n a d i a n p r o p e r t y a t any t i m e i n t h e y e a r o r a p r e v i o u s y e a r ( 2 . 3 ) . 1. I n d i r e c t r e f e r e n c e t o s p e c i f i c s e c t i o n s o f t h e new Income Tax A c t i n t h i s p a p e r . w i l l be made b y i n c l u d i n g t h e number o f t h e s e c t i o n i n p a r e n t h e s e s a t t h e e n d o f t h e p a s s a g e . R e f e r e n c e s t o s e c t i o n s o f t h e o l d A c t w i l l be done i n t h e same manner e x c e p t t h a t t h e s e c t i o n number w i l l b e p r e c e d e d b y t h e l e t t e r s O.A. 8 TAXABLE INCOME T a x a b l e i n c o m e o f a t a x p a y e r f o r a t a x a t i o n y e a r i s h i s i n c o m e f o r t h e y e a r m i n u s c e r t a i n d e d u c t i o n s p e r m i t t e d b y t h e Income Tax A c t . The b a s i c f o r m a t f o r d e t e r -m i n i n g t a x a b l e i n c o m e i s shown i n T a b l e 1.2. The C a n a d i a n t a x s y s t e m c o m p u t e s t a x a b l e i n c o m e i n two s t a g e s . The f i r s t s t a g e d e t e r m i n e s " i n c o m e f o r t h e y e a r " w h i c h i s t h e a g g r e g a t e o f i n c o m e f r o m a l l s o u r c e s l e s s s p e c i a l d e d u c t i o n s a l l o w e d b y t h e A c t and l e s s t h o s e l o s s e s w h i c h a r e n o t r e s t r i c t e d b y t h e A c t . The r e s u l t i n g " i n c o m e f o r t h e y e a r " i s t h e n u s e d a s t h e b a s i s f r o m w h i c h c e r t a i n p r e s c r i b e d d e d u c t i o n s may be t a k e n i n o r d e r t o a r r i v e a t t h e " t a x a b l e i n c o m e " f o r t h e y e a r . D e d u c t i o n s , e x e m p t i o n s , and t h e t r e a t m e n t o f l o s s e s a v a i l a b l e t o a t a x p a y e r v a r y g r e a t l y a c c o r d i n g t o t h e s o u r c e o f t h e i n c o m e and t h e n a t u r e o f t h e t a x p a y e r who e a r n s t h e i n c o m e . The s o u r c e o f i n c o m e i s o f t e n i m p o r t a n t i n d e t e r m i n i n g w h i c h e x p e n s e s o r d e d u c t i o n s f r o m i n c o m e w i l l b e a l l o w a b l e u n d e r t h e Income Tax A c t . The new A c t d i f f e r e n t i a t e s b e t w e e n f i v e s o u r c e s o f i n c o m e a s f o l l o w : I n c o m e ' f r o m - 1 . O f f i c e 2. E m p l o y m e n t 3. B u s i n e s s 4. P r o p e r t y 5. T a x a b l e c a p i t a l g a i n s Income f r o m o f f i c e o r e m p l o y m e n t i s u s u a l l y e a s y t o s e g r e g a t e i n t h a t i t i n c l u d e s s a l a r i e s , w a g e s , and o t h e r r e m u n e r a t i o n r e c e i v e d b y a t a x p a y e r f o r o c c u p y i n g a n o f f i c e o r a c t i n g a s a n e m p l o y e e f o r o t h e r s ( 5 . 1 ) . D i f f e r e n t i a t i n g b e t w e e n b u s i n e s s a n d p r o p e r t y i n c o m e i s u s u a l l y much more d i f f i c u l t . 9 Table 1.2 Basic Flow Chart for Determining Taxable Income Add: Income from- Excess of taxable Business and property c a p i t a l gains over O f f i c e and employment allowable c a p i t a l losses Less: Special Deductions Less: Losses from-Business and property Of f i c e and employment Equals: Income for the Year Less: Charitable donations, medical expenses, etc, Less: Losses from other years Less: Personal Exemptions Equals: Taxable Income IQ Business and Property Income A taxpayer who a c t i v e l y manages a rental property that he owns would usually be deemed by the taxing authorities to be earning business income from a property owned and a c t i v e l y managed by him. Whereas a taxpayer who engages a property manager to operate his property and who only receives the net income from his property would be deemed to be earning property rather than business income. The tax treatment afforded the taxpayer who i s earning business income from rental property could be very d i f f e r e n t from thataccorded a taxpayer who only receives property income. Due to the d i f f i c u l t y i n d i f f e r e n t i a t i n g between property and business income, the courts have been c a l l e d upon frequently to determine whether or not a taxpayer's income i s from a business or from property. Generally however, Section 248.1 defines income from a business to be income derived from "a profession, c a l l i n g , trade, manufacture or undertaking of any kind whatever and includes an adventure or concern i n the nature of trade but does not include an o f f i c e or employment". Business income includes the revenue generated by the business less those expenditures which must be incurred to earn that revenue and which are allowable under the provisions of the Act. Under normal circumstances, the business expenses which are allowable under the Act correspond to the common business and accounting int e r p r e t a t i o n of business expenses. Thus, wages and s a l a r i e s of employees, advertising, promotion, and o f f i c e expenses of the business are normally deductible i n f u l l . Depreciation on c a p i t a l property used i n the business i s also deductible to the extent permitted by the c a p i t a l cost allowance regulations. Property i s defined by Section 24 8.1 to mean "property of any kind whatever whether r e a l or personal or corporeal or incorporeal and, without r e s t r i c t i n g the generality of the foregoing, includes a r i g h t of any kind whatever, a share 11 or a chose i n action, and unless a contrary intention i s evident, money". Property income includes the revenue earned by property less those expenditures which must be incurred to generate that revenue and which are allowable by the Act. Property income i s d i f f e r e n t i a t e d from business income by the fa c t that property income i s derived b a s i c a l l y from the employment of c a p i t a l property whereas business income i s normally derived from the employment of both labor and c a p i t a l . Labor intensive expenses which would q u a l i f y as allowable business expenses may not q u a l i f y as allowable expenses incurred to earn property income. Thus a salary paid to the owner of a revenue property which i s managed by others would undoubtedly be disallowed as an expense of the property. Taxable Capital Gains The l a s t major source of taxable income i s from taxable c a p i t a l gains. The taxation of c a p i t a l gains i s the most s i g n i f i c a n t income tax change included i n the new Act. Prior to the new Act, c a p i t a l gains were not subject to income taxes. B a s i c a l l y the new Act subjects one half of a l l c a p i t a l gains to the normal rates of taxation except for c e r t a i n w i n d f a l l gains l i k e winnings from sweepstakes and games of chance which continue to be exempt from tax (40.2.f). However, since c a p i t a l gains enjoy p r e f e r e n t i a l tax treatment, i t w i l l s t i l l be important to a taxpayer to be able to designate that portion of his income which i s a c a p i t a l gain. The tax free status of c a p i t a l gains i n the past has resulted i n frequent j u d i c i a l cases i n order to determine whether or not a taxpayer's income has been derived from c a p i t a l gains or from some other source of income l i k e business or property. Since the new Act has only changed the tax status of a c a p i t a l gain and not i t s d e f i n i t i o n , . t h i s exten-sive j u d i c i a l law w i l l continue to be used i n determining whether or not income i s from a c a p i t a l gain. The expectation 12 o f c a p i t a l g a i n s h a s b e e n a p r i m e m o t i v e f o r many t a x -p a y e r s t o i n v e s t i n r e a l e s t a t e a n d many o f t h e c a s e s r e l a t i n g t o c a p i t a l g a i n s h a v e i n v o l v e d r e a l e s t a t e t r a n s -a c t i o n s . The i m p o r t a n c e o f c a p i t a l g a i n s t o r e a l e s t a t e i n v e s t o r s a n d t h e l a c k o f a u n i v e r s a l d e f i n i t i o n o f a c a p i t a l g a i n n e c e s s i t a t e s an e x a m i n a t i o n o f s e v e r a l j u d i c i a l c a s e s i n o r d e r t o g e n e r a l l y u n d e r s t a n d t h e n a t u r e o f c a p i t a l g a i n . An i m p o r t a n t d i s t i n g u i s h i n g f e a t u r e o f a c a p i t a l g a i n t r a n s a c t i o n i s t h e i n t e n t i o n o f t h e t a x p a y e r i n t h e p u r c h a s e a n d / o r s a l e o f a p r o p e r t y . I f i t i s a p p a r e n t t h a t t h e t a x -p a y e r p u r c h a s e d a p r o p e r t y t o e a r n r e n t a l i n c o m e o r f o r some o t h e r r e a s o n t h e n t o d i s p o s e o f i t f o r a c a p i t a l g a i n , t h e n a g a i n o n t h e s u b s e q u e n t d i s p o s i t i o n w i l l be deemed a c a p i t a l g a i n . F o r e x a m p l e , a t a x p a y e r was j u d g e d t o h a v e r e a l i z e d a c a p i t a l g a i n w h i c h a r o s e f r o m h i s a c c e p t a n c e a n u n s o l i c i t e d o f f e r f o r an a p a r t m e n t h o u s e t h a t he h a d c o n s t r u c t e d f o r i n v e s t m e n t p u r p o s e s . ^ The i n t e n t i o n m u s t h o w e v e r be s u p p o r t e d b y t h e e n t i r e c o u r s e o f c o n d u c t o f t h e t a x p a y e r i n b u y i n g , h o l d i n g a n d e v e n t u a l l y s e l l i n g t h e p r o p e r t y i n a d d i t i o n t o t h e t a x p a y e r ' s s t a t e m e n t o f h i s i n t e n t i o n i n a c q u i r i n g t h e p r o p e r t y . T h u s , a t a x p a y e r who b o u g h t 32 a c r e s o f l a n d t o b u i l d h i s home on p a r t o f i t a n d who s u b s e q u e n t l y s u b d i v i d e d t h e r e m a i n d e r o f h i s p r o p e r t y i n t o l o t s was h e l d n o t t o h a v e r e a l i z e d a c a p i t a l g a i n . I r r e g a r d l e s s o f h i s o r i g i n a l i n t e n t i o n i n a c q u i r i n g t h e l a n d , t h e s u b s e q u e n t c o u r s e o f c o n d u c t o f t h e t a x p a y e r showed t h a t h i s i n t e n t i o n h a d c h a n g e d t o one o f a n a d v e n t u r e i n t h e n a t u r e o f t r a d e w h i c h e a r n s t a x a b l e i n c o m e a n d n o t c a p i t a l g a i n s . B.C.W. I n v e s t m e n t s , 64 D.T.C. 4. No. 257 Iv. M.N.R., (T.A.B.) 55 DTC 269. 13 A s e c o n d a r y i n t e n t i o n o f a t a x p a y e r may h o w e v e r p r e v e n t a g a i n on d i s p o s i t i o n f r o m b e i n g deemed a c a p i t a l g a i n . T h us i f t h e c o u r t s d e c i d e t h a t a t a x p a y e r , i n a c q u i r i n g a p r o p e r t y f o r i n v e s t m e n t a l s o h a d a s e c o n d a r y i n t e n t i o n o f s e l l i n g t h e p r o p e r t y f o r a g a i n , t h e n s u c h a g a i n w o u l d n o t be deemed a c a p i t a l g a i n . F o r e x a m p l e , i n 1952 B a y r i d g e E s t a t e s L t d . p u r c h a s e d a p a r c e l o f l a n d f o r a m o t e l a n d s e r v i c e s t a t i o n w h i c h t h e y i n t e n d e d t o h o l d a s a n . . i n v e s t m e n t . F i n a n c i a l d i f f i c u l t i e s p r e v e n t e d t h e company f r o m a c h i e v i n g i t s i n v e s t m e n t o b j e c t i v e s o t h e p r o p e r t y was s o l d f o r a g a i n . The c o u r t d e c i d e d t h a t s i n c e t h e company i n a c q u i r i n g t h e p r o p e r t y h a d a l s o c o n s i d e r e d t h a t i t s s a l e f o r a g a i n was an a l t e r n a t i v e c o u r s e o f a c t i o n t o d e v e l o p m e n t deemed t h e 4 g a x n n o t t o be a c a p i t a l g a i n . A s e c o n d d i s t i n g u i s h i n g c h a r a c t e r i s t i c o f a c a p i t a l g a i n s t r a n s a c t i o n i s t h e r e l a t i o n s h i p o f t h e t r a n s a c t i o n t o t h e t a x p a y e r ' s b u s i n e s s . A t a x p a y e r who r e a l i z e s a g a i n f r o m a t r a n s a c t i o n w h i c h r e q u i r e s t h e s k i l l a n d k n o w l e d g e t h a t he u s e s i n h i s b u s i n e s s i s u n l i k e l y t o b e deemed a c a p i t a l g a i n . Thus a c o n t r a c t o r w i t h e x t e n s i v e e x p e r i e n c e i n r e a l e s t a t e w h o . b o u g h t a p o u l t r y f a r m w h i c h he s u b d i v i d e d i n t o t h r e e p a r c e l s a f t e r u n s u c c e s s f u l l y o p e r a t i n g t h e f a r m f o r s e v e r a l m o n t h s was n o t deemed t o h a v e r e a l i z e d a c a p i t a l . 5 • " ' g a i n . The amount o f t h e t a x p a y e r ' s t i m e a n d e f f o r t r e q u i r e d t o c o m p l e t e a t r a n s a c t i o n may a l s o be c o n s i d e r e d b y t h e c o u r t s i n d e t e r m i n i n g w h e t h e r o r n o t a c a p i t a l g a i n h a s b e e n r e a l i z e d . T h u s a r e t i r e d s c h o o l t e a c h e r who p u r c h a s e d l a k e s h o r e p r o p e r t y a n d who s o l d l o t s f o r a summer c o t t a g e s o v e r a p e r i o d o f 20 y e a r s was h e l d t o h a v e e a r n e d a t a x a b l e i n c o m e - n o t c a p i t a l g a i n s . ^ 4. B a y r i d g e E s t a t e s L t d . v . M.N.R. (1959) E x . C.R. 248, 59 D.T.C. 1 0 9 8. 5. L o r a a s v . M.N.R., (T.A.B.) 69 DTC 148. 6. S m i t h v . M.N.R., ( E x . C t . ) 63 DTC 1326. 14 F i n a l l y , the nature of the transaction may determine whether or not a gain i s a c a p i t a l gain. The gain on a transaction which appears to be an adventure or concern i n the nature of trade w i l l not be deemed a c a p i t a l gain. Thus i f a taxpayer frequently engages i n much the same type of transaction, i t i s l i k e l y that such transactions w i l l be considered as trading transactions which are taxable at the normal rates. Thus, a dealer i n milk and livestock who purchased a farm and then engaged i n a continuous series of rea l estate transactions including buying, s e l l i n g , exchanging, sub-dividing and building was held to be earning taxable 7 . income - not c a p i t a l gains. However, even a single transaction which i s ca r r i e d out i n the same way as a transaction of an adventure i n the nature of-trade may re s u l t i n the gain on the transaction being deemed taxable income. For example, a taxpayer who purchased a farm for his own use was held to be earning taxable income when he systematically 8 sub-divided the farm and sold the l o t s . 7. Chomiere v. M.N.R., '.(T.A.B.) 66 DTC 775. 8. Touzin v. M.N.R., (T.A.B.) 64 DTC 533. 15 SUMMARY The income tax system i n Canada a p p l i e s a "direct tax on the income of every person r e s i d e n t i n Canada. The Income Tax A c t , the Income Tax A c t Regul a t i o n s and the tax cases of the j u d i c i a l system p r o v i d e s the l e g a l framework upon which the income tax system i s based. Income taxes have been i n s t i t u t e d by the f e d e r a l government and the ten p r o v i n c i a l governments but the f e d e r a l government, through i t s Department of N a t i o n a l Revenue - T a x a t i o n , a d m i n i s t e r s the income tax systemfor a l l of Canada except Quebec and c o r p o r a t i o n s i n O n t a r i o . Income taxes are a p p l i e d to the t a x a b l e income of a taxpayer. Taxable income i n c l u d e s a l l the income of a taxpayer from p r o p e r t y , b u s i n e s s e s , o f f i c e s , employments, and t a x a b l e c a p i t a l g a i n s . Depending of the source of the income, c e r t a i n expenses and deductions are p e r m i t t e d to be taken from income by the taxpayer i n order to a s c e r t a i n h i s t a x a b l e income. 16 CHAPTER 2 INCOME PROPERTY INVESTMENTS A major reason that individuals invest i n r e a l property i s to earn a regular income from t h e i r invested c a p i t a l . Unlike other income producing investments, r e a l property i s a more tangible investment which requires considerably more management and entrepreneurial e f f o r t on the part of the invester. In addition, r e a l property investments are subject to many unique provisions of the Income Tax Act. This chapter w i l l examine those tax provisions which have the greatest e f f e c t on the income and ownership of income property. 1 7 PROPERTY INCOME Income earned on property i s subject to the normal rates of taxation. Property income for tax purposes generally corresponds with the property p r o f i t determined i n accordance with normal business and accounting practices. Revenue earned by the property i s recognized for tax purposes i n the year that i t i s deemed to have been earned whether or not actual receipt occurs i n that year (12.1). Expenses which have been incurred for the purpose of gaining or producing that revenue are allowable deductions for tax purposes (18.1.a). Allowable expenses therefore normally include the following: - s a l a r i e s and wages of employees operating property - repairs and maintenance - property taxes - i n t e r e s t on borrowed money (20.1.c) - reserve for doubtful receivables (20.1.1) - landscaping the grounds (20.1.aa) Reserves f o r expected repair and maintenance expenditures are not allowable for tax purposes u n t i l the actual repair i s made (18.1.e). Although expenditures made to repair and maintain the property are allowable i n the year of incurrence, expenditures which improve or extend the l i f e of a property, c a l l e d c a p i t a l expenditures, are not allowable expenses of that year (18.1.b). These c a p i t a l expenditures must be added to the c a p i t a l cost of the property. The most important difference between property income for tax purposes and the businessman's concept of income occurs with the tax treatment of depreciable assets. Buildings and other improvements to land are wasting assets which p h y s i c a l l y deteriorate and become functionally obsolete over time. The systematic a l l o c a t i o n of t h e i r cost -18 a g a i n s t the revenue earned by t h e s e a s s e t s i s acc o u n t e d f o r by d e p r e c i a t i o n expense i n t h e b u s i n e s s a c c o u n t s . However t h i s d e p r e c i a t i o n expense used f o r book purposes i s n o t an a l l o w a b l e expense f o r t a x pu r p o s e s . S p e c i f i c p r o v i s i o n has been made i n t h e income t a x l e g i s l a t i o n whereby- t h e c o s t o f d e p r e c i a b l e p r o p e r t y i s a l l o c a t e d t o t h e revenue earned by i t t h r o u g h t h e c a p i t a l c o s t a l l o w a n c e p r o v i s i o n s o f t h e A c t and i t s R e g u l a t i o n s . The R e g u l a t i o n s d i v i d e d e p r e c i a b l e a s s e t s i n t o 26 d i f f e r e n t c l a s s e s . Each c l a s s c o n t a i n s a s s e t s o f a s i m i l a r n a t u r e and d e s i g n a t e s a p a r t i c u l a r r a t e a t w h i c h the a s s e t s may be c l a i m e d as a d e d u c t i o n f o r t a x pu r p o s e s . F o r most c l a s s e s , t h e r a t e , a f i x e d r a t e o f p e r c e n t a g e , i s a p p l i e d t o t h e d e c l i n i n g o r d i m i n i s h i n g b a l a n c e i n t h a t p a r t i c u l a r c l a s s . T h i s amount i s the maximum c a p i t a l c o s t a l l o w a n c e t h a t t h e t a x p a y e r may c l a i m f o r t h a t a s s e t c l a s s i n a g i v e n y e a r . As t h e u n d e p r e c i a t e d c a p i t a l c o s t (U.C.C.) o f t h e c l a s s d e c l i n e s o v e r t i m e , t h e a b s o l u t e amount o f c a p i t a l c o s t a l l o w a n c e ( C C A . ) t h a t can be c l a i m e d i n any y e a r a l s o d e c l i n e s as i s shown i n Example 2.1. Example 2.1 C a l c u l a t i o n o f C a p i t a l C o s t A l l o w a n c e Assumptions: C o s t o f r e n t a l p r o p e r t y : Land $100,000 B u i l d i n g ( C l a s s 6 - 10%) 250,000 $350,000 C a l c u l a t i o n o f c a p i t a l c o s t a l l o w a n c e : Year 1 Year 2 Year 3 U.C.C., b e g i n n i n g o f y e a r $250, 000 $225, 000 $202, 500 Maximum C C A . c l a i m e d (10%) 25, 000 22, 500 20, 250 U.C.C., end of y e a r $225, 000 $202, 500 $182, 250 I t i s i m p o r t a n t t o note i n Example 2.1 t h a t c a p i t a l c o s t a l l o w a n c e i s o n l y t a k e n on t h e c o s t o f t h e b u i l d i n g w h i c h 19 i s t h e d e p r e c i a b l e p o r t i o n o f t h e r e n t a l p r o p e r t y . L a n d i s n e v e r c o n s i d e r e d a d e p r e c i a b l e a s s e t f o r t a x p u r p o s e s . The c a p i t a l c o s t a l l o w a n c e c l a s s e s w h i c h a r e m o s t r e l e v a n t t o i n c o m e p r o p e r t y a r e a s f o l l o w s : C l a s s T y p e s o f S t r u c t u r e C.C.A. R a t e 3 S t o n e , s t e e l , c o n c r e t e o r 5% b r i c k s t r u c t u r e s 6 L o g , s t u c c o , f r a m e , 10% g a l v a n i z e d o r c o r r u g a t e d i r o n s t r u c t u r e s 8 F u r n i t u r e a n d e q u i p m e n t 2 0 % P r o v i d e d t h a t i t i s w i t h i n t h e maximum amount a u t h o r i z e d , t h e amount o f c a p i t a l c o s t a l l o w a n c e w h i c h may be c l a i m e d i n a n y one y e a r i s a t t h e d i s c r e t i o n o f t h e t a x p a y e r . The t a x p a y e r may r e d u c e t h e amount c l a i m e d f r o m t i m e t o t i m e , and i n any one y e a r , he may t a k e no c a p i t a l c o s t a l l o w a n c e s h o u l d i t b e a d v a n t a g e o u s t o h i m . A p a r t f r o m t h e s p e c i a l c a p i t a l c o s t a l l o w a n c e p r o v i s i o n o f t h e A c t a n d c e r t a i n r e s t r i c t i v e p r o v i s i o n s r e l a t i n g t o s u c h i t e m s a s r e s e r v e s f o r r e p a i r s a n d m a i n t e n a n c e , p r o p e r t y i n c o m e f o r t a x p u r p o s e s i s b a s i c a l l y t h e same as t h e b u s i n e s s -men's c o n c e p t o f p r o p e r t y p r o f i t . E x a m p l e 2.2 d e m o n s t r a t e s t h e t e c h n i q u e b y w h i c h a s t a t e m e n t o f p r o p e r t y i n c o m e i s c o n v e r t e d t o a s t a t e m e n t o f t a x a b l e p r o p e r t y i n c o m e . Income t a x e s m u s t be p a i d o n t h e i n c o m e f o r t a x p u r p o s e s o f P a c i f i c A p a r t m e n t s o f $500 e v e n t h o u g h t h e i n c o m e f o r b o o k p u r p o s e s was $7,000. A s c a n be s e e n i n e x a m p l e 2.2, t h e d i f f e r e n c e b e t w e e n t h e i n c o m e f o r b o o k p u r p o s e s o f $7,000 a n d t h e i n c o m e f o r t a x p u r p o s e s o f $500 i s m o s t l y d u e t o t h e d i f f e r e n c e b e t w e e n t h e c a p i t a l c o s t a l l o w a n c e c l a i m e d o f $12,500 a n d t h e d e p r e c i a t i o n e x p e n s e o f $5,000. 20 Example 2.2 P a c i f i c Apartments Statement of Income for Tax Purposes 1972 Rental revenue $ 50,00 0 Expenses: Mortgage i n t e r e s t $ 20,000 Property taxes 5,000 U t i l i t i e s 4,000 Caretaker 3,00 0 Management 1,600 Insurance 400 Reserve for repairs and maintenance 4,000 Depreciation (2% of cost per year) 5,000 43,000 Income for book purposes Add: Reserve for repair and maintenance Depreciation Less: Outlays for repairs and maintenance Cap i t a l cost allowance claimed 7,000 4,000 5,000 9,000 16,000 3,000 12,500 15,500 Income for tax purposes $ 500 Capital Cost. Allowance Schedule U.C.C., beginning of year Less: C C A . claimed (Class 3 U.C.C, end of the year $250,000 - 5%) 12,500 $237,500 2 1 AN IMPORTANT CAPITAL COST ALLOWANCE RESTRICTION Under the provisions of the old Income Tax Act, the undepreciated c a p i t a l cost of the properties of the same class were pooled together into one undepreciated c a p i t a l cost account. The c a p i t a l cost allowance rate was applied to th i s aggregate amount irregardless of whether or not the properties o r i g i n a l l y composing the undepreciated c a p i t a l cost account continued to be owned by the taxpayer as long as he s t i l l owned at least one of the properties. The undepreciated c a p i t a l cost account of each class of depreciable assets was increased or decreased i n the following manner: 1 . The c a p i t a l cost of depreciable assets were added to the pool of undepreciated c a p i t a l cost of t h e i r p a r t i c u l a r class i n the year of purchase. 2. In a year of disposal, the proceeds of d i s p o s i t i o n of each depreciable asset were deducted from t h e i r class pool. If however the proceeds exceeded the o r i g i n a l c a p i t a l cost of the depreciable asset, then t h i s excess, c a l l e d a c a p i t a l gain, was excluded from the proceeds that were deducted from the pool. 3. If a l l of the depreciable assets of a p a r t i c u l a r class have been sold or no longer e x i s t , then the remaining undepreciated c a p i t a l cost of that class would be completely deductible as a terminal loss of the taxpayer. Example 2 . 3 demonstrates the accounting treatment of the c a p i t a l cost allowance system under the old Act and high-l i g h t s the following c h a r a c t e r i s t i c s of that system. 1 . The maximum c a p i t a l cost allowance could be claimed on additions acquired during the year irregardless of when they were acquired. Thus, even i f an asset 22 Example 2.3 A c c o u n t i n g f o r C a p i t a l C o s t A l l o w a n c e under t h e o l d A c t C l a s s 6(10%) A s s e t s T o t a l B l d g A B l d g B B l d g C Year 1: U.C.C., b e g i n n i n g A d d i t i o n s L e s s : C C A . c l a i m e d U.C.C, end o f y e a r $250,000 $250,000 300,000 $300,000 550,000 250,000 300,000 55,000 25,000 30,000 $495,000 $225,000 $270,000 Year 2: U.C.C, b e g i n n i n g A d d i t i o n s P r oceeds o f d i s p o s i t i o n L e s s : C C A . c l a i m e d U.C.C, end o f y e a r $495,000 $225,000 $270,000 400,000 $400,000 (250,000) (250,000) 645,000 225,000 20,000 400,000 64,500 22,500 2,000 40,000 $580,500 $202,500 $ 18,000 $360,000 Year 3: U.C.C, b e g i n n i n g $580,500 Proceeds o f d i s p o s i t i o n (250,000) ,330,500 L e s s : C C A . c l a i m e d 33 , 050 U.C.C, end o f y e a r $297,450 $202,500 $ 18,000 $360,000 (250,000) ( 47,500) 18,000 360,000 ( 4,750) 1,800 36,000 ($42,750) $ 16,200 $324,000 was acquired the l a s t day of the year, the maximum c a p i t a l cost allowance could be claimed i n that year. 2. In year 2, Building B was sold for $250,000 which was $20,000 less than i t s undepreciated c a p i t a l cost of.$270,000. This $20,000 however remained i n the class pool to be subjected to c a p i t a l cost allowance of future years. 3. In year 3, Building A was sold for i t s o r i g i n a l c a p i t a l cost of $250,000 which was $47,500 above i t s undepreciated c a p i t a l cost of $202,500.: This $47,500 of recovered c a p i t a l cost allowance continued to remain as a reduction i n the class pool balance and would be amortized over future years. 4. As a r e s u l t of the pooling of depreciable assets of the same class, the undepreciated c a p i t a l cost ','~- of the class 6 properties i s $297,450 i n year 3 even though the undepreciated c a p i t a l cost of the only e x i s t i n g property (Building C) i n that class i s $324,000. Generally, the system of aggregating depreciable properties into pools for c a p i t a l cost allowance purposes i s continued under the provisions of the new Act. However one change i n the provisions has had a major e f f e c t on r e a l estate investors. The new provision of the Act states that each depreciable property costing $50,000 or more whose'prime purpose i s to earn re n t a l income must be segregated into a separate c a p i t a l cost allowance class. Consequently c a p i t a l cost allowance that i s recaptured through sales proceeds i n excess of undepreciated c a p i t a l cost i n the year of d i s p o s i t i o n w i l l now be subject to income taxes i n that year rather than being c a r r i e d forward i n a c a p i t a l cost allowance pool. The comparative e f f e c t of t h i s new 24 income tax provision can best be demonstrated i n Example 2.4 by applying i t to the circumstances described i n Example 2.3. Each r e n t a l building i n Example 2.4 has a c a p i t a l cost of $50,000 or more. Consequently, each of the re n t a l buildings constitutes a separate undepreciated c a p i t a l cost account. Buildings which are sold during the year must have t h e i r undepreciated c a p i t a l cost accounts eliminated for tax purposes i n the following manner: 1. Where proceeds of d i s p o s i t i o n are less than the undepreciated c a p i t a l cost of a building, a terminal loss r e s u l t s . Rental Building B i n Example 2.4 had a terminal loss of $20,000 i n year 2. This terminal loss i s deductible i n f u l l from the taxpayer's income for that year. 2. Where proceeds of d i s p o s i t i o n exceed the undepreciated c a p i t a l cost of a bui l d i n g , recapture of previously claimed c a p i t a l cost allowance occurs. In Example 2.4, Rental Building A resulted i n a $47,500 recapture of c a p i t a l cost allowance i n year 3. The amount of t h i s recapture must be included i n the income of the taxpayer i n the year of-d i s p o s i t i o n . The owner of Rental Building A would have his taxable income increased by $47,500 i n year 3. 3. If the proceeds of dispostion exceed the o r i g i n a l c a p i t a l cost of the building, then the amount of the excess which i s a c a p i t a l gain i s excluded from the proceeds which are deducted from the undepreciated c a p i t a l cost of the building. This c a p i t a l gain i s accounted for separately for income tax purposes. This c a p i t a l cost allowance r e s t r i c t i o n over r e n t a l buildings which cost $50,000 or more applies to such buildings acquired by a taxpayer after 1971 except where 25 construction of the building commenced p r i o r to 1972. Again, i t i s important to r e i t e r a t e that t h i s r e s t r i c t i o n applies only to depreciable property whose primary purpose i s to earn r e n t a l income. Buildings owned by th e i r occupants and used to earn income other than re n t a l income are not affected by t h i s r e s t r i c t i o n under the new Act. 26 Example 2.4 Accounting for Capital Cost Allowance under the new Act Rental Rental Rental Bldg A Bldg B Bldg C Year 1; U.C.C., beginning of year $250,000 Additions $300,000 250,000 300,000 Deduct: C C A . claimed (10%) 25,000 30,000 U.C.C, end of year , $225,000 $2 70,000 Year 2: U.C.C, beginning of year $225,000 $270,000 Additions $400,000 Proceeds of di s p o s i t i o n (250,000) ' Terminal loss $ 20,000 225,000 400,000 Deduct: C C A . claimed (10%) 22,500 40,000 U.C.C, end of year $202,500 $360,000 Year 3: U.C.C, beginning of year $202,500 $360,000 Proceeds of d i s p o s i t i o n (250,000) Recapture of C C A . $ 47,500 ~~ 360,000 Deduct: C C A . claimed (10%) 36,000 U.C.C, end of year $324,000 27 This r e s t r i c t i o n over the claiming of c a p i t a l cost allowance w i l l have a major impact on the decisions of investors who own or are about to acquire depreciable r e n t a l property. With i n f l a t i o n and r e a l property appreciation, a depreciable r e n t a l property can have a market value far i n excess of i t s undepreciated c a p i t a l cost over a period of a few years as Building A i n Example 2.4 demonstrates. The owner of Building A must consider the f a c t that his current year's income would be increased by $47,500 i f he s e l l s the Building i n Year 3. The higher income taxes that he w i l l have to pay w i l l reduce his cash available for another investment. In fact, he would not have s u f f i c i e n t cash af t e r income taxes to buy a s i m i l a r building with the same terms of purchase. Thus the owner of a depreciable r e n t a l building or an investor contemplating such a purchase must be prepared for the eventual prospect of paying a s i g n i f i c a n t portion of the cash return r e s u l t i n g from the sale of the property as the income tax on the recaptured c a p i t a l cost allowance. Consequently, owners of depreciable r e n t a l property may f i n d themselves locked-in to retaining such properties because the income returns that they could expect on t h e i r r e s i d u a l cash investment a f t e r d i s p o s i t i o n would.be less than the income generated by t h e i r currently held properties. Under the old Act, the c a p i t a l cost allowance pools would often completely conserve the cash received upon the d i s p o s i t i o n of a depreciable p'ropertyrthereby enabling the a c q u i s i t i o n of more or larger properties. In addition to being locked-in to the continued ownership of depreciable r e n t a l buildings, an investor may be under a f i n a n c i a l incentive to demolish his older r e n t a l buildings because of t h i s new c a p i t a l cost allowance r e s t r i c t i o n . If land values have r i s e n rapidly, an owner of r e n t a l property may f i n d that the land upon which the building i s situated has a value which i s close to the value of the property as a whole. If t h i s was the case with the owner of Building B i n Example 2.4, he could demolish the building and claim a 28 a t e r m i n a l l o s s o f $2 70,000 i n Y e a r 2. The t a x s a v i n g s w h i c h w o u l d r e s u l t c o u l d more t h a n c o m p e n s a t e t h e o w n e r f o r t h e l o s s o f t h e i n c o m e w h i c h w o u l d h a v e b e e n e a r n e d f r o m t h e o l d r e n t a l b u i l d i n g . U n d e r t h e o l d A c t , t h e u n d e p r e c i a t e d c a p i t a l c o s t o f t h e d e m o l i s h e d b u i l d i n g w o u l d h a v e r e m a i n e d i n t h e c a p i t a l c o s t a l l o w a n c e p o o l t o be a m o r t i z e d . s l o w l y o v e r many f u t u r e y e a r s . The i m m e d i a t e t a x r e l i e f p r o v i d e d by t h e new A c t by d e m o l i s h i n g o l d e r b u i l d i n g s w h i c h o c c u p y u n ' d f e r c u t i l i z e d s i t e s w i l l l i k e l y a c c e l e r a t e t h e r e d e v e l o p m e n t o f many u r b a n a r e a s e v e n t h o u g h t h e e x i s t i n g d e v e l o p m e n t s a r e s t r u c t u r a l l y a n d e c o n o m i c a l l y s o u n d . T h u s , t h i s new t a x p r o v i s i o n w i l l l i k e l y s t i m u l a t e a h i g h e r a n d b e t t e r u t i l i z a t i o n o f l a n d e s p e c i a l l y l a n d l o c a t e d i n u r b a n c e n t r e s , b u t t h e new d e v e l o p m e n t s w i l l r e q u i r e much g r e a t e r r e v e n u e s t h a n w e r e g e n e r a t e d by t h e o l d e r d e v e l o p m e n t s . C o n s e q u e n t l y , t h e r e n t a l r a t e s t r u c t u r e s o f a n a r e a w i l l b e g r e a t l y i n c r e a s e d a s t h e o l d e r b u i l d i n g s a r e r e p l a c e d by n e w e r a n d more e x p e n s i v e s t r u c t u r e s . I n c o n c l u s i o n , t h e r e s t r i c t i o n o v e r c l a i m i n g c a p i t a l c o s t a l l o w a n c e on b u i l d i n g s c o s t i n g $50,000 o r more w i l l l i k e l y determmany t a x p a y e r s f r o m d i s p o s i n g o f p r o p e r t i e s w h i c h h a v e a p p r e c i a t e d i n v a l u e a n d w i l l s t i m u l a t e t a x p a y e r s t o d e m o l i s h t h e b u i l d i n g s w h i c h o c c u p y u n d e r u t i l i z e d s i t e s . - 2 9 REAL ESTATE INVESTMENTS AS A TAX SHELTER A c o n t r o v e r s i a l a s p e c t o f t h e o l d Income T a x A c t was t h a t i t s p r o v i s i o n s e n a b l e d t a x p a y e r s t o r e d u c e t h e i n c o m e t a x l i a b i l i t y o n t h e i r e m p l o y m e n t a n d b u s i n e s s i n c o m e b y c r e a t i n g p a p e r l o s s e s f o r t a x p u r p o s e s o n t h e i r p r o p e r t y i n v e s t m e n t s . By c l a i m i n g c a p i t a l c o s t a l l o w a n c e i n e x c e s s o f r e n t a l i n c o m e , a p r o p e r t y l o s s f o r t a x p u r p o s e s was c r e a t e d e v e n i f t h e p r o p e r t y h a d g e n e r a t e d a c a s h i n c o m e f o r t h e y e a r . T h i s p a p e r l o s s was t h e n u s e d t o r e d u c e o t h e r t a x a b l e i n c o m e a n d t h e r e f o r e t h e i n c o m e t a x e s o f a t a x p a y e r . A c c o r d i n g t o t h e p r o v i s i o n s o f t h e new Income Tax A c t , t h i s a v e n u e o f t a x r e d u c t i o n i s t o be c l o s e d . L o s s e s c r e a t e d b y c l a i m i n g c a p i t a l c o s t a l l o w a n c e o n r e n t a l p r o p e r t y w i l l no l o n g e r be d e d u c t i b l e f r o m n o n - r e n t a l i n c o m e o f a n i n d i v i d u a l t a x p a y e r . The i m p a c t o f t h i s new t a x p r o v i s i o n i s d e m o n s t r a t e d i n E x a m p l e 2.5. E x a m p l e 2.5 d e m o n s t r a t e s t h a t u n d e r t h e p r o v i s i o n s o f t h e o l d A c t , a t a x p a y e r c o u l d s h e l t e r h i s o t h e r i n c o m e f r o m i n c o m e t a x e s t o t h e e x t e n t o f $22,500 - t h e amount o f t h e r e n t a l l o s s f o r t a x p u r p o s e s . I n s o d o i n g , a t a x p a y e r i n a h i g h m a r g i n a l t a x r a t e o f 60% c o u l d r e d u c e h i s o v e r a l l t a x l i a b i l i t y by a s u b s t a n t i a l $ 1 3,500. The a p a r t m e n t w h i c h y i e l d e d a n o m i n a l b e f o r e t a x c a s h r e t u r n o f o n l y 2.5% i s an a t t r a c t i v e r e a l e s t a t e i n v e s t m e n t t o a t a x p a y e r i n a 60% t a x b r a c k e t i n t h a t h i s c a s h r e t u r n a f t e r t a x e s f r o m t h e a p a r t m e n t was 16% u n d e r t h e o l d A c t . U n d e r t h e new t a x p r o v i s i o n s , a c a p i t a l c o s t a l l o w a n c e on r e n t a l p r o p e r t i e s c a n n o t be u s e d t o c r e a t e l o s s e s w h i c h r e d u c e n o n -r e n t a l t a x a b l e i n c o m e . I n E x a m p l e 2.5, c a p i t a l c o s t a l l o w a n c e o f o n l y $2,500 c a n be c l a i m e d w h i c h r e d u c e s r e n t a l i n c o m e t o z e r o b u t d o e s n o t c r e a t e a n y d e d u c t i b l e l o s s e s f o r t a x p u r p o s e s . 30 Example 2.5 Tax Shelter Provisions under the old and new Acts Assumptions: 1. Marginal tax rate of taxpayer i s 6 0%. 2. Taxpayer's equity i n an apartment i s $100,000. 3. Undepreciated c a p i t a l cost of apartment building i s $250,000. 4. Rental income of the apartment before claiming c a p i t a l cost allowance i s $2,50 0. Old Act New Act Rental loss for tax purposes: Rental income before claiming C C A . $ 2,500 $ 2,500 C C A . claimed' -.. 25,000 2,500 Rental loss for tax purposes $22,500 N i l Taxpayer's cash return for the year: Rental income before C C A . $ 2,500 $ 2,500 Application of rent a l loss for tax purposes against other income of the taxpayer reduces the o v e r a l l income tax l i a b i l i t y of the taxpayer-60% of $22,500 13,500 60% of N i l N i l Cash return for the year $16,000 $ 2,500 Cash return to owner's equity of $100,000 : 16 % 2.5! 31 Although losses created by claiming c a p i t a l cost allowance on re n t a l properties can not be used to reduce non-rental taxable income, they may however be used to reduce the taxable income of other r e n t a l properties as i s shown i n Example 2.6. In Example 2.6, the re n t a l loss of $15,000 of Building A, which was caused i n part by claiming c a p i t a l cost allowance, can be used to reduce the taxable r e n t a l income of Building B and Building C. Generally, the c a p i t a l cost allowance that can be claimed on a taxpayer's rental buildings i s limited by the established c a p i t a l cost allowance rates as well as being l i m i t e d to the net r e n t a l income from those buildings p r i o r to claiming c a p i t a l cost allowance. This provision prevents the u t i l i z a t i o n of rental losses created by c a p i t a l cost allowance to eliminate other r e n t a l income and then using actual r e n t a l losses to reduce other non-rental income. In Example 2.6, the actual r e n t a l loss of $5,000 of Building A can not be preserved by u t i l i z i n g the additional $5,000 of c a p i t a l cost allowance which could otherwise be claimed on Building A. However, i f Building A had been the only rental property of the taxpayer, then without claiming any c a p i t a l cost allowance, the taxpayer could have used the actual rental loss of $5,000 to reduce his non-rental taxable income. 3 2 Example 2.6 Application of Rental Losses to Rental Income Assumption: 1. Taxpayer owns 3 buildings which he uses to earn r e n t a l income. Bldg A Bldg B Bldg C Total Rental revenue $ 30,000 $ 50,000 $ 60,000 $140,000 Expenses 35,000 4 0,000 45,000 12 0,000 Rental income (loss) (5,000) 10,000 15,000 20,000 C C A . claimed 10,000 5,00 0 5,000 2 0,00 0 Rental income (loss) for tax purposes $ (15,000) $ 5,000 $ 10,000 : N i l Undepreciated c a p i t a l cost of buildings $300,000 $100,000 $100,000 Maximum C C A . allowable (5%) $v 15)000 $ 5,000 :$: : 5,000 33 The elimination of t h i s tax shelter w i l l have a major e f f e c t on r e a l estate investors who earn high non-property income and on some forms of r e a l estate. Under the old Act, r e a l estate investors l i k e doctors, lawyers and executives who earned high employment or business incomes found cert a i n forms of r e a l estate l i k e frame apartments to be highly a t t r a c t i v e investments, not because of t h e i r a b i l i t y to generate income, but because of the savings i n income taxes which resulted from claiming c a p i t a l cost allowance on them. As was shown i n Example 2.5, a.high income taxpayer could earn an excellent cash return from an otherwise poor investment becuase of the tax provisions of the old Act. Under the new Act, t h i s tax shelter has e f f e c t i v e l y been eliminated for a l l r e a l estate investments. Consequently high income tax-payers w i l l d i r e c t t h e i r f i n a n c i a l resources into other investments which may continue to provide some form of tax shelter l i k e some classes of machinery and equipment used i n manufacturing or into those forms of r e a l estate which earn good returns. The forms of r e a l estate which provided substantial tax shelters i n the. past, l i k e frame apartments, w i l l be much less a t t r a c t ivee investments u n t i l they generate subs t a n t i a l l y higher incomes. Thus over the short term, r e a l estate which created tax shelters w i l l undergo a r e l a t i v e decline i n market value and new construction w i l l be greatly reduced. The lack of construction of new frame rent a l apartments i n 1972 and 1973 demonstrates t h i s e f f e c t . Over the long term, the economic forces of supply and demand w i l l raise the incomes of these formerly tax shelter investments to competive l e v e l s i n order to stimulate new construction. The r i s e i n re n t a l income and therefore rents of some forms of r e a l estate l i k e frame apartments could be substantial.. For example, i f a competitive return for the apartment i n Example 2.5 i s 12.5% on the owner's equity of $100,000, then the annual r e n t a l income must r i s e by $10,000. 3 4 I f t h i s apartment had an annual gross r e n t a l income o f $40,000, then i t s r e n t s must r i s e by 25% to provide a competitive r e t u r n to t h i s apartment. In c o n c l u s i o n , the e l i m i n a t i o n of t h i s income tax s h e l t e r has r e d i r e c t e d the investment c a p i t a l of many high income i n d i v i d u a l s away from c e r t a i n forms of r e a l e s t a t e e s p e c i a l l y frame apartments. Over the s h o r t term, the market value of these forms of r e a l e s t a t e w i l l l i k e l y d e c l i n e because of the lack, of i n v e s t o r i n t e r e s t . Over the long term, the fo r c e s of supply and demand f o r these forms of r e a l e s t a t e w i l l cause r e n t a l r a t e increases of a s u f f i c i e n t magnitude t o make these p r o p e r t i e s a t t r a c t i v e once again to i n v e s t o r s . RECAPTURED CAPITAL COST ALLOWANCE Ex t e n s i v e income taxes can be d e f e r r e d by a taxpayer over the years by c l a i m i n g c a p i t a l c o s t allowance on h i s d e p r e c i a b l e p r o p e r t y a t or near the maximum a l l o w a b l e r a t e each year. Since the amount of c a p i t a l c o s t allowance claimed does not have t o r e f l e c t the a c t u a l d e c l i n e i n value o f a p r o p e r t y , the maximum r a t e o f allowance can be claimed i r r e g a r d l e s s of the a c t u a l d e c l i n e , i f any, i n val u e . I t t h e r e f o r e f o l l o w s t h a t the und e p r e c i a t e d c a p i t a l c o s t bears no r e l a t i o n to economic va l u e . However the avoidance of income taxes by c l a i m i n g c a p i t a l c o s t allowance i s onl y temporary. Upon d i s p o s i t i o n of the p r o p e r t y , any e x c e s s i v e c a p i t a l c o s t allowance claimed i n the p a s t i s f u l l y t a x a b l e i n . the year o f d i s p o s i t i o n . Example 2.7 demonstrates the income tax consequences of re c a p t u r e d c a p i t a l cost, allowance. Over the 10 ye a r s , the taxpayer i n Example 2.7 has been able to reduce h i s t a x a b l e income by $10,000 each and every year by c l a i m i n g e x c e s s i v e c a p i t a l c o s t allowance. I f the taxpayer had a marginal tax b r a c k e t o f 50%, he has been a b l e to d e f e r $50,000 of income taxes over the 10 years which would have'been payable otherwise. However d i s p o s i t i o n of the b u i l d i n g i n year 10 has r e s u l t e d i n a r e c a p t u r e of $100,000 of c a p i t a l c o s t allowance which i s t a x a b l e i n f u l l i n year'10. Adding $100,000 to the taxpayer's income i n year 10 may however put him i n t o a marg i n a l tax b r a c k e t of perhaps 70% which means t h a t income taxes o f $70,000 would have t o be p a i d on the r e c a p t u r e i n year 10 even though o n l y $50,000 of income taxes were d e f e r r e d . In order to a l l e v i a t e the tax burden on such s u b s t a n t i a l c a p i t a l c o s t allowance r e c a p t u r e s , s p e c i p r o v i s i o n s were made i n the o l d A c t and have a l s o been i n c l u d e d i n the new A c t . 36, Example 2.7 Recapture o f C a p i t a l C o s t A l l o w a n c e Assumptions: 1. On J a n u a r y 1 o f y e a r 1, t a x p a y e r a c q u i r e s apartment b u i l d i n g f o r $250,000. 2. Taxpayer c l a i m s maximim c a p i t a l c o s t a l l o w a n c e each y e a r w h i c h i s $10,000 more t h a t the a c t u a l d e c l i n e i n v a l u e . 3. Apartment b u i l d i n g i s s o l d on December 31 o f y e a r 10 f o r $200,000. Recapture o f C a p i t a l C o s t A l l o w a n c e : U.C.C, b e g i n n i n g o f y e a r 1 $ 250,000 C C A . c l a i m e d o v e r 10 y e a r s 150,000 U.C.C, end o f y e a r 10 100,000 Proceeds o f d i s p o s i t i o n 200,000 Rec a p t u r e o f C C A . $ 100,000 3 7 Under the old Act, many c a p i t a l cost allowance recaptures could be protected by the c a p i t a l cost allowance pooling system. Capital cost allowance was based on the undepreciated c a p i t a l cost of a class of assets so that the d i s p o s i t i o n of one of the assets for proceeds i n excess of i t s undepreciated c a p i t a l cost would only reduce the c a p i t a l cost of the class. Recapture would not occur unless the c a p i t a l cost of the class became a negative balance. An expanding r e a l estate investment program could avoid income taxes on i t s recaptures for years under the old Act. However i f circumstances did r e s u l t i n a substantial recapture of c a p i t a l cost allowance which was currently taxable, then Section 43 of the old Act permitted t h i s recapture to be averaged over a maximum of 5 previous years. Instead of being taxed at the high marginal tax rates, the recapture was taxed as i f i t had been r e a l i z e d i n equal portions over the preceding 5 years. The r e s u l t i n g tax rate on the recapture would only be s l i g h t l y higher than the taxpayer's normal marginal rate. Under the provisions of the new Act, a taxpayer has three averaging options for the tax treatment of recaptured c a p i t a l cost allowance. These provisions w i l l be u t i l i z e d to a much greater extent then the averaging provision under the old Act. The reason for t h i s i s that taxable recaptures are l i k e l y to be much more prevalent under the new Act because depreciable re n t a l properties that cost $50,000 or more must be segregated into separate c a p i t a l cost allowance classes. Recaptured c a p i t a l cost allowance which re s u l t s from the d i s p o s i t i o n of these r e n t a l properties w i l l no longer be allowed to be buried i n class pools. The averaging provisions for recaptured c a p i t a l cost allowance under the new Act are as follows: 38 1. The technique of averaging the recapture over a maximum of 5 years which existed under the old Act can s t i l l be elected to be used by a taxpayer u n t i l 1975 (I.T.A.R. 42). Only i n d i v i d u a l taxpayers may u t i l i z e t h i s t r a n s i t i o n a l provision. 2. The new Act introduces a general averaging formula which i s available to every Canadian resident i n d i v i d u a l whose income i n a p a r t i c u l a r year i s at least 10% greater than that of the immediately preceding year and at least 20% greater than the average of his income over the 4 preceding years (118). The income i n excess of these q u a l i f y i n g l i m i t s w i l l be taxed as though i t had been earned over 5 years. The c a l c u l a t i o n of thi s general averaging formula w i l l be automatically computed each year by the Tax Department. As a r e s u l t of thi s general averaging provision, an i n d i v i d u a l with an inordinate r i s e i n taxable income i n any one year caused by a recapture of c a p i t a l cost allowance w i l l automatically benefit from averaging. However, an important exception to thi s general averaging re s u l t s i f the t r a n s i t i o n a l provision described i n 1 above i s selected. In that case, general averaging w i l l not be applicable. 3. Section 61 of the new Act provides a further means of averaging c e r t a i n unusual income amounts including recaptured c a p i t a l cost allowance. The tax on these amounts can be deferred by the purchase of a special income averaging annuity contract that meets c e r t a i n conditions. The contract must be purchased from an authorized company and must be paid for by a single lump sum payment. An annuity payment must be made at least once a year and the f i r s t payment 39 must be made w i t h i n 10 months o f the c o n t r a c t d a t e . The term o f t h e a n n u i t y can be e i t h e r f o r t h e l i f e o f t h e t a x p a y e r o r a g u a r a n t e e d term n o t i n e x c e s s o f 15 y e a r s . F i n a l l y , t h e g u a r a n t e e d term can n o t e x t e n d beyond th e t a x p a y e r ' s 85 b i r t h d a y . As t h e a n n u i t y payments a r e r e c e i v e d , they must be i n c l u d e d i n t h e income o f t h e t a x p a y e r . Thus, t h i s a v e r a g i n g p r o v i s i o n e n a b l e s t h e t a x p a y e r t o s p r e a d t h e income t a x l i a b i l i t y o f a c a p i t a l c o s t a l l o w a n c e r e c a p t u r e over many y e a r s . A l s o , the e l e c t i o n o f t h i s p r o v i s i o n does not p r e c l u d e t h e a p p l i c a t i o n o f t h e a u t o m a t i c a v e r a g i n g p r o v i s i o n d e s c r i b e d i n 2 above. T h i s p r o v i s i o n can be v e r y advantageous t o a taxpayer, who i s a p p r o a c h i n g r e t i r e m e n t . The proceeds o f a r e c a p t u r e w h i c h a r e o t h e r w i s e t a x a b l e a t h i g h m a r g i n a l r a t e s due t o t h e t a x p a y e r ' s h i g h employment o r b u s i n e s s income can be used t o p u r c h a s e an a n n u i t y whose f u t u r e payments w i l l be t a x a b l e a t t h e much lower r a t e s a p p l i c a b l e t o t h e t a x p a y e r ' s r e t i r e m e n t income. Other t a x p a y e r s may n o t d e r i v e v e r y m u c h . b e n e f i t from t h i s p r o v i s i o n . To b e n e f i t from t h i s p r o v i s i o n , a t a x p a y e r must i n v e s t t h e e n t i r e amount o f a t a x a b l e r e c a p t u r e i n t h e income a v e r a g i n g a n n u i t y . S i n c e t h i s a n n u i t y may e a r n a r e l a t i v e l y u n a t t r a c t i v e r e t u r n when compared t o r e a l e s t a t e i n v e s t m e n t s , i t may n o t be a f e a s i b l e a l t e r n a t i v e t o an i n v e s t o r who d e s i r e s t o maximize h i s i n v e s t m e n t r e t u r n s . 40 Although provisions of the new Income Tax Act s t i l l enable a taxpayer to spread the income tax l i a b i l i t y of a recapture of c a p i t a l cost allowance over a number of years, the major advantage of the old Act of deferring the tax on a.recapture by reducing the undepreciated c a p i t a l cost of a pool of assets i s no longer available to r e n t a l properties costing $50,000 or more under the new Act. Under the o l d Act, an expanding r e a l estate investment port f o l i o could avoid paying, any. taxes on a recapture.for years. The cash which would have been required to pay the tax could therefore be used over and over again to.acquire more r e a l estate and to earn more income. Under the new Act, income taxes incurred on a recapture of c a p i t a l cost allowance must be paid immediately upon d i s p o s i t i o n or over a .period of a few years as provided under the Act. In order f o r . an investor to earn the same income from his investment c a p i t a l , h e . w i l l have to earn a higher rate of return on his cash equity since he i s no longer able to earn a return on the cash which must be paid as income taxes on his recaptures of c a p i t a l cost allowance. Therefore, r e a l estate investments which benefited by th i s income tax d e f e r r a l under the old Act must generate more income i n order for them to be as at t r a c t i v e as investment under the new Act as they were under the old Act. 41 Land vs. Buildings Controversy Recaptured c a p i t a l cost allowance and.the income taxes thereon can be very substantial for properties held for many years or where rapid appreciation of property values has occurred. Since most r e a l estate investments consist of a non-depreciable component - land, and a depreciable component - buildings and equipment, the amount of recapture is. dependent upon the a l l o c a t i o n of the sales proceeds, of the property between, the depreciable and non-depreciable components. Income tax considerations are very s i g n i f i c a n t when i t i s r e a l i z e d that land appreciation may be taxed as a c a p i t a l gain whereas building appreciation may consist of f u l l y taxable recaptured c a p i t a l cost allowance. Upon di s p o s i t i o n of .a property which includes land and buildings, the taxpayer must make a reasonable a l l o c a t i o n of the consideration received.for his property between the depreciable property and the property that i s not depreciable. This creates two major problems for most taxpayers.when they s e l l t h e i r property. The f i r s t problem.is that a.reasonable a l l o c a t i o n i s often very d i f f i c u l t to make. The second problem i s that the incentive to save tax do l l a r s by minimizing, the value of the depreciable property i s very strong so that.irregardless of how reasonable the a l l o c a t i o n may be i t i s often disputed by the Tax Department. The separation of the value of a building and the land upon which i t . i s situated i s often very a r b i t r a r y under the best of circumstances. An apartment has a certain value because of i t s physical structure and appearance, i t s age and i t s location. The value of the apartment as a 42 whole can often be well substantiated by many comparable apartments which are of a s i m i l a r s i z e , age.and location. However, what portion of that., value i s . a ttributable to the size., shape ^ exposure and. location of the apartment s i t e and what portion i s attributable to.the physical depreciable apartment i s often .only conjecture. A common technique, of. ..separating the value of. the building from i t s land i s . t o determine the value of the land as i f i t was vacant and then subtract t h i s value from the value of the property as a whole. A major shortcoming of t h i s residual method i s that.there i s . r a r e l y very many vacant building s i t e s with the same.size, shape, exposure and.location.. Various valuation techniques are used to eliminate differences between comparable building s i t e s but t h e i r a p p l i c a t i o n . i s often, disputed even among experts. Because of the complexity, of a l l o c a t i n g consideration received for a property between i t s depreciable and non-depreciable components, a-taxpayer would be well advised to consult a.professional- property appraiser whose expertise and well documented research w i l l , provide, strong support for the taxpayer's a l l o c a t i o n . The second a l l o c a t i o n problem, i s that due to the strong incentive for the taxpayer.to undervalue the depreciable part of the property the Tax Department i s l i k e l y to.be suspicious of a .taxpayer' s a l l o c a t i o n of consideration received for his property. Even with the a l l o c a t i o n of the sales proceeds being i m p l i c i t l y stated in a contract between arms' length p a r t i e s , the Tax Department w i l l often require, substantial evidence that the apportionment i s borne out.by facts. Often one of the arms! length parties .may not be as concerned as the other party over the a l l o c a t i o n of the sales proceeds. For example, the buyer of an apartment may not need to claim very much.capital cost.allowance i n future years 43 so that understating the acq u i s i t i o n cost, of ...the. apartment building may not be important to him whereas the s e l l e r may save substantial amounts which would otherwise be payable as income taxes on.recaptured c a p i t a l cost allowance by undervaluing the building and overvaluing the land. In such a case, the Tax .Department would l i k e l y require substantial evidence ..that the agreed upon a l l o c a t i o n was reasonable. Generally however, a negotiated a l l o c a t i o n by a s e l l e r who wishes to reduce the.portion, of the consideration paid.for the depreciable property and by a buyer who wishes to maximize the amount of c a p i t a l cost allowance which can be claimed.in the future w i l l l i k e l y be accepted by the Tax Department... Substantial evidence supporting an a l l o c a t i o n w i l l be.required where the a l l o c a t i o n i s not part of an agreement.or where the parties did not deal at arms' length. I t . i s e s p e c i a l l y important that the taxpayer has substantial evidence and expert testimony.supporting his a l l o c a t i o n i n order to counter evidence provided by the Tax.Department. In. conclusion, a,taxpayer i s required by the Income Tax.Act to allocate consideration received fV<ff a property between i t s depreciable and non-depreciable components. The impact of income taxes i s often much more severe when the consideration i s mostly allocated to the depreciable property because of the recapture of c a p i t a l cost allowance. This a l l o c a t i o n i s often a r b i t r a r y and vulnerable to Tax Department c r i t i c i s m because the value of land and buildings i s d i f f i c u l t to separate and there i s a strong monetary incentive to undervalue the depreciable property. Therefore, a taxpayer i s well advised to include an a l l o c a t i o n clause as part of the agreement to sell...his property and to be prepared to provide substantial evidence to support the a l l o c a t i o n to the Tax Department and possibly to the courts which may have to adjudicate the dispute. 44 PROPERTY TAXES AND INTEREST ON UNDEVELOPED LAND Section 18.2 of the new Act r e s t r i c t s the amount of i n t e r e s t and property taxes that can be deducted as expenses from revenue earned from undeveloped land. Interest and property taxes which can be expensed for tax purposes are limited to the amount of gross revenue from the land aft e r a l l other carrying costs .have been deducted. The purpose of t h i s provision i s to prevent a taxpayer from using i n t e r e s t and property taxes to create property losses which are used to reduce the tax l i a b i l i t y on other income of the taxpayer, and then have the taxpayer claim a c a p i t a l gain on d i s p o s i t i o n of the property which was tax free under the old Act and p a r t i a l l y taxable under the new Act. Therefore, to prevent the carrying cost of owning property from being used to reduce income subject to the normal rates of taxation, t h i s r e s t r i c t i v e provision was enacted. Section 18.2 applies to a l l undeveloped land except for land which i s used as follows: - part of the inventory of a business - held for the purpose of carrying on a business - held for the primary purpose of earning income therefrom - used to support a building or i n conjunction with a b u i l d i n g (parking l o t ) . Interest and property taxes which can not be expensed for tax purposes may be added to the cost base of the land (53.1.h). Consequently, these disallowed carrying costs can be used to reduce the amount of any taxable gain or increase the amount of an allowable c a p i t a l loss which arises from: d i s p o s i t i o n of the land. The tax treatment afforded i n t e r e s t and property taxes on undeveloped land i s demonstrated i n Example 2.8. 4.5 Example 2.8 Interest and Property Taxes on Undeveloped Land Rental revenue General expenses Less: Interest Property taxes Rental losses Undeveloped Land A B C N i l $ 200 $ 500 900 $1,000 N i l ( 200) 1,500 300 (--40 0) 2,000 500 1,000 3,000 600 1,800 2,500 3,600 $2,000 $2,900 $2,600 Di s t r i b u t i o n of re n t a l losses: - Rental losses not caused by inte r e s t and property taxes to be deductible from other income - $ 200 $ 400 N i l - Rental losses caused by inte r e s t and property taxes to be added to cost base of the land - 1,800 2,500 $2,600 Di s t r i b u t i o n of rent a l losses $2,000 $2,900 $2,600 ' 4 6 Example 2.8 shows that expenses of undeveloped land other than i n t e r e s t and property taxes may s t i l l create ; property losses which can be deducted from other income of the taxpayer. Thus, the taxpayer i n the example may deduct $600 from his other taxable income. However, the remainder of the property losses which have been caused by i n t e r e s t and property taxes of $ 6 , 9 0 0 must be added to the -".cost base of the undeveloped land. This new provision which greatly r e s t r i c t s the d e d u c t i b i l i t y of the costs of carrying vacant land w i l l have a major impact on land speculators. In the past, a land speculator who had a marginal tax rate of 50% had, i n e f f e c t , his costs of carrying his speculative land reduced by 50%. For example, in t e r e s t and property taxes on ten acres of land that cost $100,000 could be $12,000. a year. However, the after tax cost of holding t h i s land to a tax-payer i n the 50% marginal tax bracket under the old Act would have been only $6,000 a year. If the speculator sold the land a f t e r 5 years for $150,000 then his p r o f i t would be approximately $20,000 over and above the cost of $100,000 and. 5 years of holding costs of $6,000 a year. Under the new Act, the annual costtof holding the land cannot be reduced so i t w i l l remain at $12,000 a year. The speculator upon s e l l i n g the land a f t e r 5 years for $150,000 w i l l incur a loss of $10,000 because the cost base of the land w i l l then be $160,000. Thus, the e f f e c t of this new tax provision i s to greatly increase the cost of speculating i n vacant. land.. Consequently, i t w i l l be much less p r o f i t a b l e i n the future for land speculators to hold back the development of t h e i r lands i n order to extract a higher price from the market. HOBBY FARMING A common r e a l e s t a t e investment o f hig h income i n d i v i d u a l s has been the purchase of r u r a l l a n d which i s then used f o r c a r r y i n g on a l i m i t e d farming o p e r a t i o n . In a d d i t i o n t o having a home i n the country and the f u t u r e e x p e c t a t i o n of a p p r e c i a t i n g l a n d v a l u e s , these i n d i v i d u a l s were able to d e r i v e b e n e f i t s from the income tax system. Under the o l d A c t , these i n d i v i d u a l s were a b l e to expense many of the c o s t s of h o l d i n g and improving the land s i n c e they were deemed to be c a r r y i n g on a l i m i t e d farming o p e r a t i o n . As a r e s u l t , i n t e r e s t , p r o p e r t y taxes, la n d c l e a r i n g , drainage, and s o i l t i l l a g e e xpenditures were abl e to be deducted from the farm income. I f these expenses exceeded the farm income, then the r e s u l t i n g farm l o s s , under l i m i t e d c o n d i t i o n s , c o u l d be used to reduce the oth e r t a x a b l e income of the taxpayer. The o l d A c t i n S e c t i o n 13.1 pr o v i d e d t h a t where a taxpayer' c h i e f source of income f o r a t a x a t i o n year was n e i t h e r farming nor a combination of farming and some oth e r source of income then a l l o w a b l e farm l o s s e s would be deemed to be the l e s s e r o f : (a) amount of the farm l o s s or (b) $2,500 p l u s h of the farm l o s s i n excess of $2,500 to a maximum of $5,000 Thus i n any one year, a hobby farmer c o u l d c r e a t e an allow a b l e f a r m l o s s which c o u l d be used to reduce other t a x a b l e income to a maximum of $5,000, by i n c u r r i n g a farm l o s s to a maximum of $7,500 ($2,500 p l u s h of $7,500 - $2,5 Farm l o s s e s i n excess of $7,500 and the p o r t i o n of the farm l o s s which was not a l l o w a b l e a g a i n s t other income c o u l not be used t o reduce o t h e r t a x a b l e income of the c u r r e n t or any other year under the o l d A c t . The income tax p r o v i s i o n s r e l a t i n g t o hobby farmers under the new Act are s i m i l a r to those under the o l d A c t . 48 Farming i s defined i n the same general terms as including: " t i l l a g e of the s o i l , livestock r a i s i n g or exhibiting, maintaining of horses for racing, r a i s i n g of poultry, fur farming, dairy farming, f r u i t growing and the keeping of bees"(248.1). Costs of holding and improving the hobby farm including i n t e r e s t and property taxes can s t i l l be expensed for income tax purposes. Section 31.1 of the new Act defines an allowable loss of a hobby farmer to be the lesser of the farm loss, or $2,500 plus h of the farm loss i n excess of $2,500 to a maximum of $5,000. However the disallowed farm loss, c a l l e d a " r e s t r i c t e d farm loss", can now be applied against farm income of the immediately preceding year or the following 5 years ( l l l . l . c ) . Also, i n t e r e s t and property taxes which are included i n these r e s t r i c t e d farm losses and which are not applied against farm income of other years, can now be added to the cost base of the land (53.1.i). Example 2.9 demonstrates the tax treatment of the farm losses of a hobby farmer. In thi s example, the taxpayer can reduce his other taxable income for years 1973 to 1975 by the allowable farm losses of $5,000, $4,000, and $2,500 respectively. Since he has made a cash p r o f i t on his hay operations, these losses consist e n t i r e l y of those expenditures which are necessary to hold the land (interest and property taxes) and to improve i t (land c l e a r i n g ) . Since i n a l l l i k e l i h o o d these costs w i l l be recaptured by land appreciation, these farm losses are l i k e l y to be only losses for tax purposes. Even i f the r e s t r i c t e d farm losses of 1973 and 1974 can not be used to reduce farming income of other years, they can be added to the cost base of the land since both losses consist of i n t e r e s t and property tax expense. In conclusion, hobby farm investments are l i k e l y to continue to be favourable investments of high income taxpayers 49 who can continue to obtain income tax savings while having the pleasure of a home in the country. Consequently, the pressure around the urban centres to sub-divide large acreages into small hobby farms w i l l continue. In so doing, economical farming units w i l l be broken down into uneconomical ones and the cost of expanding urban centres into these hobby farmsareas w i l l continue to escalate because of the high cost of reassembling and developing small acreages. 5 0 Example 2.9 Farm Losses of a Hobby Farm Hay sales Expenses: Hay cutting contract Land clearing Interest Property taxes Farm loss 1973 1974 1975 N i l $2,000 $4,000 N i l 900 1,600 $5,000 3,000 1,400 3,500 3,400 3,300 : 200 200 200 8,700 7,500 6,500 $8,700 $5,500 $2,500 Calculation of allowable farm l o s s : LesssjT of • a. farm loss (as above) $8,700 $5,500 $2,500 b/ $2,500 plus 1/2 of excess (maximum of $5,000) $5,000 $4,000 $2,500 Allowable farm loss $5,000 $4,000 $2,500 Di s t r i b u t i o n of farm losses: Allowable farm loss $5,000 $4,000 $2,500 Restricted farm loss (difference) 3,700 1,500 N i l $8,700 $5,500 $2,500 51 CONCLUSION The new Income Tax Act .and. i t s Regulations have a s i g n i f i c a n t bearing on.the o v e r a l l p r o f i t a b i l i t y of income property investments. Provisions having.the greatest e f f e c t on property income are those.which r e l a t e to depre-ciable property, rental-.-los.ses-.,. i n t e r e s t and ..property taxes on undeveloped land, and hobby farms. Capital cost allowance ..regulations s t i p u l a t e what costs must be c a p i t a l i z e d for. tax purposes as well. as. the rate at which these costs, can be written-off against income. A difference i n c a p i t a l cost allowance rates.. can have a major e f f e c t on the af t e r tax p r o f i t a b i l i t y . . o f a. property since a high rate may protect the cash, income of a>.?property from income.taxes for many years, whereas.a low rate w i l l expose the cash income to high rates of taxation, immediately. Upon d i s p o s i t i o n of a property, substantial income taxes can be incurred on recaptured.capital cost allowance since the f u l l amount of the recapture must be added to the tax-payer's income i n the year.of.disposition. Under the old Act, payment of this, tax could be deferred for many years due to the recapture, being a part of a much larger c a p i t a l cost allowance pool. -Under the new Act, t h i s tax d e f e r r a l provision no longer exists for re n t a l buildings costing $50,000 or more, since these, buildings must each comprise a separate c a p i t a l . c o s t allowance.account,. and therefore a recapture on any one account must be taken into income immediately. Consequently, the substantial tax l i a b i l i t y which can r e s u l t from the di s p o s i t i o n of' a ren t a l b u i l d i n g w i l l strongly deter an investor from s e l l i n g his building since the expected return .on his .residual cash equity invested elsewhere w i l l l i k e l y be less than the income generated by his rent a l b u i l d i n g . In addition to. locking a taxpayer into his present r e a l estate holdings, t h i s new $50,000 tax rule will.stimulate the taxpayer to take terminal losses by demolishing those buildings located on land which has a value dlose to the value of the property 52 as a whole. As a r e s u l t , b e t t e r u t i l i z a t i o n w i l l l i k e l y be made of land i n urban c e n t r e s but many low r e n t a l b u i l d i n g s which house low income earners and s m a l l businesses w i l l be e l i m i n a t e d . The problem of a l l o c a t i n g the s a l e s proceeds o f a pr o p e r t y .between i t s depreciable- 1 and non-depreciable components continues under the new Act s i n c e c a p i t a l gains are taxed much l e s s than r e c a p t u r e d c a p i t a l c o s t allowance. The v u l n e r a b i l i t y of a taxpayer to reassessment and much hi g h e r taxes from the s a l e of a p r o p e r t y n e c e s s i t a t e s the taxpayer to c o l l e c t s u b s t a n t i a l evidence to support h i s a l l o c a t i o n of the c o n s i d e r a t i o n between d e p r e c i a b l e and non-depreciable p r o p e r t y . R e n t a l l o s s e s c r e a t e d by the c a p i t a l c o s t allownace p r o v i s i o n s can s h e l t e r income from income taxes. Under the o l d A c t , a hig h income i n d i v i d u a l c o u l d reduce the tax l i a b i l i t y on,his r e n t a l and n o n - r e n t a l income by c l a i m i n g c a p i t a l c ost allowance i n excess of h i s r e n t a l income. Consequently, many p r o p e r t i e s , l i k e frame apartments, which earned a r e l a t i v e l y poor r e t u r n were o f t e n very a t t r a c t i v e to h i g h income taxpayers who c o u l d use the excess c a p i t a l c o s t allownace to reduce the taxes on t h e i r o t h e r income. Under the new Ac t , the amount of c a p i t a l c o s t allowance t h a t can be claimed i n a year i s l i m i t e d to the l e s s e r of the maximum r a t e s f o r the c l a s s or the taxpayer's r e n t a l income and t h e r e f o r e i t cannot be used to s h e l t e r any of h i s n o n - r e n t a l income. T h i s income tax change has caused many high income i n d i v i d u a l s to r e d i r e c t t h e i r investment c a p i t a l away from many forms of r e a l e s t a t e , l i k e frame apartments, which earned a nominal income but p r o v i d e d s u b s t a n t i a l tax savings to, t h e i r owners. Consequently, the c o n s t r u c t i o n and value of these f o r m e r l y tax s h e l t e r 53 properties has declined over 1972 and 1973. New construction of these properties w i l l only be. resumed when the r e n t a l rates have r i s e n to levels which compensate the investor for his formerly tax shelter benefits. These re n t a l increases are l i k e l y to be substantial... The i n t e r e s t and property tax expenses of holding non-productive land are now limited by the new Act to the extent of the income generated, by the land-. In the past, these expenses usually caused property losses which could be used to reduce the taxes on other income of the taxpayer. Upon d i s p o s i t i o n of the non-productive land, a c a p i t a l gain would be claimed which was not taxable under the old Act, and i s only p a r t i a l l y taxable under the new Act. Although the unclaimed i n t e r e s t and property taxes can be added to the cost base.of' the land under the new Act which w i l l reduce a future c a p i t a l gain, a major tax advantage has- been l o s t by non-productive land investors who w i l l now have.to incur the f u l l cost of holding the non-productive land. By sub s t a n t i a l l y increasing the costs of holding unproductive land, t h i s new tax provision reduces greatly the a b i l i t y of land speculators to: withhold t h e i r land from development. F i n a l l y , the tax advantages of being a hobby farmer have continued tors survive under the new Act.. In addition to having a home i n the country and being able to benefit from land appreciation, the hobby farmer can get tax r e l i e f for his non-farm income by continuing to incure those expenses of holding and improving land, such as i n t e r e s t , property-taxes, and.land clearing. Consequently, the new Income Tax Act continues to stimulate the forces which segment the r u r a l areas around urban centres into small uneconomical hobby farm units. In so doing, the Act has further perpetuated the problem of declining productive farmland and the r i s i n g costs of urbanizing suburban areas. 54 CHAPTER 3 CAPITAL GAINS AND THE REAL ESTATE INVESTOR The prospect of making a c a p i t a l gain has been a prime motivating force which has made r e a l estate a very a t t r a c t i v e investment for many people. The pressure of population i n our expanding c i t i e s has resulted i n a continuous and often high rate of r e a l property appreciation. In the past, these gains were often tax free which made re a l property investments even more a t t r a c t i v e . Under the new Income Tax Act which became e f f e c t i v e January 1, 1972, these c a p i t a l gains became taxable. However, since these gains are only subject to one half of the normal rates of taxation, c a p i t a l gains on r e a l estate w i l l continue to be very a t t r a c t i v e to most investors. This chapter examines the income tax implications for r e a l property which i s held for the purpose of r e a l i z i n g a c a p i t a l gain. Since the new Act d i f f e r e n t i a t e s between non-depreciable c a p i t a l property, depreciable c a p i t a l property, and personal property, the income tax treatment of each form of property w i l l be examined separately i n th i s chapter. 55 CAPITAL GAINS TERMINOLOGY In order to minimize any possible confusion over s i m i l a r but unique terms used i n the income tax l e g i s l a t i o n , some of the more important terminology w i l l be defined here before progressing with the examination of the implications of income taxes on r e a l property held for the purpose of r e a l i z i n g a c a p i t a l gain. The new Act d i f f e r e n t i a t e s between three forms of r e a l property as follows: 1. C a p i t a l property of a taxpayer means--any depreciable property of the taxpayer, and -any property (other than depreciable property), any gain or loss from the d i s p o s i t i o n of which would, i f the property were disposed of, be a c a p i t a l gain or a c a p i t a l l o s s , as the case may be, of the taxpayer (54.b). 2. Depreciable property of a taxpayer means property upon which the taxpayer i s allowed to claim c a p i t a l cost allowance i n computing his income for the year (13.21.b). 3. Personal-use property of a taxpayer includes property owned by him that i s used primarily for the personal use or enjoyment of the taxpayer or for the personal use or enjoyment of one or more individuals each of whom i s - the taxpayer - a person related to the taxpayer, or - where the taxpayer i s a t r u s t , a beneficiary under the t r u s t or any person related to the beneficiary ( 5 4 . f . i ) . The following terms which re l a t e to the gains and losses on d i s p o s i t i o n of property have t h e i r own unique meaning i n the new Act. 1. A c a p i t a l gain of a given taxation year i s the gain r e a l i z e d from the dispostion of property i n the year 5-6 which would not otherwise be included i n income (39.1.a). 2. A taxable c a p i t a l gain for a given taxation year from the d i s p o s i t i o n of property i s h of the c a p i t a l gain for the year from the d i s p o s i t i o n of that property (38.a). 3. A c a p i t a l loss for a taxation year i s the loss incurred from the d i s p o s i t i o n of property i n that year (other than depreciable property) which would not be deductible i n computing income (39.1.b). Losses incurred on the d i s p o s i t i o n of depreciable property are provided for under the c a p i t a l cost allowance provisions of the new Act. 4. An allowable c a p i t a l loss for a taxation year from the d i s p o s i t i o n of property i s h of the c a p i t a l loss for the year from the d i s p o s i t i o n of that property (38.b). 57 NON-DEPRECIABLE CAPITAL PROPERTY A c a p i t a l g a i n r e s u l t s from the d i s p o s i t i o n of non-d e p r e c i a b l e c a p i t a l p r o p e r t y whenever the proceeds, of • d i s p o s i t i o n exceed the a d j u s t e d c o s t base of the p r o p e r t y p l u s any o u t l a y s or expenses a s s o c i a t e d w i t h the d i s p o s i t i o n . The a d j u s t e d c o s t base of the p r o p e r t y i s normally the c o s t of a c q u i s i t i o n t h a t i s a d j u s t e d f o r amounts s p e c i f i c a l l y allowed by the A c t . One h a l f of t h i s . c a p i t a l g a i n , c a l l e d the t a x a b l e c a p i t a l g a i n , i s added to the income of the taxpayer' i n the year of d i s p o s i t i o n and i s then s u b j e c t e d to the normal r a t e s of t a x a t i o n . In Example 3.1, a taxpayer who i s i n a 60% marginal tax b r a c k e t and who r e a l i z e s a c a p i t a l g a i n of $2,000 must pay income taxes of $600 on a t a x a b l e c a p i t a l g a i n of $1,000. In e f f e c t , the taxpayer's investment r e t u r n which i s i n the form of a c a p i t a l g a i n i s reduced by $600 which i s 30%.of h i s c a p i t a l g a i n of $2,000. In o r d e r f o r the taxpayer to earn the same r e t u r n under the new A c t , as was p o s s i b l e under the o l d A c t , he would have t o i n c u r a c a p i t a l g a i n of almost $3,000 i n order to have an a f t e r tax r e t r u n of $2,000.- Consequently, investments l i k e r e a l e s t a t e which were a t t r a c t i v e under the o l d Act because o f . t h e i r a b i l i t y to generate c a p i t a l gains w i l l be l e s s a t t r a c t i v e under the new Act because a s i g n i f i c a n t p o r t i o n of the c a p i t a l g a i n must be p a i d as income taxes. Furthermore, i n v e s t o r s who have earned a s u b s t a n t i a l but u n r e a l i z e d c a p i t a l g a i n on t h e i r p r o p e r t i e s w i l l be d e t e r r e d from d i s p o s i n g of them because o f the s u b s t a n t i a l income taxes which w i l l be i n c u r r e d upon d i s p o s i t i o n . A taxpayer i n c u r s a c a p i t a l l o s s from the d i s p o s i t i o n of a non-depreciable p r o p e r t y whenever the a d j u s t e d c o s t base of the p r o p e r t y and the r e l a t e d c o s t s of d i s p o s i t i o n exceed the proceeds o f - d i s p o s i t i o n . One h a l f of t h i s c a p i t a l l o s s can be deducted from the t a x a b l e c a p i t a l gains of the taxpayer. I f these a l l o w a b l e . c a p i t a l l o s s e s 58/ Example 3•1 Taxable Capital Gains Proceeds of d i s p o s i t i o n $13,000 Deduct: Adjusted cost base (acquisition cost) $10,000 Outlays and expenses of di s p o s i t i o n 1,000 11,000 Capi t a l gain $ 2,0:00 Taxable c a p i t a l gain (1/2) $ 1,000 Income taxes payable by a taxpayer i n a 60% bracket - .60 x $1,000 = $ : 600 59 in a year exceed the taxable c a p i t a l gains of a taxpayer, then these net c a p i t a l losses can be applied against taxable c a p i t a l gains of the taxpayer i n the immediately preceding year or i n any future year of the taxpayer ( l l l . l . b ) . In addition to thi s provision, taxpayers who are individuals can apply a maximum of $1,000.of the net c a p i t a l loss against other income of the current, immediately preceding, or any future year ( l l l . l . b ) . Example 3.2 demonstrates the tax treatment of the net ca p i t a l losses of a taxpayer who i s assumed to have personal exemptions of $2,000. Net c a p i t a l losses are. applied to income after non-capital losses^ have been considered. In Example 3.2, the $10,000 net c a p i t a l loss incurred i n 1973 has eliminated the $6,000 of taxable c a p i t a l gains of years 1972, 1974 and 1975. The remaining $4,000 of net c a p i t a l loss has been applied i n amounts of $1,000 to the other income of years 1972 to. 1975.. It i s important to note that only $1,000 of a net c a p i t a l loss can be applied to the other income of a taxpayer i n the year that the loss i s incurred even i f the net c a p i t a l loss exceeds the taxpayer's other income as was i n the case in Example 3.2. These provisions d i f f e r greatly from the old Act where c a p i t a l losses were never decuctible. Being deductible from taxable c a p i t a l gains, r e a l i z e d c a p i t a l losses w i l l become a t t r a c t i v e to taxpayers who have re a l i z e d taxable c a p i t a l gains. Consequently, many taxpayers w i l l be under an incentive to dispose of those properties which have incurred c a p i t a l losses i n order to apply these losses against r e a l i z e d taxable c a p i t a l gains. 6 0 Example 3.2 Application of Net Capital Losses 1972 1973 1974 1975 Net c a p i t a l loss $(10,000) Taxable c a p i t a l gains $2,000 $ 1,000 $ 3,000 Ordinary income 8,000 8,000 8,000 8,000 Income for year 10,000 8,000 9,000 11,000 Less; Personal exemptions 2,000 2,000 2,000 2,000 Taxable income before application of net•• c a p i t a l loss 8,000 6,000 7,000 9,000 Application of net c a p i t a l l o s s : -to taxable cap. gains 2,000 1,000 3,000 -to other income 1,000 1,000 1,000 1,0 00 Net c a p i t a l loss applied 3,000 1,000 2,000 4,000 Revised taxable income $ 5,000 $ 5,000 $ 5,000 $ 5,000 61 Adjustments to Cost Base of Non-Depreciable Capital Property The cost base of non-depreciable c a p i t a l property i s normally the a c q u i s i t i o n cost of the property. However certain adjustments to the cost base have been s p e c i f i c a l l y allowed by the new Act. The excess of interest.and property taxes over the income generated by vacant or low income producing property can be added to the cost base of the land (53.1.h). S i m i l a r l y , i n t e r e s t and property taxes related to land owned by a hobby farmer may be added to the cost base of the land provided that these expenses were not deducted i n computing income nor deducted as part of a r e s t r i c t e d farm loss i n computing income of other years (53.1.i). Adjustments which are allowed to reduce the cost base of non-depreciable property include grants or subsidies which are received by the taxpayer from a government and which are s p e c i f i c a l l y related to the acquired property (53.2.k). Also i f part of a. property i s : disposed of, the cost base of the property must be reduced to an amount which can reasonably be attributable to the remaining property (43). This l a t t e r s i t u a t i o n would e a s i l y arise where land i s sub-divided.and sold i n parcels. Non-Depreciable Capital Property Owned at December 31, 1971 The provisions of the new Income Tax Act do not apply to c a p i t a l gains and c a p i t a l losses that have arisen p r i o r to January 1, 1972 (I.T.A.R.•26.1). Taxable c a p i t a l gains and allowable c a p i t a l losses must arise as the r e s u l t of valuation changes occurring aft e r December 31, 1971. Therefore to determine the amount of gains or losses subject to the new tax provisions, i t i s necessary to ascertain a base value for a l l c a p i t a l property as at 62 December 31, 1971. The new Act p r o v i d e s t h a t an i n d i v i d u a l taxpayer may u t i l i z e pne of two techniques to determine a December 31, 1971 v a l u a t i o n base f o r h i s non-depreciable c a p i t a l p r o p e r t y h e l d on t h a t date. These techniques are as f o l l o w s : 1. tax f r e e zone method (I.T.A.R. 26.3) 2. f a i r market value method (I.T.A.R. 26.7) One of these methods must be s e l e c t e d by a taxpayer i n the year t h a t he f i r s t d i sposes of c a p i t a l p r o p e r t y h e l d on December 31, 1971, and on'ce t h i s s e l e c t i o n i s made, t h i s method must be used f o r a l l subsequent d i s p o s a l s . Tax Free Zone Method The t a x f r e e zone, method u t i l i z e s t h r e e v a l u a t i o n s of a p r o p e r t y i n determining the v a l u a t i o n base t o be used f o r c a l c u l a t i n g a t a x a b l e c a p i t a l g a i n or an a l l o w a b l e c a p i t a l l o s s . These t h r e e . p r o p e r t y v a l u a t i o n s are as f o l l o w s : 1. Pre 1972 c o s t of a c q u i s i t i o n 2. F a i r market value on December 31, 1971,,-3. Proceeds o f the p o s t 1971 d i s p o s i t i o n . I f t h e . p r o p e r t y i s s o l d f o r an amount i n excess of a c q u i s i t i o n c o s t (1) or f a i r market value on December .31, 1971 (2), then the v a l u a t i o n base used f o r c a l c u l a t i n g the c a p i t a l g a i n w i l l be the hi g h e r of (1) or (2). I f t h e . p r o p e r t y i s s o l d f o r l e s s than e i t h e r of these two v a l u e s , then the v a l u a t i o n base, w i l l be the l e s s e r o f (1) or (2). I f the proceeds of d i s p o s i t i o n l i e between (1) and (2), then n e i t h e r a c a p i t a l g a i n nor a c a p i t a l l o s s r e s u l t s . T h i s range between the c o s t o f a c q u i s i t i o n and the f a i r market value on December 31, 1971 i s the tax f r e e zone from which t h i s method d e r i v e s i t s name. Example 3.3 summarizes the tax f r e e zone method and Example 3.4 demonstrates i t s a p p l i c a t i o n t o an acre of land purchased i n 1971 f o r $10,000 and s o l d f o r v a r y i n g amounts subsequent to t h a t time. Example 3.3 Calculation of Capital Gains (Losses) Tax Free Zone Method Amount of Proceeds Greater than both o r i g i n a l cost and December 31/71 value. Between o r i g i n a l cost and December 31/71 value. Less than both o r i g i n a l cost and December 31/71 value. Capital Gain (Loss) Ca p i t a l gain = proceeds minus greater of cost or Dec. 31/71 value. No c a p i t a l gain nor c a p i t a l l o Capital loss = proceeds minus lower of cost or Dec. 31/71 value 6.4 Example 3.4 Application of the Tax Free Zone Method Case A Case B Case C Case D 1. Pre 1972 cost $10,000 $10,000* $10,000 $10,000 2. Market value 12/31/71 12,000* 8>000 8,000* 12,000 3. Proceeds of d i s p o s i t i o n 14,000 14,000 6,000 11,000* Calculation of cap i t a l ^ g a i n : Prpceeds of di s p o s i t i o n $14,000 $14,000 $ 6,000 $11,000 Less: Dec. 31/71 value base (*)12,000 10,000 8,000 11,000 Capital gain (loss) $' 2,0p0 $ 4,000 $ (2,0:00) : N i l Composition of actual gain (loss) on d i s p o s i t i o n : Capital gain (loss) above$ 2,000 $ 4,000 $(2,000) N i l Pre 1972 gain (loss) 2,000 N i l (2,000) $ 1,000 Actual gain (loss) $ 4,000 $ 4,000 $ (4,000) $ 1,000 December 31, 1971 valuation base for ca l c u l a t i n g c a p i t a l gains or losses under the tax free zone method (see Example 3.3). 65 F a i r Market Value Method The f a i r market value method of determining, a valuation base for c a l c u l a t i n g post 1971 c a p i t a l losses i s available only to i n d i v i d u a l taxpayers. Under th i s method, a l l property held by the taxpayer at December 31, 1971 i s valued at i t s f a i r market value as of that date. Generally, t h i s method would only be advantageous to a taxpayer whose property at December 31, 1971 i s worth more than i t s cost but the post 1971 proceeds of d i s p o s i t i o n are l i k e l y to be less than the December 31, 1971 valuations. Under the tax free zone method, allowable c a p i t a l losses would be based on the lower valuation (cost) rather than the higher December 31, 1971 valuations. Example 3.5 demonstrates the s i t u a t i o n where a taxpayer would benefit more from the f a i r market method than the tax free zone method. In Example 3.5, e l e c t i o n of the f a i r market value method by the taxpayer would r e s u l t i n $5,000 o f . c a p i t a l losses being available to o f f s e t c a p i t a l gains of the taxpayer. El e c t i o n of the tax free zone method would only have resulted i n $1,000 of ca p i t a l . l o s s e s being available to reduce c a p i t a l gains. The higher c a p i t a l loss of the f a i r market value method i s due to the fact that the aggregate market value of the properties held at December 31, 1971 i s $29,000 whereas the proceeds of d i s p o s i t i o n aggregate only $24,000. It i s important to note i n t h i s example that the c a p i t a l losses are only losses for tax purposes since there was r t o actual gain or loss on d i s p o s i t i o n (proceeds of d i s p o s i t i o n equal a c q u i s i t i o n cost of $24,000). Either the tax free zone method or the f a i r market value method must be elected by the taxpayer i n the f i r s t year that properties held on December 31, 1971 are disposed. Once elected, a valuation method cannot be revoked and 66 Example 3.5 Comparison of the F a i r Market Value Method and the Tax Free Zone Method Case A Case B Case C Total 1. Pre 1972 cost $10,000* $ 6,000 $ 8,000* $24,000 2. Market value 12/31/71 12,000 10,000 7,000 29,000 3. Proceeds of d i s p o s i t i o n 8,000 7,000* 9,000 24,000 Capital gains (losses): -under F.M.V. method $(4,000) $(3,000) $ 2,000 $(5,000) -under tax free zone (2,000) N i l 1,000 (1,000) * December 31, 1971 valuation base under the tax free zone method. 67 applies to a l l further dispositions of properties held p r i o r to 1972. A prudent p o l i c y regarding d i s p o s i t i o n of such properties i s to avoid d i s p o s i t i o n of small properties i n order to extend, the period of e l e c t i o n for as long as possible. Regardless of which valuation day method i s u t i l i z e d by the taxpayer, i t i s important that the taxpayer be able to provide substantial evidence of the market value of his properties as at December 31, 1971. Capital gains r e a l i z e d p r i o r to January 1, 1972 remain tax free but those r e a l i z e d a f t e r that date are taxable. As the years pass, i t w i l l become much more d i f f i c u l t and expensive to ascertain the market value of a property as of December 31, 1971. The Tax Department with i t s vast resources w i l l have substantial evidence to support i t s valuation of the taxpayer's property so. that the taxpayer w i l l also have to have extensive support for his valuation i n order to minimize the amount of his taxable post 1971 c a p i t a l gain. 6 8 DEPRECIABLE PROPERTY Depreciable property f a l l s into the category of c a p i t a l property. The income tax treatment of c a p i t a l gains derived from the d i s p o s i t i o n of depreciable property i s b a s i c a l l y the same as those derived from c a p i t a l property. However because depreciable property i s normally expected to decline i n value over time through physical deterioration and economic obsolescence, provision has been made i n the Income Tax Act to alloc a t e the cost of t h i s depreciable property against the income generated by i t . If on d i s p o s i t i o n the proceeds exceed the undepreciated cost of the property, part or a l l of this excess represents the cost of the property which was permitted by the Act to be written-off against income. Therefore, for purposes of c a l c u l a t i n g a c a p i t a l gain on the d i s p o s i t i o n of depreciable property, the undepreciated c a p i t a l cost of the property can not be used as the cost base of the property. Consequently, a c a p i t a l gain on depreciable property i s defined as the excess of the proceeds of d i s p o s i t i o n over the c a p i t a l cost of the property. Proceeds of d i s p o s i t i o n which are i n excess of the undepreciated c a p i t a l cost but equal to or less than the c a p i t a l cost of the property constitute a recapture of c a p i t a l cost allowance which i s taxed at the normal rates. In Example 3.6, Building B has been sold for $20,000 i n excess of i t s o r i g i n a l c a p i t a l cost of $100,000. This $20,000 i s a c a p i t a l gain r e a l i z e d from the d i s p o s i t i o n of depreciable property of which one half w i l l be subject to the normal rates of taxation of the taxpayer. The recaptured c a p i t a l cost allowance of $30,000 w i l l be subject to the normal rates of taxation (Chapter 2). Building A has been sold for $10,000 less than i t s .. o r i g i n a l c a p i t a l cost, but since the c a p i t a l cost allowance provisions provide for t h i s decline i n value at the time of d i s p o s i t i o n , no s p e c i a l tax treatment i s afforded 69 Example 3.6 Calculation of Capital Gain on Depreciable Property Bldg.A Bldg B Assumptions: Capital cost - 1973 . $100,000 $100,000 Undepreciated c a p i t a l cost - 1977 70,000 70,000 Proceeds of d i s p o s i t i o n - 1977 90,000 120,000 Calculation of c a p i t a l gains: Proceeds of d i s p o s i t i o n $ 90,000 $120,000 Less: Capital cost " 100,000 100,000 Capi t a l gain (1/2 taxable) N i l $ 20,000 Recapture of c a p i t a l cost allowance: Lesser of proceeds or c a p i t a l cost $ 90,000 $100,000 Undepreciated c a p i t a l cost 70,000 70,00 0 Recapture ( f u l l y taxable) $ 20,000 $ 30,000 70 t h i s decline i n value. However since the proceeds of dis p o s i t i o n of Building A exceed i t s undepreciated c a p i t a l cost of $ 7 0 , 0 0 0 , there i s a recapture of c a p i t a l cost allowance of $20,000 which i s subject to tax. Cost Base of Depreciable Property The cost base used to determine c a p i t a l gains on the d i s p o s i t i o n of depreciable property i s normally the acquisi t i o n cost of the property. In the purchase of an exis t i n g building, the ac q u i s i t i o n cost would consist of the purchase price applicable to the depreciable property plus a proportionate share of the l e g a l , commission, and other expenses incurrred by the purchaser. A common problem i n the acq u i s i t i o n of depreciable property i s that i t i s part of a package containing both depreciable and non-depreciable property (buildings and land). The vendor who wishes to minimize any recapture of c a p i t a l cost allowance usually wants as l i t t l e as possible of the purchase price to be allocated to the depreciable property. The purchaser on the other hand who wants to maximize the amount of future c a p i t a l cost allowance to be claimed wants as much of the purchase price as possible to be allocated to the depreciable property. The purchase price allocated to the depreciable property by an agreement between the vendor and the purchaser w i l l normally be accepted by the Tax Department as the proper cost base of the depreciable property. In cases where the taxpayer uses a d i f f e r e n t cost base, where no a l l o c a t i o n agreement was made or where the vendor and purchaser did not deal at arm's length, then the purchaseiprice allocated to the depreciable property must be reasonable i n order for i t to be acceptable to the taxing a u t h o r i t i e s . The cost base of depreciable property constructed by the taxpayer consists of a l l outlays and expenses incurred 71 by the taxpayer which relate d i r e c t l y to the depreciable property. The cost of a l l materials included i n the depreciable property and the wages and sal a r i e s of a l l those workers who developed, planned, andconstructed the property are to be included i n the cost base of the depreciable property. Expenditures not d i r e c t l y related to the depreciable property under construction would not generally be included i n the cost base of the property but would be written-off for tax purposes i n the year of occurrence. These i n d i r e c t expenditures would include general and administrative costs of the taxpayer-builder, property taxes on the property, and i n t e r e s t on borrowed monies used to finance costruction. The fact that these i n d i r e c t expenses can be written-off for tax purposes in the current year or carr i e d to other years as part of a business loss i s generally of greater benefit to a taxpayer than increasing the cost base of the property. However. the taxpayer has the option of e l e c t i n g to c a p i t a l i z e the cost of borrowed money used to finance the construction of depreciable property (21). This e l e c t i o n would be b e n e f i c i a l to the taxpayer when there i s some doubts as to whether these financing expenses can be u t i l i z e d as. deductions from income. By increasing the cost base, a greater amount of c a p i t a l cost allowance can be taken and any future c a p i t a l gains, and the income taxes thereon, w i l l be l e s s . Depreciable Property Owned December 31, 1971 Capital gains which have accrued to depreciable property p r i o r to 1972 are not taxable under the provisions of the new Act (I.T.A.R. 26.1). However c a p i t a l gains a r i s i n g on depreciable property subsequent to 1971 are taxable, therefore i t i s necessary to determine a base value for 72 a l l d e p r e c i a b l e p r o p e r t y owned by a taxpayer a t December 3 1 , 197 1 . Because o f . t h e i n h e r e n t ' n a t u r e of d e p r e c i a b l e p r o p e r t y and the c a p i t a l c o s t allowance p r o v i s i o n s of the Act,. n e i t h e r the tax f r e e zone nor the f a i r market value method can be used f o r determining a December 3 1 , 1971 v a l u a t i o n base" f o r d e p r e c i a b l e . property.. T h e r e f o r e , the new A c t s t i p u l a t e s t h a t c a p i t a l gains, r e a l i z e d on d e p r e c i a b l e p r o p e r t y owned at December 3 1 , 1971 w i l l be the.excess of proceeds o f d i s p o s i t i o n over the o r i g i n a l c a p i t a l c o s t of the p r o p e r t y ( 5 4 . a ) . However i n order to exempt from tax those c a p i t a l gains which have accrued to the p r o p e r t y p r i o r to 1 9 7 2 , the proceeds of d i s p o s i t i o n of p r o p e r t y owned a t December 3 1 , 1971 are deemed to be the sum of the f o l l o w i n g (I.T.A.R.20.1): 1. the c a p i t a l c o s t of the d e p r e c i a b l e p r o p e r t y p l u s 2. the excess of the proceeds of d i s p o s i t i o n over the f a i r market value of "the .property as a t -December 3 1 , 1 9 7 1 . Example 3.7 demonstrates the c a l c u l a t i o n . o f a c a p i t a l g a i n r e a l i z e d on the d i s p o s i t i o n of d e p r e c i a b l e p r o p e r t y t h a t was owned by the taxpayer a t December.31, 1 9 7 1 . In Example 3.7, the deemed, proceeds of d i s p o s i t i o n i n c l u d e the c a p i t a l c o s t of the p r o p e r t y of $60,000 p l u s the post 1971 c a p i t a l . g a i n of $20,000. As a r e s u l t , the c a p i t a l g a i n which i s s u b j e c t t o • t a x i s only $17,000 a f t e r d i s p o s i t i o n c o s t s , r a t h e r than the a c t u a l g a i n of $37,000. I t i s important to note t h a t the c o s t s of d i s p o s i t i o n a r e . f i r s t a p p l i e d a g a i n s t the c a p i t a l g a i n t h a t i s t a x a b l e r a t h e r than the tax f r e e pre 1 9 7 2 . c a p i t a l g a i n . Under the o l d A c t , . t h e taxpayer would r e a l i z e a tax f r e e c a p i t a l g a i n of $.37 / 000 . i n .Example 3.7. A c a p i t a l g a i n of $37,000 r e a l i z e d s i n c e January 1, 1972 would i n c r e a s e the taxpayer's taxable, income for. the year of d i s p o s i t i o n by $18,500 (1/2 o f . $ 3 7 , 0 0 0 ) . Assuming a m a r g i n a l tax r a t e of 5 0 % , the taxpayer wouldxxbe . r e q u i r e d to pay $9,250 of the r e a l i z e d c a p i t a l .gain as income-taxes. 73 In Example 3.7, the taxpayer was.able to attribute.$20,000 of the c a p i t a l gain to the period p r i o r to January 1, 1972. In doing so, he was able to reduce the income taxes on the c a p i t a l gain from $9,250 to $4,250.(1/2 of $17,000 @ 50%) for a cash'saving of $5,000. It i s therefore extremely important for a taxpayer to be able to allocat e as much of a r e a l i z e d c a p i t a l gain to the period p r i o r to January 1, 1972 and to be able to provide substantial support for that a l l o c a t i o n . 74 Example 3.7 Calculation of Capital Gain on Disposal of Depreciable Property owned December 31, 1971 Assumptions: 1. Capital cost of property $ 6 0,0 00 2. F a i r market value on December 31, 1971 80,000 '* 3. Proceeds of d i s p o s i t i o n 100,000 Calculation of c a p i t a l gain (taxable): Deemed proceeds of d i s p o s i t i o n : Capital cost $ 60,000 Add: Proceeds of d i s p o s i t i o n $100,000 Less F.M.V. Dec. 31/71 80,000 2 0,000 Deemed proceeds of d i s p o s i t i o n 80,000 Deduct: Adjusted cost base (capital cost) 6 0,000 Legal fees, commissions etc. 3,000 63,000 Capital gain (taxable) $ 17,000 75 PERSONAL-USE PROPERTY Personal-use property i s property that i s owned by an i n d i v i d u a l taxpayer which i s used primarily for his own personal use or'enjoyment or that of persons related to him. Residences, cottages, furniture, automobiles, and paintings are examples of such personal-use property. A c a p i t a l gain that i s r e a l i z e d on the d i s p o s i t i o n of personal-use property i s taxable under the provisions of the new Act. The c a p i t a l gain i s determined i n the same manner as a c a p i t a l gain r e s u l t i n g from the dispostion of c a p i t a l property, that i s , the c a p i t a l gain i s the excess of the proceeds of d i s p o s i t i o n over the cost base of the property. The cost base of personal-use property i s normally the o r i g i n a l cost of the property. Although most personal-use property depreciates over time, no c a p i t a l cost allowance i s allowed to be claimed by the new Act on t h i s property. Consequently, the additional tax burden which results from the recapture of c a p i t a l cost allowance on depreciable property does not ari s e with personal property. Example 3.8 demonstrates the tax -treatment afforded a c a p i t a l gain r e a l i z e d by a taxpayer on the d i s p o s i t i o n of personal-use property. The taxpayer i n Example 3.8 i s required by the new Act to include the taxable c a p i t a l gain of $1,500 i n his 1976 income. Although c a p i t a l gains r e a l i z e d from the d i s p o s i t i o n of personal-use property are subject to tax, c a p i t a l losses which are incurred on the d i s p o s i t i o n of personal-use property are not deductible for tax purposes except for losses incurred on d i s p o s i t i o n of l i s t e d personal property. L i s t e d personal property includes a limited number of non-depreciable personal-use property such as paintings and coin and stamp c o l l e c t i o n s . C apital losses incurred on the d i s p o s i t i o n of such l i s t e d personal „ .... 76 Example 3.8 P e r s o n a l - U s e Property-C a l c u l a t i o n o f C a p i t a l G a i n s Assumptions: 1. I n 1972, t a x p a y e r p u r c h a s e s a l a k e c o t t a g e f o r $10,000. 2. Taxpayer uses c o t t a g e f o r h i s own enjoyment u n t i l 1976 when he s e l l s i t f o r $15,000. C a l c u l a t i o n o f c a p i t a l g a i n : Proceeds o f d i s p o s i t i o n L e s s - a d j u s t e d c o s t base: A c q u i s i t i o n c o s t A d d i t i o n t o c o t t a g e - 1 9 7 3 A d j u s t e d c o s t base -expenses o f d i s p o s i t i o n C a p i t a l g a i n 10,000 1,500 11,500 500 $ 15,000 12,000  $ 3,000 T a x a b l e c a p i t a l g a i n (h) $ 1,500 77 property are deductible for tax purposes. Capital gains which have accrued on personal-use property as of December 31, 1971 w i l l not be subject to tax under the provisions of the new Act. These pre 1972 c a p i t a l gains w i l l be exempted from tax i n the same manner that the pre 1972 c a p i t a l gains accrued on depreciable property are exempted from tax. The proceeds of d i s p o s i t i o n are deemed to be an amount such that the pre 1972 c a p i t a l gain i s excluded from the taxable c a p i t a l gains c a l c u l a t i o n . Change In Use E l e c t i o n The new Act contains a provision which deems that a taxpayer has disposed of his property at i t s f a i r market value i f he changes the use of the property (45.1). The Act defines a change i n use of property as occurring when a property that was acquired for the purpose of producing income i s used for some other purpose or when a property that was acquired for some, other use i s used to produce income (45.1). Thus, a taxpayer who converts personal-use property to income property or income property to personal-use property w i l l be deemed by the Act to have disposed of the property at i t s f a i r market value at the time of the change and to have r e a l i z e d any c a p i t a l gains or losses which have accrued on the property. Consequently, a taxpayer who moves into a house which he previously has used to earn rental income w i l l be deemed to have sold the house for i t s f a i r market value. If the house has appreciated i n value, he w i l l have to pay tax on the taxable c a p i t a l gain, even though he continues to own the house. According to t h i s provision, even i f a taxpayer temporarily changes the use of aproperty, for example, rents his summer cottage for; a month, he w i l l s t i l l be deemed to have disposed of the cottage and to have r e a l i z e d any c a p i t a l gains or losses which have accrued on the property to that date. 7f In order t o reduce the r a t h e r onerous impact of t h i s change i n use p r o v i s i o n on p r o p e r t y which i s o c c a s i o n a l l y used to produce income, the new A c t has p r o v i d e d t h a t where a p r o p e r t y has undergone a changein use from non-income producing to income producing, a taxpayer may e l e c t i n the year of the change i n use to have the change i n use igno r e d f o r tax purposes ( 45 .2 ) . C a p i t a l gains which have accrued on the p r o p e r t y to the date of the change i n use w i l l s t i l l be s u b j e c t to tax but they w i l l not be deemed to be r e a l i z e d u n t i l the taxpayer's change i n use e l e c t i o n has been r e s c i n d e d . By making t h i s e l e c t i o n , a taxpayer can o c c a s i o n a l l y use h i s personal-use p r o p e r t y to earn income without being t a x a b l e on c a p i t a l gains u n t i l he a c t u a l l y d i s p o s e s o f the pr o p e r t y . Example 3.9 demonstrates the comparative advantages of making t h i s change i n use e l e c t i o n . Example 3.9 shows t h a t the t o t a l amount of the t a x a b l e c a p i t a l g a i n o f $5,000 i s the same whether o r not the change i n use e l e c t i o n o f S e c t i o n 45.2 i s taken. However by making use of t h i s e l e c t i o n , the taxpayer has avoided paying income taxes on the t a x a b l e c a p i t a l g a i n u n t i l the year of a c t u a l d i s p o s i t i o n . For a taxpayer w i t h a marginal tax r a t e o f 60%, t h i s means t h a t he has d e f e r r e d $1,800 (.60 X $3,000) of income taxes u n t i l 1979 on ta x a b l e c a p i t a l g ains earned i n 1974 and 1975. Example 3.9 a l s o demonstrates the f a c t t h a t the adj u s t e d c o s t base o f p r o p e r t y which has undergone a change i n use i s e q u i v a l e n t t o the deemed proceeds o f the l a t e s t deemed d i s p o s i t i o n whenever the change i n use e l e c t i o n i s not taken. Thus the ad j u s t e d c o s t base of the cottage i n 1979 i s e q u i v a l e n t t o the market v l a u e o f the cot t a g e a t the time o f the 1975 deemed d i s p o s i t i o n o f $26,000. Income earned by a p r o p e r t y upon which the change i n use e l e c t i o n has been taken i s s t i l l t a x a b l e i n the year t h a t i t i s earned. The ta x a b l e income can not however be 79 Example 3.9 Change i n Use Ele c t i o n Assumptions: 1. In 1972, a taxpayer purchased a lake cottage for his own PUSe for $2 0,000. 2. In years 1974 and 1975, the taxpayer rents the cottage. 3. Cottage has a f a i r market value of $24,000 i n 1974 and $26,000 i n 1975. 4. In 1979, the taxpayer s e l l s the cottage for $30,000. Calculation of Taxable Capital Gains: No Ele c t i o n E l e c t i o n 1974 - Change i n Use: Deemed proceeds of dispostion $ 24,000 Less: Adjusted cost base 20,000 Deemed c a p i t a l gain $: : 4,000 Taxable c a p i t a l gain (1/2) $ : 2,000 1975 - Change i n Use: Deemed proceeds of d i s p o s i t i o n $ 26,000 Less: Adjusted cost base 24,000 Deemed c a p i t a l gain $: : 2,000 Taxable c a p i t a l gain (1/2) $ 1,000 1979 - Actual Disposition: Proceeds of d i s p o s i t i o n $ 30,000 $ 30,000 Less: Adjusted cost base 26,000 2 0,000 Deemed c a p i t a l gain $ . 4,000 $ 10,000 Taxable c a p i t a l gain (1/2) $ 2,000 $ : 5,000 Total taxable c a p i t a l gain $ 5,000 $ 5,000 80 reduced by c l a i m i n g c a p i t a l c o s t allowance. The e f f e c t of the change i n use e l e c t i o n i s to d i s r e g a r d the change i n use which has a c t u a l l y taken p l a c e , t h e r e f o r e , s i n c e the p r o p e r t y i s c o n s i d e r e d t o s t i l l be non-income producing, c a p i t a l c o s t allowance can not be claimed. F i n a l l y , i t i s important to r e i t e r a t e t h a t the change i n use e l e c t i o n of S e c t i o n 45.2 can o n l y be a p p l i e d to those changes i n use where the p r o p e r t y i s converted from a non-income producing to one t h a t i s an income producer. Consequently, t a x a b l e c a p i t a l gains can not be d e f e r r e d under t h i s e l e c t i o n where a p r o p e r t y i s converted from an income producer to some oth e r use. Non-Taxable C a p i t a l Gains G e n e r a l l y a l l c a p i t a l gains w i t h the e x c e p t i o n of w i n d f a l l gains such as sweepstake^winnings are s u b j e c t to tax under the new A c t . However, c a p i t a l gains r e a l i z e d on two c l a s s e s of personal-use p r o p e r t y are not s u b j e c t to tax. Non-taxable c a p i t a l gains can be r e a l i z e d on personal-use p r o p e r t y valued at under $1,000 and on p r i n c i p a l r e s i d e n c e s . In order to e l i m i n a t e the need f o r taxpayers to account f o r c a p i t a l gains r e a l i z e d on p e r s o n a l p r o p e r t y of r e l a t i v e l y low v a l u e , the new Act has s t i p u l a t e d t h a t the income tax p r o v i s i o n s r e l a t i n g to c a p i t a l gains on personal-use p r o p e r t y do not apply where the a d j u s t e d c o s t base of the p r o p e r t y i s l e s s than $1,000 and the proceeds of d i s p o s i t i o n do not exceed $1,000. To implement t h i s exemption p r o v i s i o n , the A c t deems t h a t the a d j u s t e d c o s t base o f a l l personal-use p r o p e r t y i s the g r e a t e r of $1,000 or the a c t u a l a d j u s t e d c o s t base (46.1.a). The proceeds of d i s p o s i t i o n of personal-use p r o p e r t y are a l s o deemed to be the g r e a t e r of $1,000 or the a c t u a l proceeds of d i s p o s i t i o n (46.1.b). The a p p l i c a t i o n of 81 these provisions i s demonstrated i n Example 3.10. In Example 3.10, no taxable c a p i t a l gain r e s u l t s from the d i s p o s i t i o n of personal-use property which cost and was sold for less than $1,000. Thus, the $300.capital gain r e a l i z e d on Property A i s not taxable. Also, a property which cost less than $1,000 i s only taxable on the proceeds of d i s p o s i t i o n i n excess of $1,000. Only $400 of the $600 c a p i t a l gain r e a l i z e d on the d i s p o s i t i o n of Property B i s subject to tax. F i n a l l y , a property that has a cost base of more than $1,000 but i s subsequently sold for less than $1,000 only incurs a c a p i t a l loss to the extent that the cost base exceeds $1,000. Property C only incurs a c a p i t a l loss for tax purposes of $500 rather than the actual loss of $700. However t h i s l a t t e r case only creates a c a p i t a l loss which i s deductible from taxable c a p i t a l gains where the property disposed of i s l i s t e d personal property (paintings, stamps, and coins). The reason that losses incurred on the disposal of regular personal-use property are not deductible for tax purposes i s that the taxing authorities f e e l that the loss i n value of the items, evidenced by the loss on disposal, represents the cost of personal use of the item and i s c l e a r l y a personal expense which i s not deductibe for tax purposes. Capital gains which are r e a l i z e d from the d i s p o s i t i o n of p r i n c i p a l residences are not taxable. Section 54.g of the new Act defines a p r i n c i p a l residence of a taxpayer as a housing unit or a share of c a p i t a l stock of a co-operative housing corporation owned i n whole or i n part by the taxpayer and o r d i n a r i l y inhabited by him. The p r i n c i p a l residence includes the land under and around the housing unit which contributes to the use and enjoyment of the taxpayer. However where the land area exceeds one acre, the taxpayer must j u s t i f y that the excess land i s necessary to his use and enjoyment of the residence (54.g). For a residence to 82 Example 3.10 Non-Taxable Ca p i t a l Gains $1,000 Rule Property A Property B Property C Actual Deemed Actual Deemed Actual Deemed Cost Cost Cost Cost Cost Cost Proceeds $800 $1,000 $1,400 $1,400 $' 800 $1,000 Less: Cost Base 500 1,000 800 1,000 1,500 1,500 Capital Gain(Loss) $300 N i l $ 600 $ 400 $ (700)$ (500) 83 q u a l i f y as a p r i n c i p a l r e s i d e n c e , i t must be desig n a t e d as the p r i n c i p a l r e s i d e n c e f o r the year by the taxpayer and no other p r o p e r t y can a l s o be, so desig n a t e d d u r i n g t h a t same year. Since o n l y one p r o p e r t y can be de s i g n a t e d as a p r i n c i p a l r e s i d e n c e i n one year, a taxpayer who s e l l s h i s p r i n c i p a l r e s i d e n c e and purchases another one i n the same year w i l l normally d e s i g n a t e the s o l d r e s i d e n c e to be h i s p r i n c i p a l r e s i d e n c e o f t h a t year i n order to a v o i d any tax on c a p i t a l gains r e s u l t i n g from i t s d i s p o s i t i o n . Should the taxpayer s e l l two r e s i d e n c e s d u r i n g the year, he must pay c a p i t a l gains tax on one of the homes s i n c e he can o n l y d e s i g n a t e one p r i n c i p a l r e s i d e n c e i n any g i v e n year. I f a r e s i d e n c e owned by a taxpayer i s de s i g n a t e d as h i s one and o n l y r e s i d e n c e f o r every year t h a t he owns i t , then a c a p i t a l g a i n a r i s i n g upon d i s p o s i t i o n o f t h i s p r i n c i p a l r e s i d e n c e w i l l not be s u b j e c t to income taxes. The c a p i t a l g a i n w i l l be completely tax f r e e . Tax i m p l i c a t i o n s however a r i s e i f d u r i n g the p e r i o d of ownership, the r e s i d e n c e . i s not de s i g n a t e d or does not q u a l i f y as a p r i n c i p a l r e s i d e n c e . To q u a l i f y as a p r i n c i p a l r e s i d e n c e , the r e s i d e n c e must be " o r d i n a r i l y i n h a b i t e d " by the taxpayer. I f the taxpayer i s t r a n s f e r r e d to a new l o c a t i o n f o r a few y e a r s , h i s r e s i d e n c e can not: be desig n a t e d as h i s p r i n c i p a l r e s i d e n c e even i f he owns no oth e r r e s i d e n c e . A l s o i f he r e n t s out h i s r e s i d e n c e d u r i n g t h i s p e r i o d , he w i l l be deemed to have d i s p o s e d of i t f o r i t s f a i r market value even i f he l a t e r r e o c c u p i e s the r e s i d e n c e . However t h i s s i t u a t i o n can be a l l e v i a t e d by the change i n use e l e c t i o n d i s c u s s e d p r e v i o u s l y . Under the change i n use e l e c t i v e p r o v i s i o n , a taxpayer can de s i g n a t e a r e s i d e n c e to be h i s p r i n c i p a l r e s i d e n c e f o r up to f o u r years without " o r d i n a r i l y i n h a b i t i n g " the r e s i d e n c e and p r o v i d i n g t h a t i t i s used to earn income (54.g). In summary, a r e s i d e n c e q u a l i f i e s as a p r i n c i p a l r e s i d e n c e i f i t i s o r d i n a r i l y i n h a b i t e d by the taxpayer or i f i t has been so 84 designated by the taxpayer i n accordance with the change i n use e l e c t i v e provision. If during the period of ownership, a residence does not q u a l i f y as a p r i n c i p a l residence, then a l l or part of the c a p i t a l gain which arises on d i s p o s i t i o n of the residence w i l l be subject to tax. Section 40.2.b of the new Act states that where a taxpayer i s an i n d i v i d u a l the c a p i t a l gain that i s subject to tax i s the c a p i t a l gain r e a l i z e d on d i s p o s i t i o n minus that proportion which i s : 1. one plus the number of taxation years ending af t e r 1971 for which the property was his p r i n c i p a l residence and during which he was a resident of Canada i s of: 2. the number of taxation years ending after 1971 during which he owned a l l or part of the property. Example 3.11 demonstrates the tax treatment - afforded a c a p i t a l gain r e a l i z e d on a p r i n c i p a l residence. In Example 3.11, only 10% of the c a p i t a l gain r e a l i z e d on d i s p o s i t i o n of the house i s subject to tax. Although the house was not designated as the p r i n c i p a l residence for two of the ten years of ownership, Section 40.2.b enables a l l but one year to benefit from the non-taxable c a p i t a l gain. In f a c t i f the house had not be designated as a p r i n c i p a l residence for only one year, the entire amount of the c a p i t a l gain of $10,00 0 would have been exempt from tax. F i n a l l y , conversion of a residence to a p r i n c i p a l residence or v i c a versa does not r e s u l t i n any deemed c a p i t a l gains, unlike the conversion to income producing property. The tax free status of a c a p i t a l gain which has accrued to a p r i n c i p a l residence greatly enhances the investment p o t e n t i a l of home ownership i Urbanization has caused substantial increases i n the value of e x i s t i n g houses, p a r t i c u l a r l y over the past few years. Thus, a t y p i c a l house which sold i n Vancouver, B r i t i s h Columbia f o r $26,000 in 1971 would s e l l for about $39,000 in 1973. This gain i n 85 value of $13,000 represents a 50% increase'in value over two years. If such a house was the princ i p a l , residence of a taxpayer, the entire amount of the gain would be tax free. A taxpayer with a 40% marginal tax rate would have to make a c a p i t a l gain on an investment which was taxable of $16,250 i n order to have a net af t e r tax gain of $13,000 as i s demonstrated below. Capital gain on a taxable investment $16,250 Taxable c a p i t a l gain (1/2 of above) $ 8,12 5 Net gain af t e r income taxes: Capital gain $16,250 Income Taxes 40% of $8,12 5 3,250 Net gain a f t e r income taxes $13,000 The taxpayer i n the above.example would have to r e a l i z e a c a p i t a l gain on a taxable investment which i s 1.25 times greater than the c a p i t a l gain r e a l i z e d on his p r i n c i p a l residence (in order to r e a l i z e the same gain af t e r income taxes. The tax free status of c a p i t a l gains r e a l i z e d on a p r i n c i p a l residence w i l l act as a strong incentive for taxpayers to own t h e i r residence. This increased demand of taxpayers to own t h e i r home rather than rent one w i l l be a further factor which w i l l escalate house prices e s p e c i a l l y over the short term. Over the long term, the tax free status of the c a p i t a l gain r e a l i z e d on a p r i n c i p a l residence and the a b i l i t y of the average taxpayer to use leverage i n acquiring his home w i l l make home ownership a desirable investment for most taxpayers. 86 Example 3.11 Calculation of the Taxable Capital Gain on the Disposition of a P r i n c i p a l Residence Assumptions: l. I n 1972, a taxpayer purchases a house to be used as a summer residence for $25,000. 2.Taxpayer rents the house for years 1974 and 1975 but he designates house to be his p r i n c i p a l residence during these years. 3.In 1976, taxpayer reoccupies house and continues to designate i t as his p r i n c i p a l residence. 4.Taxpayer s e l l s house i n ,1981 for $35,000. Calculation of taxable c a p i t a l gain: 1.House does not qual i t y as a p r i n c i p a l residence for the 2 years 1972 and 1973. 2.Capital gain r e a l i z e d on d i s p o s i t i o n : Proceeds of d i s p o s i t i o n $35,000 Less: Adjusted cost, base 25,000. Capital gain r e a l i z e d on d i s p o s i t i o n $10,000 3.Non-taxable portion of c a p i t a l gain: Years as p r i n c i p a l residence + One 8+1 Years of ownership ~ 10 = .9 4.Taxable c a p i t a l gain: Capital gain r e a l i z e d on d i s p o s i t i o n $10,000 Less: Non-taxable c a p i t a l gain .9x10,000= 9,000 Capital gain subject to tax $ 1,000 Taxable c a p i t a l g a i n (h) $ 500 87 CONCLUSION The strong incentive to invest i n r e a l estate for the purpose of making c a p i t a l gains has been c u r t a i l e d considerably by the new Act. The new Act stipulates that one hal f of a c a p i t a l gain, c a l l e d a taxable c a p i t a l gain, i s to be sub-jected to the normal rates of taxation. Under the old Act, c a p i t a l gains were completely tax free. J u s t i f i a b l y however, one half of a c a p i t a l l o s s , . c a l l e d an allowable c a p i t a l loss, can be used to reduce the taxable c a p i t a l gains of the tax-payer of the immediately preceding year, current year, and any future year. In addition, an i n d i v i d u a l taxpayer can apply $1,000 of a net c a p i t a l loss i n any one year against other income. Under the old Act, there was no tax r e l i e f for c a p i t a l losses. The new Income Tax Act i s not retroactive so that unrealized c a p i t a l gains which have accrued on property p r i o r to January 1, 1972 remain free of tax. These pre 1972 tax free c a p i t a l gains are preserved by u t i l i z i n g either the tax free zone method or the f a i r market value method to determine the portion of a c a p i t a l gain which i s taxable upon d i s p o s i t i o n of a property owned by December 31, 1971 by the taxpayer. Under the tax free zone method, the c a p i t a l gain subject to tax i s the excess of the proceeds of d i s p o s i t i o n over the higher of the property's cost or f a i r market value at December 31, 19 71. Conversely, a c a p i t a l loss i s based on the difference between the lesser of the property's cost or f a i r market value at December 31, 1971 and the proceeds of di s p o s i t i o n . If the proceeds of d i s p o s i t i o n l i e between the cost and f a i r market value at December 31, 1971, neither a c a p i t a l gain nor a c a p i t a l loss r e s u l t s . The f a i r market value method can only.be used by i n d i v i d u a l taxpayers. Under th i s method, a l l c a p i t a l gains and c a p i t a l losses are based on the f a i r market value of the taxpayer's properties at December 31, 1971. The f a i r market 88 value method would benefit a taxpayer i n the s i t u a t i o n where his properties had a value on December 31, 1971 i n excess of cost but where t h e i r proceeds of d i s p o s i t i o n are expected to be less than that valuation-day value. I t Is important to remember that a taxpayer may choose only one of the two methods and once he has chosen he must apply the same method to the d i s p o s i t i o n of a l l his pre 1972 properties. Depreciable property which i s also c a p i t a l property i s subjected to s p e c i a l provisions of the Income Tax Act because of i t s expected loss i n value over time. Since the c a p i t a l cost allowance provisions compensate the taxpayer for t h i s loss i n value, no c a p i t a l losses'are allowable for depreciable property. Capital gains can however accrue on depreciable property]. Because recaptured c a p i t a l cost allowance i s f u l l y taxable, these c a p i t a l gains are based on the excess of proceeds over the o r i g i n a l cost of the deprecia-ble property rather than i t s undepreciated c a p i t a l cost. These c a p i t a l gains are taxable i n the same manner as c a p i t a l gains on non-depreciable property. C a p i t a l gains which have accrued to depreciable property p r i o r to 1972 are not subject to tax. However because of the s p e c i a l tax treatment granted depreciable property, neither the tax free zone method nor the f a i r market value method can be used to exempt pre 1972 c a p i t a l gains. These c a p i t a l gains are exempted however by reducing the proceeds of d i s p o s i t i o n by the amount of the pre 19 72 c a p i t a l gains before c a l c u l a t i n g the post 1971 c a p i t a l gains which are tax-able. Under the new Act, property which i s owned by a tax-payer and used for his own personal use or enjoyment or that of persons related to him i s subject to the taxable c a p i t a l gains provisions. However losses on disposal of such personal-use property are not deductible from taxable c a p i t a l gains because the loss i n value i s deemed by the taxing authorities to be the normal wear and tear on the property. Deductible c a p i t a l losses are allowable for a selected number of non-depreciable, personal-use properties such as paintings and 89 coin and stamp c o l l e c t i o n s . Capital gains r e s u l t i n g from the d i s p o s i t i o n of personal-use property are taxable i n the same manner as other c a p i t a l gains. Capital gains which have accrued on personal-use property as of December 31, 1971 are exempted from tax i n the same way as pre 1972 c a p i t a l gains on depreciable property. The proceeds of d i s p o s i t i o n are reduced to the extent of the pre 1972 c a p i t a l gain before the taxable c a p i t a l gains c a l c u l a t i o n i s made. Personal-use property i s vulnerable to the change i n use provisions of the new Act. Disposition at f a i r market value i s deemed to have occurred i f personal-use property i s used to produce income or i f income producing property becomes personal-use property. Consequently the c a p i t a l gains a r i s i n g from the deemed dispositon w i l l be taxable even though the same taxpayer continues to own the property. This onerous change-in-use provision i s a l l e v i a t e d by the change i n use el e c t i o n provision which enables a taxpayer to defer the paying of the tax on the c a p i t a l gain u n t i l actual d i s p o s i t i o n occurs. This e l e c t i o n provision however only applies where personal-use property i s temporarily used to produce income. Tax free c a p i t a l gains continue to ex i s t under the new Income Tax Act for some personal-use property. C a p i t a l gains a r i s i n g from the d i s p o s i t i o n of personal-use property remain free of tax i f the property has a cost base less than $1,000 and the proceeds of d i s p o s i t i o n do not exceed $1,000. Even more s i g n i f i c a n t l y , c a p i t a l gains a r i s i n g from the d i s p o s i t i o n of a p r i n c i p a l residence remain tax free. In summary, although the d i s p o s i t i o n of property now attracts Income tax the amount of tax l i a b i l i t y incurred i s one-half of the normal rate due to the f a c t that only one-half of the gain i s taxable. In addition, investing i n r e a l estate has generally been very l u c r a t i v e . Although the r e a l p r o f i t from the transaction w i l l be reduced due to taxation, there w i l l s t i l l continue to be high incentive for investing i n r e a l estate. 90 CHAPTER 4 SPECIAL CASES INVOLUNTARY DISPOSITIONS Involuntary dispositions include dispositions of property by destruction, expropriation, t h e f t , and foreclosure (54.h). To a l l e v i a t e the p o t e n t i a l hardships of the c a p i t a l gains provisions of the new Act on involuntary d i s p o s i t i o n s , the Act has prescribed s p e c i a l provisions for such dis p o s i t i o n s . Section 44 of the new Act stipulates that where a taxpayer has received proceeds for property destroyed or expropriated and has expended an amount to replace t h i s property before the end of the following taxation year then the c a p i t a l gain subject to tax w i l l be the lesser of: 1. excess of the proceeds of d i s p o s i t i o n over the adjusted cost base of the disposed property, or 2. the amount, i f any, by which the proceeds of d i s p o s i t i o n exceed the cost of the replacement property. The cost base of the replacement property w i l l be i t s c a p i t a l cost minus any c a p i t a l gain r e a l i z e d on the disposed property which i s not taxable because of Section 44. This adjustment of the cost base of the replacement property ensures that any c a p i t a l gain r e a l i z e d on the disposed property which was not taxable at the time of destruction or expropriation w i l l be taxable, i f the replace-ment property i s subsequently sold for more than i t s adjusted cost base.. Example 4.1 demonstrates the tax treatment afforded destroyed or expropriated property. In Case 1 of Example 4.1, the reinvestment of a l l of the proceeds of expropriation i n another property has resulted i n the c a p i t a l gain r e a l i z e d on the expropriated property remaining free of income taxes. 91 Example 4.1 Disposition by Expropriation Case Case Case 1 2 3 ^cSsfbasrof expropriated prop. $50 00C) $ 5 ( > , 0 0 0 $50,000 Proceeds of expropriation 60,000 60,00 0 4 0,000 Cost of replacement property 60,000 40,000 45,000 Calculation of c a p i t a l gain si Lesser of A or B: A. Proceeds of expropriation Less: Adjusted cost base Capital gain (loss) B. Proceeds of expropriation Less: Cost of replacement Capital gain C. Capital gain (loss) subject to tax .bject to tax: $60,000 $60,000 $40,000 50,000 50,000 50,000 $10,000 $10,000 (lo.ooo) $60,000 $60,000 $40,000 60,000 40,000 45,000 — N i l $20,000 N i l N i l $10,000 (10/000) A a J a S a l C ^ s t b a S e ° £ r e P l a C S m e n t 1 ^ 0 ^ 4 0 , 0 0 0 $45,000 92 T h i s c a p i t a l g a i n of $10,000 has however reduced the c o s t base of the replacement p r o p e r t y so t h a t i f i t i s s o l d f o r more than $ 5 0 , 0 0 0 , the r e s u l t i n g c a p i t a l g a i n w i l l be s u b j e c t to tax. Case 2 demonstrates t h a t i f the c o s t of the replacement p r o p e r t y i s l e s s than the c o s t base of the e x p r o p r i a t e d p r o p e r t y , then the e n t i r e amount of the c a p i t a l g a i n i s s u b j e c t to tax. F i n a l l y Case 3 shows t h a t where the proceeds of e x p r o p r i a t i o n are l e s s than the a d j u s t e d c o s t base of the e x p r o p r i a t e d p r o p e r t y , then the r e s u l t i n g c a p i t a l l o s s i s e l i g i b l e to be deducted from c a p i t a l gains of the taxpayer. S e c t i o n 44 of the A c t which enables the d e f e r r a l of c a p i t a l gains on destraoyed or e x p r o p r i a t e d p r o p e r t y does not apply to p r o p e r t y s t o l e n or damaged. However ins u r a n c e proceeds used to r e p a i r damaged p r o p e r t y i n order to f a c i l i t a t e i t s s a l e w i l l not be i n c l u d e d as p a r t of the proceeds of d i s p o s i t i o n (54.h) as i s shown i n Example 4.2. Example 4.2 Tax Treatment of Insurance Proceeds on Damaged Property Assumptions: Adj u s t e d c o s t base of p r o p e r t y b e f o r e f i r e $20,000 Insurance proceeds used t o r e p a i r damage 10,000 Proceeds of d i s p o s i t i o n 20,000 C a l c u l a t i o n of t a x a b l e c a p i t a l g a i n : Proceeds of d i s p o s i t i o n $20,000 A d j u s t e d c o s t base 20,000 C a p i t a l g a i n r e a l i z e d N i l The s p e c i a l tax p r o v i s i o n s governing d i s p o s i t i o n s by f o r e c l o s u r e are i n c l u d e d i n S e c t i o n 79 of the new A c t . In a f o r e c l o s u r e , the mortgagor i s deemed to have d i s p o s e d of h i s mortgaged p r o p e r t y f o r the amount of the o u t s t a n d i n g p r i n c i p a l , i n t e r e s t , and oth e r c o s t s of the mortgage ( 7 9 . c ) . 93 C a p i t a l gains or l o s s e s of the mortgagor on the f o r e c l o s u r e of h i s p r o p e r t y are based on t h i s f o r e c l o s u r e amount. I f at a l a t e r date, the mortgagor makes f u r t h e r payments i n s a t i s f a c t i o n o f the mortgagee's c l a i m s , then such payments w i l l be deemed to be c a p i t a l l o s s e s of the mortgagor i n the year of payment (79.d). The mortgagee i n a f o r e c l o s u r e i s deemed to have a c q u i r e d the p r o p e r t y f o r the amount of the mortgage claims e x t i n g u i s h e d by the f o r e c l o s u r e ( 7 9 . f j . To prevent the c r e a t i o n of c a p i t a l l o s s e s on the f o r e c l o s e d mortgage, the A c t s t i p u l a t e s t h a t the ad j u s t e d c o s t base of -the f o r e c l o s e d mortgage i s to be n i l (79.g). A mortgagee w i l l t h e r e f o r e o n l y be able t o r e a l i z e an a l l o w a b l e c a p i t a l l o s s on a f o r e c l o s u r e a t the time of the a c t u a l d i s p o s i t i o n of the f o r e c l o s e d p r o p e r t y . Example 4.3 demonstrates the f o r e c l o s u r e p r o v i s i o n s of the new A c t . In Example 4.3, the mortgagor, E, r e a l i z e s a c a p i t a l l o s s of $40,000 when h i s p r o p e r t y i s f o r e c l o s e d . The mortgagee, M, does not r e a l i z e e i t h e r a c a p i t a l g a i n nor a c a p i t a l l o s s u n t i l the f o r e c l o s e d p r o p e r t y i s s o l d . I f at a l a t e r date, E makes a f u r t h e r payment to M then E w i l l r e a l i z e a c a p i t a l l o s s and M w i l l r e a l i z e a c a p i t a l g a i n at t h a t time. 9 4 -E x a m p l e 4.3 F o r e c l o s u r e s C a s e 1 C a s e 2 A s s u m p t i o n s : E's e q u i t y $ 40,000 $ 40,000 M's m o r t g a g e 60,000 60,000 C o s t o f p r o p e r t y $100,000 $100,000 M f o r e c l o s e s and s e l l s p r o p e r t y $ 50,000 $ 70,000 E's c a p i t a l l o s s on f o r e c l o s u r e : Deemed p r o c e e d s o f f o r e c l o s u r e $ 60,000 $ 60,000 L e s s : A d j u s t e d c o s t b a s e o f p r o p e r t y 100,000 100,000 C a p i t a l l o s s $ 40,000 $ 40,000 M's c a p i t a l o n f o r e c l o s e d m o r t g a g e : P r o c e e d s o f f o r e c l o s u r e N i l N i l L e s s : A d j u s t e d c o s t b a s e o f m o r t g a g e N i l N i l C a p i t a l l o s s N i l N i l A d j u s t e d c o s t b a s e o f p r o p e r t y t o M w h i c h i s e q u a l t o m o r t g a g e c l a i m s $ 60,000 $ 60,000 M's c a p i t a l g a i n ( l o s s ) o n f o r e c l o s e d p r o p e r t y P r o c e e d s o f d i s p o s i t i o n $ 50, 000 $ 70, ,000 L e s s : A d j u s t e d c o s t b a s e 60, 000 60, ,000 C a p i t a l g a i n ( l o s s ) $ ( 1 0 , 000) $ .10, ,000 95 OPTIONS The granting of an option i s deemed by the Act to be a d i s p o s i t i o n of a property which has an adjusted cost base of zero (49.1). The c a p i t a l gain r e a l i z e d by a taxpayer who has granted the option i s equal to the consideration received for the option less any expenses of issuing the option. Thus, a taxpayer who receives $1,000 for a six month option on 100 acres of land that he owns would r e a l i z e a c a p i t a l gain as follows: Proceeds for granting option $1,000 Less: Adjusted cost base of option N i l Legal fees $ 100 100 Capital gain r e a l i z e d $ 9 00 The taxpayer who receives the option i s deemed to have acquired the option for a cost base equal to the consideration paid for the option plus any other related expenses. In the above example, the cost base of the acquired option would be as follows: Consideration paid for option $1,000 Add: Legal fees and other costs 250 Adjusted cost base of option $1,250 Upon expiration of the option, the taxpayer holding the option would normally be considered to have incurred a c a p i t a l loss equal to the adjusted cost base of the option. In the above example, a c a p i t a l loss of $1,250 i s incurred. Proceeds of d i s p o s i t i o n Less: Adjusted cost base of option Capital loss N i l $1,25 0 $1,250 96 Thus the granting of an option r e s u l t s i n an immediate c a p i t a l gain to the grantor of the option but does not r e s u l t i n a c a p i t a l loss to the holder of the option u n t i l i t has expired. If during the option period, the holder of the option s e l l s the option to another party then he would be deemed to have disposed of the option and to have r e a l i z e d a c a p i t a l gain or loss as the case may be.. I f , i n the example above, the option holder s e l l s the option for $5,000, f.hen he would r e a l i z e a c a p i t a l gain of $3,500. Proceeds of d i s p o s i t i o n of option $5,000 Less: Adjusted cost base $1,250 Legal fees 250 1,500 Capital gain r e a l i z e d $3,500 The cost base of the option to the second party who purchased the option would again be equal to the consideration paid plus any other related costs. Upon expiration of the option, the party holding the option would incur a c a p i t a l loss equal to the adjusted cost base of the option. Subsequent sales of an option do not a f f e c t the tax s i t u a t i o n of the o r i g i n a l grantor of the option. If the option i s exercised, i t i s no longer regarded as a d i s p o s i t i o n of property by the grantor but as part of the consideration received for the property to which the option relates (49.3). Thus i n the above example, the taxpayer granting the option i s no longer considered to have r e a l i z e d a c a p i t a l gain of $900. The $1,000 received for the option would be considered as part of the proceeds of d i s p o s i t i o n of the 100 acres and the $100 of expenses r e l a t i n g to the option would be included as part of the costs of d i s p o s i t i o n of the 100 acres. S i m i l a r l y , the cost base of the property acquired through exercising the option includes a l l the costs of acquiring the option. Thus i f i n the example, the second 97 o p t i o n h o l d e r e x e r c i s e s the o p t i o n , then the c o s t base of the 100 acres would be as f o l l o w : Purchase p r i c e of 100 acres $50,000 L e s s : I n i t i a l o p t i o n p a i d 1,000 $49,000 A c q u i s i t i o n c o s t o f o p t i o n 5,000 Related c o s t s i n c l u d i n g o p t i o n c o s t s 3,000 A d j u s t e d c o s t base of 100 acres $57,000 The tax treatment of op t i o n s d e s c r i b e d above a p p l i e s to most r e a l e s t a t e t r a n s a c t i o n s . Exceptions to these r u l e s occur when p e r s o n a l p r o p e r t y i s optioned. C a p i t a l gains r e a l i z e d on p e r s o n a l p r o p e r t y are s u b j e c t to tax so c a p i t a l gains a r i s i n g from o p t i o n s granted on p e r s o n a l p r o p e r t y are a l s o t a x a b l e . Thus the $100 r e c e i v e d f o r an op t i o n on a taxpayer's l a k e c o t t a g e i s a c a p i t a l g a i n to him t h a t i s t a x a b l e . However, s i n c e c a p i t a l l o s s e s i n c u r r e d on the d i s p o s i t i o n of p e r s o n a l p r o p e r t y are not d e d u c t i b l e c a p i t a l l o s s e s , c a p i t a l l o s s e s a r i s i n g from o p t i o n s on p e r s o n a l p r o p e r t y are t h e r e f o r e not d e d u c t i b l e to the purchaser of the o p t i o n . Thus, the $100 p a i d f o r an o p t i o n on a cottage which i s not e x e r c i s e d i s a non-deductible p e r s o n a l expenditure. C a p i t a l gains on the d i s p o s a l of p r i n c i p a l r e s i d e n c e s are exempt from tax so c a p i t a l gains r e a l i z e d from g r a n t i n g o p t i o n s on a taxpayer's p r i n c i p a l r e s i d e n c e are a l s o not t a x a b l e . S i m i l a r l y , the purchaser of an o p t i o n on a p r i n c i p a l r e s i d e n c e does not i n c u r a d e d u c t i b l e c a p i t a l l o s s i f he does not e x e r c i s e the o p t i o n . 98 Example 4.4 Summary, of Tax Treatment of Options Event Treatment of Grantor Treatment of Holder G r a n t i n g o p t i o n . Proceeds are t a x a b l e as.a c a p i t a l g a i n . Cost base equal to a c q u i s i t i o n c o s t . E x p i r y of o p t i o n . No tax s i g n i f i c a n c e . D i s p o s i t i o n as of date of e x p i r y . C a p i t a l l o s s equal to c o s t base. Sale of o p t i o n No tax s i g n i f i c a n c e . D i s p o s i t i o n y i e l d s by h o l d e r . '- a c a p i t a l g a i n or l o s s . E x e r c i s e of Proceeds of o p t i o n Cost base of o p t i o n o p t i o n . are i n c l u d e d as p a r t i n c l u d e d i n c o s t base of proceeds of of a c q u i r e d p r o p e r t y . d i s p o s i t i o n of p r o p e r t y t h a t was optioned. 9 9 NON-ARM'S LENGTH TRANSACTIONS When a taxpayer decides to s e l l property to his brother, to give property to his children, or to bequeath property to his heirs, he i s governed by s p e c i f i c provisions of the new Income Tax Act r e l a t i n g to non-arm's length transactions. Persons who are related to one another are deemed by the Act to not deal with each other at arm's length .(251.1). Related persons include an ind i v i d u a l and a corporation or corporations controlled by him as well as other individuals connected to him by blood r e l a t i o n s h i p , marriage or adoption (251.2). A primary intent of the non-arm's length provisions of the Act i s to prevent taxpayers from tran s f e r r i n g c a p i t a l gains and c a p i t a l losses accruing on property to persons related to them. To avoid paying income taxes on a c a p i t a l gain, a taxpayer may decide to s e l l the appreciated property to a person related to him. For example, a father might s e l l a b u i l ding l o t to his son at i t s o r i g i n a l cost i n order to avoid a substantial taxable c a p i t a l gain which would r e s u l t i f i t was sold at i t s f a i r market value. In order to prevent such c a p i t a l gain transfers, the new Act stipulates that d i s p o s i t i o n of property to persons with whom a taxpayer i s not dealing at arm's length, for proceeds less than f a i r market value, w i l l be deemed to be made for proceeds equal to the f a i r market value (69.1.b). However, the new Act does not sti p u l a t e that the person acquiring the property i s also deemed to have acquired i t at a cost equal to that f a i r market value. Consequently, a non-arm's length transaction for proceeds less than f a i r market value could r e s u l t i n a c a p i t a l gain being taxed twice as i s demonstrated i n Example 4.5. In Example 4.5, the non-arm's length provisions of the Act have deemed that A has re a l i z e d a c a p i t a l gain of 10 0 Example 4.5 Non-Arm's Length Transaction Proceeds less than F a i r Market Value Assumptions: 1.Individual A s e l l s 10 acres of land valued at $100,000 to his brother for $50,000. 2. Adjusted cost base of land to A i s $50,000. 3. Brother s e l l s land for $100,000. A's Tax Position: Deemed c a p i t a l gain r e a l i z e d by A: Deemed proceeds of d i s p o s i t i o n (fair-market value) $100,000 Less: Adjusted cost base 50,000 Deemed c a p i t a l gain r e a l i z e d by A $ 50,000 Brother's Tax Position: Adjusted cost base of land to brother i s equal to i t s a c q u i s i t i o n cost (not f a i r market value) $ 50,000 Capital gains r e a l i z e d by brother: Proceeds of di s p o s i t i o n $100,000 Less: Adjusted cost base 50,000 Capital gain r e a l i z e d by brother $ 50,000 101 $50,000 on d i s p o s i t i o n of the 10 acres of land to his brother /even though the actual proceeds are equal to the cost base of the land. Although A has been deemed to have sold his land at i t s f a i r market value of $100,000, his brother has not been deemed to have acquired the land at that price but at his actual cost of $50,000. Thus, the brother i s also deemed to have r e a l i z e d a $50,000 c a p i t a l gain when he s e l l s the land at i t s f a i r market value of $100,000. Consequently, the same c a p i t a l gain of $50,000 i s subject to tax i n the hands of A as well as those of his brother. In order to gain some tax r e l i e f , a taxpayer may attempt to incur:an a r t i f i c i a l c a p i t a l loss by acquiring property from a related person at an i n f l a t e d price and then disposing of the property for a c a p i t a l loss. For example, a father i n a high marginal tax bracket might attempt to incur a substantial allowable c a p i t a l loss by s e l l i n g a parcel of land he has recently acquired from his son at a highly i n f l a t e d p r i c e . Therefore, to prevent the creation of such a r t i f i c i a l losses, the new Act stipulates that where a taxpayer acquires property i n a non-arm's length transaction, at an amount i n excess of i t s f a i r market value, then he i s deemed to have acquired the property at that f a i r market value (69.1sa). However, th i s provision does not s t i p u l a t e that the person s e l l i n g the property w i l l also be deemed to have sold the property for i t s f a i r market value. Thus, the taxpayer w i l l be pre-vented from claiming a c a p i t a l loss on the transaction but the s e l l e r could s t i l l incur an additional taxable c a p i t a l gain or a reduced allowable c a p i t a l loss as i s demonstrated in Example 4.6. In attempting to transfer a c a p i t a l loss of $50,000 accrued on the 10 acres of land from his brother to himself, Individual A i n Example 4.6 has transferred the c a p i t a l loss from his brother to himself, but because of the non-arm's length provisions of the Act, A is-unable to claim the c a p i t a l loss for tax purposes. Consequently neither A 102-'. Example 4 . 6 Non-Arm's Length T r a n s a c t i o n Proceeds i n Excess of F a i r Market Value Assumptions: 1. I n d i v i d u a l A purchases 10 acres of land v a l u e d a t $100,000 from h i s b r o t h e r f o r $150,000. 2. Adjusted c o s t base o f land t o b r o t h e r i s $150,000. 3. A s e l l s l a n d f o r $100,000. Broth e r ' s Tax P o s i t i o n : C a p i t a l l o s s i n c u r r e d by b r o t h e r : Proceeds of d i s p o s i t i o n ( r e c e i v e d from A) $150,000 Less: A d j u s t e d c o s t base 150,000 C a p i t a l l o s s i n c u r r e d by b r o t h e r N i l A's Tax P o s i t i o n : Adjusted c o s t base of land t o A i s deemed by A c t to be i t s f a i r market value $100,000 Deemed c a p i t a l l o s s i n c u r r e d by A: Proceeds o f d i s p o s i t i o n $100,000 Les s : Deemed ad j u s t e d c o s t base of land 100,000 Deemed c a p i t a l l o s s i n c u r r e d by A N i l 10 3 nor h i s b r o t h e r w i l l be able to u t i l i z e . a n a c t u a l c a p i t a l l o s s of $50,000. D e p r e c i a b l e Property The non-arm's l e n g t h p r o v i s i o n s of the new A c t apply to d e p r e c i a b l e p r o p e r t y i n the same manner as other c a p i t a l p r o p e r t y . Where proceeds of d i s p o s i t i o n are l e s s than f a i r market v a l u e , the d e p r e c i a b l e p r o p e r t y i s deemed to have been s o l d f o r i t s f a i r market va l u e . At t h i s f a i r market v a l u e , a c a p i t a l g a i n and/or a r e c a p t u r e of c a p i t a l c o s t allowance may occur which would not otherwise have r e s u l t e d . The purchaser, i n t u r n a c q u i r e s the p r o p e r t y at h i s a c t u a l c o s t , being l e s s than f a i r market v a l u e . S i m i l a r l y , where the proceeds of d i s p o s i t i o n exceed the f a i r market v a l u e , the d e p r e c i a b l e p r o p e r t y i s deemed to have been a c q u i r e d a t i t s f a i r market v a l u e . Consequently, the excess proceeds p a i d f o r the p r o p e r t y w i l l i n c r e a s e the c a p i t a l g a i n or c a p i t a l c o s t allowance r e c a p t u r e of the s e l l e r but w i l l not i n c r e a s e the c a p i t a l c o s t of the p r o p e r t y to the buyer. However, the a p p l i c a t i o n of the g e n e r a l non-arm's l e n g t h p r o v i s i o n s r e l a t i n g to d e p r e c i a b l e p r o p e r t y under the new A c t d i f f e r g r e a t l y from the tax treatment a f f o r d e d d e p r e c i a b l e p r o p e r t y under the o l d A c t . Under S e c t i o n 17.7 of the o l d A c t , d e p r e c i a b l e p r o p e r t y s o l d f o r l e s s than i t s f a i r market v a l u e i n a non-arm's l e n g t h t r a n s a c t i o n was not deemed to have been s o l d a t i t s f a i r market v a l u e . Proceeds of d i s p o s i t i o n t o the s e l l e r of the d e p r e c i a b l e p r o p e r t y were deemed t o be the a c t u a l proceeds r e c e i v e d . On the other hand, the purchaser was deemed to have a c q u i r e d the p r o p e r t y a t a c a p i t a l c o s t equal to t h a t of the s e l l e r i r r e g a r d l e s s of whether or not the a c t u a l a c q u i s i t i o n c o s t was l e s s than or exceeded the s e l l e r ' s c a p i t a l c o s t . I f the a c t u a l a c q u i s i t i o n c o s t was 10 4 l e s s than the c a p i t a l c o s t however, then the b a s i s f o r c l a i m i n g c a p i t a l c o s t allowance by the purchaser was deemed to be t h i s lower a c q u i s i t i o n c o s t . The d i f f e r e n c e between the c a p i t a l c o s t and t h i s lower a c q u i s i t i o n c o s t was deemed by the o l d A c t (20.4) to have been p r e v i o u s l y claimed by the purchaser as c a p i t a l c o s t allowance so t h a t a subsequent d i s p o s i t i o n f o r proceeds i n excess of t h i s lower a c q u i s i t i o n c o s t would r e s u l t i n a r e c a p t u r e of c a p i t a l c o s t allowance. The comparative advantages o f the non-arm's l e n g t h p r o v i s i o n s of the o l d A c t over those of the new A c t are demonstrated i n Example 4.7. In Example 4.7, Taxpayer A has s o l d h i s apartment b u i l d i n g valued a t $150,000 to h i s b r o t h e r f o r o n l y $100,000. A's b r o t h e r s e l l s the apartment to a s t r a n g e r f o r i t s market v a l u e of $ 1 5 0 , 0 0 0 . Under the o l d A c t , Taxpayer A would on l y have i n c u r r e d income taxes on the c a p i t a l c o s t allowance r e c a p t u r e of $20,000 which i s the amount by which the proceeds r e c e i v e d from h i s b r o t h e r of $100,000 exceed the undepreciated c a p i t a l c o s t of the apartment of $80,000. However, under the new A c t , Taxpayer A i s deemed to have s o l d h i s apartment b u i l d i n g f o r i t s f a i r market value of $ 1 5 0 , 0 0 0 . Consequently he would be t a x a b l e on a deemed c a p i t a l g a i n of $30,000 which i s the excess of the deemed proceeds over h i s c a p i t a l c o s t o f $120,000 as w e l l as a r e c a p t u r e of c a p i t a l c o s t allowance of $40,000. When A's b r o t h e r s e l l s the apartment f o r $ 1 5 0 , 0 0 0 , he was o n l y deemed under the o l d Act to have r e a l i z e d a c a p i t a l g a i n of $30,000 which i s the excess of the proceeds over A's c a p i t a l c o s t of $120,000 and a r e c a p t u r e of c a p i t a l c o s t allowance of $20,000. Under the new A c t , A's b r o t h e r w i l l not i n c u r a r e c a p t u r e of c a p i t a l c o s t allowance but he w i l l r e a l i z e a c a p i t a l g a i n of $50,000 which i s the excess of the proceeds over h i s a c t u a l a c q u i s i t i o n c o s t of o n l y $100,000. R e a l i z i n g t h a t c a p i t a l gains were tax f r e e under the o l d A c t , i t i s 10 5 Example 4.7 Depreciable Property Comparison of Non-Arm's Length Provisions of the old Act and the new Act Assumptions: 1. Taxpayer A s e l l s his apartment to his brother $100,000 2. Capital cost of apartment building to A 120,000 3. Undepreciated c a p i t a l cost at date of sale 80,000 4. F a i r market value at date of sale 150,000 5. Subsequent sale of apartment by brother 150,000 New Act Old Act A's Tax Po s i t i o n : Deemed c a p i t a l gain r e a l i z e d by A: Deemed proceeds of d i s p o s i t i o n $150,000 $100,000 Less: C a p i t a l cost 120,000 120,000 Deemed c a p i t a l gain r e a l i z e d by A $ 30,000 N i l Recapture of c a p i t a l cost, allowance by A: Lesser of. proceeds or c a p i t a l cost $120,000 $100,000 Less: Undepreciated c a p i t a l cost 80,000 80,000 Recapture of c a p i t a l cost allowance $ 40,000 $ 20,000 Brother's Tax Position: Deemed c a p i t a l cost of property to B $100,000 $120,000 Basis of c a p i t a l cost allowance to B; N.A.-Acquisition cost $100,000 0.A.-Lesser of c a p i t a l or acq. cost '• $100 , 000 Capi t a l gain r e a l i z e d by brother B: Proceeds of d i s p o s i t i o n $150,000 $150,000 Less: Deemed c a p i t a l cost 100,000 120,000 Capital gain r e a l i z e d by B $ 50,000 $ 30,000 Recapture of c a p i t a l cost allowance by B: Lesser of proceeds or c a p i t a l cost $100,000 $120,000 Less: Undepreciated c a p i t a l cost 100,000 100,000 Recapture of c a p i t a l cost allowance N i l $ 20,000 Summary: Capital gains r e a l i z e d by-A $ 30,000 N i l Brother 50,000 $.30,000 Total c a p i t a l gains r e a l i z e d $ 80,000 $ 30,000 Recapture of c a p i t a l cost allowance by-A $ 40,000 $ 20,000 Brother N i l 20,000 Total recapture of C C A . $ 40,000 $ 40,000 106 easy to see the s u b s t a n t i a l b e n e f i t s p r o v i d e d f o r d e p r e c i a b l e p r o p e r t y under the non-arm's l e n g t h p r o v i s i o n s of the o l d A c t which do not e x i s t under the new Act. 10 7-TAX FREE ROLLOVERS A r e a l estate investor who i s an i n d i v i d u a l may desire at some time to transfer property to his children or some other related individuals or he may desire to take advantage of the corporate e n t i t y by tr a n s f e r r i n g his properties to a corporation controlled by him. However, under the non-arm's length provisions of the Income Tax Act , an investor who transferred his property i n such a manner would be subject to tax on his unrealized c a p i t a l gains and recaptured c a p i t a l cost allowance. Consequently, most investors would be reluctant to undertake such actions. However, both the old Act and the new Act permitted, under limited conditions, the transfer of properties free of tax to certain related persons. These tax free rol l o v e r s of properties from one person to another include transfers of property by an i n d i v i d u a l to the following: 1. Canadian corporations owned 80% by the i n d i v i d u a l . 2. His spouse or a tr u s t on behalf of his spouse. 3. Heirs of the i n d i v i d u a l . Property Transfers by Individuals to Corporations Section 85.1 of the new Act provides that where a taxpayer af t e r 19 71 disposes of c a p i t a l property to a Canadian corporation of which immediately a f t e r the d i s p o s i -tion the taxpayer owns not less than 80% of the issued shares of each class of the c a p i t a l stock of the corporation, then the taxpayer and the corporation may j o i n t l y e l e c t on a prescribed form to s t i p u l a t e the proceeds of d i s p o s i t i o n and the corporation's cost of the property. U t i l i z a t i o n of t h i s section by a taxpayer and a corporation enables c a p i t a l gains accrued on property to be transferred without 10 8 Example 4.8 Tax Free Rollovers Individuals to Corporations Assumptions: 1. Individual A s e l l s 40 acres of land for 10,000 common shares to his wholly owned Canadian corporation B. 2. Adjusted cost base of land $ 50,000 3. Fa i r market value of land on date of sale 200,000 4. F a i r market value of the 10,000 shares 200,000 5. Transfer price agreed to i n the el e c t i o n 50,000 Calculation of c a p i t a l gains on d i s p o s i t i o n of land: Deemed proceeds of d i s p o s i t i o n (elected price) $ 50,000 Less: Adjusted cost base of"land 50,000 Capital gain deemed to be r e a l i z e d N i l Cost base of 40 acres of land to corporation B which i s equal to the elected price $ 50,000 Cost base of the 10,000 shares to A which i s equal to the elected price $ 50,000 109'-tax from an i n d i v i d u a l taxpayer to an 80% c o n t r o l l e d c o r p o r a t i o n . Without t h i s e l e c t i o n , the u n r e a l i z e d c a p i t a l gains would be deemed by the A c t to be r e a l i z e d and would t h e r e f o r e be t a x a b l e even though the taxpayer may own 1 0 0 % of the c o r p o r a t i o n . Example 4.8 demonstrates the tax advantages d e r i v e d from t h i s r o l l o v e r p r o v i s i o n of the new A c t . I n d i v i d u a l A i n Example 4.8 has u t i l i z e d the r o l l o v e r p r o v i s i o n s o f the new A c t i n order to t r a n s f e r l a n d owned by him to a wholly owned c o r p o r a t i o n without i n c u r r i n g tax on h i s u n r e a l i z e d c a p i t a l g a i n of $ 1 5 0 , 0 0 0 . A subsequent s a l e of the land f o r proceeds i n excess of i t s c o s t base of $50,000 w i l l r e s u l t i n a t a x a b l e c a p i t a l g a i n t o C o r p o r a t i o n B but not to I n d i v i d u a l A. I n d i v i d u a l A w i l l not be deemed to have r e a l i z e d a c a p i t a l g a i n u n t i l he d i s p o s e s o f the 10,000 shares f o r proceeds i n excess of t h e i r deemed c o s t of $50,000. In e f f e c t , I n d i v i d u a l A has exchanged 40 acres of land v a l u e d a t $200,000 and having a c o s t base of $50,000 f o r 10,000 common shares w i t h the same market v a l u e and c o s t base as the la n d . The r o l l o v e r p r o v i s i o n s of S e c t i o n 85.1 are s u b j e c t to s p e c i f i c c o n s t r a i n t s which govern the e l e c t e d t r a n s f e r p r i c e agreed upon by an i n d i v i d u a l and h i s c o n t r o l l e d c o r p o r a t i o n . I f t h i s agreed p r i c e exceeds the f a i r market value o f the p r o p e r t y t r a n s f e r r e d , then the A c t deems the e l e c t e d p r i c e t o be equal to t h a t f a i r market value ( 8 5 . 1 . c ) . T h i s c o n s t r a i n t prevents a c a p i t a l l o s s t h a t has accrued on p r o p e r t y of an i n d i v i d u a l from b e i n g t r a n s f e r r e d to a c o r p o r a t i o n as i s demonstrated i n Example 4.9. In Example 4.9, I n d i v i d u a l A c o u l d have t r a n s f e r r e d a c a p i t a l l o s s of $50,000 to h i s c o r p o r a t i o n i f t h i s r o l l o v e r c o n s t r a i n t d i d not e x i s t . The r o l l o v e r c o n s t r a i n t , however, causes the e l e c t e d t r a n s f e r p r i c e to be equal to the f a i r market v a l u e o f the land of $200,000. Consequently, the u n r e a l i z e d c a p i t a l l o s s o f $50,000 can not be t r a n s f e r r e d to the c o r p o r a t i o n but must be r e a l i z e d by I n d i v i d u a l A on the t r a n s f e r date. 110 Example 4.9 Rollovers of Ca p i t a l Losses Individuals to Corporations Assumptions: 1. Individual A s e l l s land to a wholly owned corporation for 5,000 common shares. 2. Adjusted cost base of land $250,000 3. F a i r market value of both land and shares 200,000 4. Elected price agreed upon by A and corporation 250,000 5/- Corporation s e l l s land 200,000 Sec. 85.1 No Constraint Constraint C a p i t a l loss incurred on r o l l o v e r of land: Deemed proceeds of d i s p o s i t i o n $200,000 $250,000 Less: Adjusted cost base 250,000 250,000 Capital loss incurred by A $ 50,000 N i l Cost base of land to corporation $200,000 $250,000 Cost base of 5,000 shares to-A $200,000 $250,000 Capi t a l loss incurred on d i s p o s i t i o n of land: Proceeds of d i s p o s i t i o n $200,000 $200,000 Less: Adjusted cost base 200,000 250,000 Capital loss incurred by corporation N i l $ 50,000 I l l A second r o l l o v e r constraint of the Act prevents the r e a l i z - a t i o n of a c a p i t a l gain with the transfer.-for consideration other than common shares of an 80% controlled corporation (85.1.b). If the consideration, other than common shares, which i s received for the property has a f a i r market value i n excess of the agreed p r i c e , then the elected price w i l l be deemed to be equal to that f a i r market value. Example 4.10 demonstrates the constraint over the elected price of a r o l l o v e r where the consideration excluding common shares has a f a i r market value i n excess of the price agreed upon by the i n d i v i d u a l and his corporation. Without the Section 85 r o l l o v e r constraint, Individual A in Example 4.10 could have r e a l i z e d a $50,000 tax free c a p i t a l gain on the land for consideration other than common shares (cash). Because of the constraint, Individual A has real i z e d a c a p i t a l gain of $50,000 which i s subject to tax and also the cost base of the common shares received by him has been reduced to zero. Although the constraints of Section 85 l i m i t the f l e x i b i l i t y of the r o l l o v e r provisions between indivi d u a l s and 80% controlled corporations, an i n d i v i d u a l can nevertheless transfer property to a 80% controlled corporation for any agreed price which does not exceed the f a i r market value of the property or which i s - not less than the f a i r market value of the consideration other than common shares. Section 85.1.e includes an additional r o l l o v e r constraint which i s s p e c i f i c a l l y related to depreciable property. If the proceeds of d i s p o s i t i o n of a depreciable property as determined by the general r o l l o v e r provisions of Section 85 are less than the lea s t of the following: 1. undepreciated c a p i t a l cost of the property 2. c a p i t a l cost of the property 3. f a i r market value of the property as of the r o l l o v e r date then the proceeds of d i s p o s i t i o n w i l l be deemed to be the Example 4.10 Tax Free Rollovers and Realized C a p i t a l Gains Individuals to Corporations Assumptions: 1. Individual A s e l l s land to his wholly owned corporation for 5,000 common shares and $100,000 i n cash. 2. F a i r market value of land $200,000 3. Adjusted cost base of land 50,000 4. Elected price agreed upon by A and corporation 50,000 Sec. 85.1 No Constraint Constraint-Capital gain r e a l i z e d on r o l l o v e r : Deemed proceeds of d i s p o s i t i o n $100,000 $ 50,000 Less: Adjusted cost base of land 50,000 50,000 Capi t a l gain r e a l i z e d by A $ 50,0 00 N i l Cost base of land to corporation $100,000 $ 50,000 Cost base of shares to A: Deemed proceeds of d i s p o s i t i o n $100,000 $ 50,000 Less: Consideration other than shares 100,000 100,000 Cost base of common shares N i l $ (50,0 00") 113 lesser of these three amounts. Example 4.11 demonstrates the application of t h i s constraint to a r o l l o v e r of depreciable property. Example 4.11 demonstrates that the r o l l o v e r price elected by the i n d i v i d u a l and the corporation w i l l only be deemed to be the proceeds of d i s p o s i t i o n i f i t exceeds the lesser of the c a p i t a l cost, undepreciated, c a p i t a l cost or the f a i r market value of the property. If the deemed proceeds exceed the undepreciated c a p i t a l cost of the property, then a recapture of c a p i t a l cost allowance occurs. A l t e r n a t i v e l y a terminal loss can be incurred i f the deemed proceeds are less than the undepreciated c a p i t a l cost of the property. F i n a l l y , the c a p i t a l cost of the depreciable property to the corporation i s the same as that of the in d i v i d u a l . If the deemed proceeds of d i s p o s i t i o n are less than t h i s c a p i t a l cost, then the corporation i s deemed to have claimed c a p i t a l cost allowance equivalent to the difference. If the property i s subsequently sold for more than i t s a c q u i s i t i o n cost, then i t w i l l be subject to tax on the recapture of t h i s deemed c a p i t a l cost allowance. Property Transfers by Taxpayer to Spouse The second type of tax free r o l l o v e r s of property which are permitted by the new Act consist of transfers of property from a taxpayer to his spouse. Section 7 3.1 of the new Act stipulates that a f t e r 1971, c a p i t a l property other than depreciable property i s deemed to have been disposed of at i t s adjusted cost base to the taxpayer i f i t i s transferred to his spouse or a tr u s t created by him under which his spouse i s the exclusive beneficiary of the income from the property during her l i f e t i m e . In turn, the spouse or tr u s t of the spouse i s also deemed to have acquired the property for t h i s same adjusted cost base. 114 E x a m p l e 4.11 Tax F r e e R o l l o v e r s o f D e p r e c i a b l e P r o p e r t y I n d i v i d u a l s t o C o r p o r a t i o n s C a s e 1 C a s e 2 A s s u m p t i o n s : E l e c t e d p r i c e o f t r a n s f e r r e d p r o p e r t y $100,000 $ 80,000 C o n s t r a i n t s o v e r deemed p r o c e e d s o f d i s p o s i t i o n : 1. U n d e p r e c i a t e d c a p i t a l c o s t $110,000 $110,000 2. C a p i t a l c o s t 150,000 150,000 3. F a i r m a r k e t v a l u e on-rollover 130,000 90,000 Deemed p r o c e e d s o f d i s p o s i t i o n : G r e a t e r o f - E l e c t e d p r i c e $100,000 $ 80,000 - L e s s e r o f 1, 2, o r 3 110,000 90,000 Deemed p r o c e e d s o f d i s p o s i t i o n $110,000 $ 90,000 R e c a p t u r e o f c a p i t a l c o s t a l l o w a n c e : Deemed p r o c e e d s o f d i s p o s i t i o n $110,000 $ 90,000 L e s s : U n d e p r e c i a t e d c a p i t a l c o s t 110,000 110,000 R e c a p t u r e ( t e r m i n a l l o s s ) N i l $ (20,000) C a p i t a l c o s t o f p r o p e r t y t o c o r p o r a t i o n w h i c h i s t h e same as t h a t o f i n d i v i d u a l $150,000 $150,000 C a p i t a l c o s t a l l o w a n c e deemed t o h a v e b e e n c l a i m e d b y c o r p o r a t i o n : C a p i t a l c o s t o f d e p r e c i a b l e p r o p e r t y $150,000 $150,000 L e s s : A c q u i s i t i o n c o s t 110,000 90,000 C a p i t a l c o s t a l l o w a n c e deemed t o h a v e b e e n c l a i m e d $ 40,000 $ 60,000 115 Consequently, c a p i t a l gains accrued on c a p i t a l p r o p e r t y o t h e r than d e p r e c i a b l e p r o p e r t y t h a t i s t r a n s f e r r e d to a spouse continues to remain f r e e of income taxes. However, c a p i t a l gains which are r e a l i z e d by the d i s p o s i t i o n of the p r o p e r t y t r a n s f e r r e d to the spouse w i l l be i n c l u d e d i n the t a x a b l e income of the taxpayer and not the income of the spouse (74.2). T h i s p r o v i s i o n prevents a taxpayer from t r a n s f e r r i n g a t a x a b l e c a p i t a l g a i n to h i s spouse who i s l i k e l y to be i n a much lower marginal tax b r a c k e t . A f u r t h e r r e s t r i c t i o n of the Act over p r o p e r t y r o l l o v e r s s t a t e s t h a t income from p r o p e r t y which i s t r a n s f e r r e d by a taxpayer to h i s spouse or a t r u s t of the spouse s h a l l be deemed to be income of the taxpayer (74.1). Thus n e i t h e r a r e a l i z e d c a p i t a l g a i n nor income from the a p p r e c i a t e d p r o p e r t y can be t r a n s -f e r r e d by a taxpayer to h i s spouse. A l s o , p r o p e r t y which i s s u b s t i t u t e d f o r t r a n s f e r r e d p r o p e r t y i s governed by these p r o v i s i o n s . Thus the r o l l o v e r p r o v i s i o n s governing t r a n s f e r s of c a p i t a l p r o p e r t y from a taxpayer to h i s spouse permit p r o p e r t y to be t r a n s f e r r e d without i n c u r r i n g income taxes but they do not e l i m i n a t e nor reduce the u l t i m a t e tax l i a b i l i t y on c a p i t a l gains or income from the t r a n s f e r r e d p r o p e r t y . D e p r e c i a b l e p r o p e r t y t r a n s f e r r e d by a taxpayer to h i s spouse or a t r u s t of h i s spouse i s deemed to have been dis p o s e d f o r i t s undepreciated c a p i t a l c o s t to the taxpayer (73.1.c). The spouse i s a l s o deemed to have a c q u i r e d the t r a n s f e r r e d p r o p e r t y at t h i s same undepreciated c a p i t a l c o s t . In a d d i t i o n , the c a p i t a l c o s t of the p r o p e r t y to the spouse i s a l s o deemed to be equal to the c a p i t a l c o s t of the p r o p e r t y to the taxpayer (73.2). T h i s l a t t e r p r o v i s i o n ensures t h a t any c a p i t a l c o s t allowance which was claimed by the taxpayer t h a t i s r e c a p t u r e d on a subsequent d i s p o s i t i o n w i l l be s u b j e c t to tax. C a p i t a l gains r e a l i z e d on d i s p o s i t i o n o f the d e p r e c i a b l e p r o p e r t y and income earned by the p r o p e r t y are i n c l u d e d i n the income of the 116 taxpayer and not the income of the spouse. Thus d e p r e c i a b l e p r o p e r t y l i k e o t h e r c a p i t a l p r o p e r t y can be t r a n s f e r r e d by a taxpayer to h i s spouse without i n c u r r i n g income taxes on the t r a n s f e r but r e a l i z e d c a p i t a l gains and o t h e r income of the p r o p e r t y i s t a x a b l e income of the taxpayer, not the spouse. Pr o p e r t y T r a n s f e r s by I n d i v i d u a l s to T h e i r H e i r s An i n d i v i d u a l taxpayer who d i e s on or a f t e r January 1, 1972 i s c o n s i d e r e d by the new Act to have dis p o s e d of each c a p i t a l p r o p e r t y owned by him immediately b e f o r e h i s death (70.5). The proceeds of d i s p o s a l to the taxpayer and the a c q u i s i t i o n c o s t t o the h e i r s of c a p i t a l p r o p e r t y other than d e p r e c i a b l e p r o p e r t y i s deemed to be the f a i r market value of the p r o p e r t y a t time of death. Consequently no tax f r e e r o l l o v e r o f non-depreciable c a p i t a l p r o p e r t y i s p e r m i t t e d by the new A c t . A l l c a p i t a l gains and l o s s e s accrued on non-depreciable p r o p e r t y are deemed to be r e a l i z e d a t time of death and are t h e r e f o r e s u b j e c t to income taxes. The new A c t permits a l i m i t e d tax f r e e r o l l o v e r of d e p r e c i a b l e p r o p e r t y . D e p r e c i a b l e p r o p e r t y i s deemed to have been di s p o s e d of immediately p r i o r to death f o r an amount t h a t i s midway between the undepreciated c a p i t a l c o s t of the p r o p e r t y and i t s f a i r market value (70.5.b). C a p i t a l g a i n s , r e c a p t u r e of c a p i t a l c o s t allowance and t e r m i n a l l o s s e s are based on t h i s c a l c u l a t e d amount. H e i r s of the deceased are deemed to have a c q u i r e d . t h e d e p r e c i a b l e p r o p e r t y a t a c o s t equal to the c a l c u l a t e d amount, however i f the c a l c u l a t e d amount i s l e s s than the c a p i t a l c o s t of the p r o p e r t y to the deceased then the h e i r s are a l s o deemed to have a c q u i r e d the p r o p e r t y a t a c a p i t a l c o s t equal to t h a t of the deceased (70.5.e). T h i s l a t t e r p r o v i s i o n means t h a t c a p i t a l gains 117 and c a p i t a l cost allowance recaptures r e s u l t i n g from future dispositions w i l l be based on the c a p i t a l cost of the property to the deceased. Example 4.12 demonstrates the tax implications of bequests of depreciable property. Example 4.12 demonstrates that part of the tax on c a p i t a l gains accrued on depreciable property at time of death can be deferred. In Case 1, a substantial portion of the c a p i t a l gain i s transferred tax free to the heirs of the taxpayer as i s shown below: Fai r market value of property at date of death $170,000 Less: C a p i t a l cost 100,000 Actual c a p i t a l gain at date of death 70,000 Less: C a p i t a l gain deemed to be r e a l i z e d 10,000 Capital gain transferred tax free to heirs $ 60,000 If the depreciable property of Case 1 i s subsequently sold for proceeds that are greater than i t s a c q u i s i t i o n cost of $110,000 then a l l or part of the transferred c a p i t a l gain w i l l be subject to tax. Capital cost allowance, claimed by the deceased on his depreciable property, which i s not recaptured at the date of death w i l l be subject to tax at a l a t e r date i f the heirs s e l l the property for an amount i n excess of t h e i r a c q u i s i t i o n cost. In Case 2 of Example 4.12 a l l or part of the $40,000 ($100,000 - $60,000) of c a p i t a l cost allowance which i s not recaptured at date of death w i l l be taxable i f the heirs s e l l the property for more than t h e i r a c q u i s i t i o n cost of $60,000. The general provisions of the new Act described above do not apply to c a p i t a l property bequeathed to a spouse or a trust on behalf of a spouse of the taxpayer. The tax treatment afforded property l e f t to a spouse (or trust) are b a s i c a l l y the same as those provisions governing transfers of c a p i t a l property to a spouse during the taxpayer's l i f e t i m e . C a pital property other than depreciable 118 Example 4.12 Tax Free Rollovers Bequests of Depreciable Property Case 1 Case 2 Case 3 Assumptions: 1. U.C.C. at date of death $ 50,000 $ 50,000 $ 50,000 2. F.M.V. at date of death 170,000 70,000 30,000 3. Cap i t a l cost of property 100,000 100,000 100,000 Deemed proceeds of d i s p o s i t i o n to deceased and ac q u i s i t i o n cost to he i r s : U.C.C. $ 50,000 $ 50,000 $ 50,000 Add (deduct) h of excess (deficiency) of F.M.V. over the U.C.C. 60,000 10,000 (10,000) $110,000 $ 60,000 $.40,000 Calculation of re a l i z e d c a p i t a l gains at time of death: Deemed proceeds of disposition$110,000 $ 60,000 $ 40,000 Less: Capital cost Capital gain 100, $ 10, 000 000 100,000 N i l 100,000 N i l Recapture of c a p i t a l cost-allowance (terminal loss) : Lesser of deemed proceeds of dis p o s i t i o n or c a p i t a l cost $100,000 $ 60,000 $ 40,000 Less: U.C.C. 50,000 50,000 50,000 Recapture of c a p i t a l cost allowance (terminal loss) $ 50,000 $ 10,000 $ (10,000) 119 p r o p e r t y i s deemed to have been d i s p o s e d by the deceased taxpayer and to have been a c q u i r e d by the spouse (or t r u s t ) at i t s a d j u s t e d c o s t base to the deceased taxpayer (70.6). D e p r e c i a b l e p r o p e r t y i s deemed to have been d i s p o s e d by the deceased and a c q u i r e d by h i s spouse a t i t s u n d e p r e c i a t e d c a p i t a l c o s t (70.6). Where t h i s u ndepreciated c a p i t a l c o s t i s l e s s than the c a p i t a l c o s t of the p r o p e r t y to the deceased taxpayer then f o r purposes of determining c a p i t a l gains and c a p i t a l c o s t allowance, r e c a p t u r e s , the c a p i t a l c o s t of the p r o p e r t y to the spouse i s deemed to be t h a t of the deceased. These p r o v i s i o n s enable a taxpayer to bequeath h i s c a p i t a l p r o p e r t y to h i s spouse (or t r u s t ) completely f r e e oH income taxes. No income taxes w i l l be i n c u r r e d by the spouse (or t r u s t ) on c a p i t a l gains accrued on the p r o p e r t y u n t i l the spouse d i s p o s e s of the p r o p e r t y or u n t i l her death. Income earned by the p r o p e r t y d u r i n g her l i f e t i m e w i l l be i n c l u d e d i n her t a x a b l e income. The r o l l o v e r p r o v i s i o n s which apply to bequests of c a p i t a l p r o p e r t y which have been d e s c r i b e d above d i f f e r g r e a t l y from t h e . r o l l o v e r p r o v i s i o n s of the o l d A c t . Under the o l d A c t , p r o p e r t y of a deceased taxpayer was not deemed to have been t r a n s f e r r e d to h i s h e i r s a t i t s f a i r market value.(O.A. 20.6.d). Consequently a deceased taxpayer c o u l d a v o i d completely the tax on c a p i t a l c o s t allowance r e c a p t u r e by d i s p o s i n g of d e p r e c i a b l e p r o p e r t y i n h i s w i l l a t i t s u n d e p r e c i a t e d c a p i t a l c o s t . V a l u a t i o n o f p r o p e r t y bequests had no e f f e c t on the t a x a t i o n of c a p i t a l gains s i n c e such c a p i t a l gains were not t a x a b l e under the o l d A c t . The p r o p e r t y a c q u i r e d by the h e i r s was deemed by the o l d A c t to be a c q u i r e d by them at i t s f a i r market v a l u e i r r e g a r d l e s s o f the d i s p o s i t i o n v a l u e used by the deceased (0.A. 20.6.c). T h i s l a t t e r p r o v i s i o n enabled the h e i r s to c l a i m c a p i t a l c o s t allowance on d e p r e c i a b l e p r o p e r t y which may have been f u l l y d e p r e c i a t e d by the deceased taxpayer. Example 4.13 demonstrates the s i g n i f i c a n t advantages of the 120 r o l l o v e r p r o v i s i o n s of the o l d A c t which governed bequests of d e p r e c i a b l e p r o p e r t y over the r o l l o v e r p r o v i s i o n s of the new A c t . Example 4.13 shows t h a t under the o l d Act c a p i t a l gains were not s u b j e c t to income taxes so t h a t an u n r e a l i z e d c a p i t a l g a i n of $70,000 on the d e p r e c i a b l e p r o p e r t y was not t a x a b l e i n the hands of the deceased nor i n those of the h e i r s . However under the new A c t , a l l of t h i s c a p i t a l g a i n c o u l d be s u b j e c t to income taxes. Since the d e p r e c i a b l e p r o p e r t y i s deemed to have been d i s p o s e d f o r $110,000, $10,000 of the u n r e a l i z e d c a p i t a l g a i n i s t h e r e f o r e deemed to have been r e a l i z e d by the deceased of which $5,000 w i l l be added to the ta x a b l e income of the deceased. The d i s p o s i t i o n of the p r o p e r t y f o r $170,000 by the h e i r s w i l l r e s u l t i n the remainder of the u n r e a l i z e d c a p i t a l g a i n o f $60,000 to be deemed to have been r e a l i z e d by the h e i r s o f which $30,000 w i l l be added to the t a x a b l e income o f . t h e h e i r s . Under the o l d A c t , the tax on c a p i t a l c o s t allowance r e c a p t u r e s c o u l d be avoided completely whereas a l l of the recaptur e c o u l d be ta x a b l e under the new A c t . Under the o l d A c t i n Example 4.13, the deceased taxpayer c o u l d t r a n s f e r h i s d e p r e c i a b l e p r o p e r t y having a f a i r market value of $170,000 to h i s h e i r s a t i t s undep r e c i a t e d c a p i t a l c o s t of o n l y $50,000. A c c o r d i n g l y , no r e c a p t u r e of c a p i t a l c o s t allowance was deemed to have o c c u r r e d . However the h e i r s were deemed to have a c q u i r e d the d e p r e c i a b l e p r o p e r t y f o r $170,000 and c o u l d t h e r e f o r e begin to take c a p i t a l c o s t allowance on t h i s amount. Under the new Ac t , the deceased taxpayer i s deemed to have r e c a p t u r e d $50,000 of c a p i t a l c o s t allowance which i s f u l l y t a x a b l e . A l s o the h e i r s are deemed to have a c q u i r e d the d e p r e c i a b l e p r o p e r t y f o r on l y $100,000 upon which they may base t h e i r c a p i t a l c o s t allowance c l a i m s . In summary, Example 4.13 demonstrates t h a t a d e p r e c i a b l e 121 Example 4.13 Comparison of the Rollover Provisions Governing Bequests of Depreciable Property under the old and new Acts Old Act New Act Assumptions: 1. U.C.C. of property at date of death $ 50, 000 $ 50, 000 2. F.M.V. of property at date of death 170, 000 170, 000 3. Capital cost of property to deceased 100, 000 100, 000 4. Proceeds to heir from d i s p o s i t i o n 170, 000 170, 000 Tax Consequences to Deceased: Deemed proceeds of di s p o s i t i o n to deceased: U.C.C. of property $ 50, 000 $ 50, 000 Add h of excess of F.M.V. over U.C.C. n/ a 60, 000 Deemed proceeds of d i s p o s i t i o n $ 50, 000 $110, 000 Calculation of taxable c a p i t a l gains at time of death: Deemed proceeds of d i s p o s i t i o n $ 50, 000 $110, 000 Less: C a p i t a l cost 100, 000 100, 000 Capital gains deemed to be re a l i z e d Ni 1 $ 10, 000 Taxable c a p i t a l gains (h) N i l $ 5, 000 Recapture of c a p i t a l cost allowance: Lesser of deemed proceeds or c a p i t a l c. $ 50, 000 $100, 000 Less: U.C.C. of property 50, 000 50, 000 Recapture of c a p i t a l cost allowance Ni 1 $ 50, 000 Tax Consequences to Heir: Calculation of taxable c a p i t a l gain: Proceeds of actual d i s p o s i t i o n $170, 000 $170, 000 Less: Deemed c a p i t a l cost to heir 170, 000 110, 000 Ca p i t a l gain r e a l i z e d Ni 1 $ 60, 000 Taxable c a p i t a l gain (h) Ni 1 $ 30, 000 Recapture of c a p i t a l cost, allowance: Lesser of proceeds or deemed c a p i t a l c. $170, 000 $100, 000 Less: U.C.C. of property 170, 000 100, 000 Recapture of c a p i t a l cost allowance Ni 1 Ni 1 Summary of additions to income caused by bequest,and subsequent.disposition: To Deceased: Taxable c a p i t a l gain Ni 1 $ 5, 000 Recapture of c a p i t a l cost allowance Ni 1 50, 000 Ni 1 $ 55, 000 To Heir: Taxable c a p i t a l gain Ni 1 $ 30, 000 Total additions to income subject to tax Ni 1 $ 85, 000 122 p r o p e r t y having an u n r e a l i z e d c a p i t a l g a i n of $70,000 and claimed c a p i t a l c o s t allowance of $50,000 c o u l d be t r a n s f e r -red f r e e o f income taxes by a deceased taxpayer to h i s h e i r s under the o l d A c t . Under the new A c t , the deceased taxpayer would i n c u r a t a x a b l e c a p i t a l g a i n of $5,000 and a r e c a p t u r e o f c a p i t a l c o s t allowance of $50,000. In a d d i t i o n , the h e i r s would i n c u r a t a x a b l e c a p i t a l g a i n of $30,000 upon d i s p o s i t i o n of the d e p r e c i a b l e p r o p e r t y . In t o t a l , income taxes must be p a i d on t a x a b l e income of $85,000 which i s one h a l f of the f a i r market value of the d e p r e c i a b l e p r o p e r t y i n Example 4.13. 123 CONCLUSION The new Income Tax Act has made s p e c i a l p r o v i s i o n s f o r i n v o l u n t a r y d i s p o s i t i o n s , o p t i o n s , non-arm's l e n g t h t r a n s -a c t i o n s , and tax f r e e r o l l o v e r s which have a major e f f e c t on many r e a l e s t a t e investments. An i n v o l u n t a r y d i s p o s i t i o n of a p r o p e r t y through e x p r o p r i a t i o n o r d e s t r u c t i o n would normally s u b j e c t any u n r e a l i z e d c a p i t a l gains a c c r u i n g on the p r o p e r t y to be t a x a b l e even i f a l l of the proceeds were used to a c q u i r e a s i m i l a r p r o p e r t y . To a l l e v i a t e t h i s obvious i n j u s t i c e , the new A c t p r o v i d e s t h a t the tax on the c a p i t a l g a i n can be d e f e r r e d i f the proceeds of the i n v o l u n t a r y d i s p o s i t i o n are r e i n v e s t e d i n another p r o p e r t y . In a mortgage f o r e c l o s u r e , the mortgagor i s deemed to have r e c e i v e d proceeds f o r h i s p r o p e r t y equal to the amount of the mortgage claims a t the date of f o r e c l o s u r e . Any subsequent amounts p a i d by the mortgagor to the mortgagee are deemed c a p i t a l l o s s e s of the mortgagor i n the year of payment. The mortgagee does not i n c u r any c a p i t a l gains or l o s s e s u n t i l he f i n a l l y d isposes of the f o r e c l o s e d p r o p e r t y . With the advent of t a x a b l e c a p i t a l g a i n s , the tax treatment of o p t i o n s i s an important c o n s i d e r a t i o n to r e a l e s t a t e i n v e s t o r s . A p r o p e r t y owner who r e c e i v e s money f o r g r a n t i n g an o p t i o n to purchase h i s p r o p e r t y i s deemed to have r e a l i z e d a c a p i t a l g a i n equal to the monies r e c e i v e d s i n c e the c o s t base of' the o p t i o n granted i s deemed to be zero. These o p t i o n monies w i l l o n l y be deemed to be p a r t o f the s a l e pro-ceeds of the p r o p e r t y i f and when the o p t i o n i s e x e r c i s e d . Money p a i d f o r an o p t i o n to purchase e i t h e r becomes a c a p i t a l l o s s upon e x p i r a t i o n of the o p t i o n or becomes p a r t of the c o s t base of the p r o p e r t y when the o p t i o n i s e x e r c i s e d . The income tax i m p l i c a t i o n s under the new A c t of non-arm's l e n g t h t r a n s a c t i o n s are of c r u c i a l importance to r e a l e s t a t e i n v e s t o r s . A p p r e c i a t e d p r o p e r t y t r a n s f e r r e d between r e l a t e d persons at a p r i c e below f a i r market va l u e w i l l be deemed to have been s o l d by the vendor at t h a t f a i r market value but the p r o p e r t y w i l l be deemed to have been a c q u i r e d by the purchaser a t the a c t u a l p r i c e p a i d . Consequently, the o r i g i n a l owner w i l l be deemed to have r e a l i z e d completely the u n r e a l i z e d c a p i t a l g a i n but the new owner co u l d a l s o r e a l i z e the same gai n i f he s e l l s the p r o p e r t y f o r more than h i s low a c q u i s i t i o n c o s t . Thus a c a p i t a l g a i n c o u l d be s u b j e c t t o tax twice i f the p r o p e r t y i s t r a n s f e r r e d between r e l a t e d persons a t an amount below f a i r market v a l u e . An attempt to t r a n s f e r a c a p i t a l l o s s from one r e l a t e d person to another c o u l d r e s u l t i n t t h e M o s s of an otherwise d e d u c t i b l e c a p i t a l l o s s . The purchaser i s deemed by the A c t to have a c q u i r e d the p r o p e r t y a t i t s f a i r market v a l u e and not i t s i n f l a t e d a c q u i s i t i o n c o s t so t h a t subsequent d i s p o s i t i o n a t the same f a i r market value w i l l not i n c u r a c a p i t a l l o s s . On the other hand, the s e l l e r w i l l be deemed to have r e c e i v e d proceeds equal to the i n f l a t e d p r i c e . A l l or p a r t of an a c t u a l c a p i t a l l o s s c o u l d w e l l be e l i m i n a t e d by t h i s s a l e of p r o p e r t y i n excess of -fair market v a l u e . The o v e r a l l r e s u l t i s t h a t a tax d e d u c t i b l e c a p i t a l l o s s can not be u t i l i z e d by e i t h e r taxpayer-buyer or s e l l e r . Under the new Act t r a n s f e r s of d e p r e c i a b l e p r o p e r t y between r e l a t e d persons can i n c u r s u b s t a n t i a l income taxes which were not i n c u r r e d under the o l d A c t . Under the o l d A c t , d e p r e c i a b l e p r o p e r t y was deemed to have been s o l d f o r the a c t u a l proceeds r e c e i v e d and to be a c q u i r e d a t the s e l l e r ' s u ndepreciated c a p i t a l c o s t . The p r o p e r t y ' s undepre-c i a t e d c a p i t a l c o s t was deemed to equal the proceeds p a i d . Consequently, u n r e a l i z e d c a p i t a l gains c o u l d be completely t r a n s f e r r e d to r e l a t e d person and, depending upon the a c t u a l p r i c e o f the d e p r e c i a b l e p r o p e r t y , a l l or p a r t of the c a p i t a l c o s t allowance claimed c o u l d a v o i d r e c a p t u r e . Under the new A c t , the t r a n s f e r of d e p r e c i a b l e p r o p e r t y between r e l a t e d persons i s deemed to have o c c u r r e d a t i t s f a i r market v a l u e . Consequently the s u b s t a n t i a l income taxes on u n r e a l i z e d 125 c a p i t a l gains and c a p i t a l c o s t allowance r e c a p t u r e s can not be avoided nor d e f e r r e d as was the case under the o l d A c t . The new Income Tax Act s t i p u l a t e s c e r t a i n s i t u a t i o n s where a taxpayer can r o l l o v e r p r o p e r t y to o t h e r persons w i t h -out i n c u r r i n g an income tax l i a b i l i t y . An i n d i v i d u a l can t r a n s -f e r p r o p e r t y to a c o r p o r a t i o n i n exchange f o r shares without r e a l i z i n g a c a p i t a l g a i n on the p r o p e r t y p r o v i d e d t h a t he owns 80% of every c l a s s of share of the c o r p o r a t i o n . The shares w i l l have a c o s t base equal t o the o l d c o s t base of the t r a n s f e r r e d p r o p e r t y so t h a t subsequent d i s p o s i t i o n of the shares w i l l r e s u l t i n a t a x a b l e c a p i t a l g a i n even i f the c o r p o r a t i o n s t i l l r e t a i n s the p r o p e r t y . P r o p e r t y can be t r a n s -f e r r e d by a taxpayer to h i s spouse under the new A c t without the c a p i t a l gains accrued thereon being deemed to have been r e a l i z e d . However subsequent d i s p o s i t i o n o o f the p r o p e r t y by the spouse w i l l cause the c a p i t a l g a i n to be r e a l i z e d by the taxpayer and not by the spouse f o r tax purposes. P r o v i s i o n s of the new A c t a l s o ensure t h a t any c a p i t a l gains or c a p i t a l c o s t allowance r e c a p t u r e s caused by d i s p o s i t i o n by the spouse w i l l a l s o be deemed to be r e a l i z e d by the tax-payer r a t h e r than the spouse. F i n a l l y , a taxpayer can o b t a i n l i m i t e d tax r e l i e f by d i s p o s i n g of h i s p r o p e r t y through h i s w i l l . P r o p e r t y l e f t to h i s spouse or a t r u s t on b e h a l f of h i s spouse i s deemed to have been s o l d by him and a c q u i r e d by h e r i a t i t s a d j u s t e d c o s t base to the deceased. The tax on u n r e a l i z e d c a p i t a l gains and r e c a p t u r e d c a p i t a l c o s t allowance i s d e f e r r e d u n t i l subsequent d i s p o s i t i o n by the spouse or u n t i l her death. C a p i t a l p r o p e r t y , o t h e r than d e p r e c i a b l e p r o p e r t y , bequeathed to h e i r s other than the taxpayer's spouse i s deemed to have been di s p o s e d a t t h e i r f a i r market va l u e . U n r e a l i z e d c a p i t a l gains w i l l t h e r e f o r e f i n a l l y be s u b j e c t to income taxes under the new A c t . Under the o l d A c t , none of the c a p i t a l gains a c c r u i n g on.bequeathed p r o p e r t y would have been s u b j e c t to income taxes. D e p r e c i a b l e p r o p e r t y i s a l s o deemed to have been di s p o s e d of at date of death, but a t a 126 : reduced p r i c e . Deemed proceeds o f d i s p o s i t i o n f o r d e p r e c i a b l e p r o p e r t y are the amount midway between the undepreciated c a p i t a l c o s t o f the p r o p e r t y and i t s f a i r market v a l u e . R e a l i z e d c a p i t a l gains and c a p i t a l c o s t'allowance r e c a p t u r e s are based on t h i s d e s i g n a t e d amount. However, subsequent d i s p o s i t i o n o f the d e p r e c i a b l e p r o p e r t y by the h e i r s , f o r proceeds i n excess of the desi g n a t e d amount, w i l l r e s u l t i n f u r t h e r amounts of the p r e v i o u s l y u n r e a l i z e d c a p i t a l g a i n or untaxed c a p i t a l c o s t allowance r e c a p t u r e s being s u b j e c t to t a x a t i o n . The- tax i m p l i c a t i o n s f o r bequeathed d e p r e c i a b l e p r o p e r t y are immense under the new A c t e x p e c i a l l y when i t i s co n s i d e r e d t h a t under the o l d A c t , n e i t h e r u n r e a l i z e d c a p i t a l gains nor c a p i t a l c o s t allowance r e c a p t u r e s were s u b j e c t to t a x a t i o n when d e p r e c i a b l e p r o p e r t y was bequeathed. 127 Bibliography Analysis of the Canadian Tax Reform B i l l 1971, Don M i l l s , Ontario: C. C. H. Canadian Limited, 1971. Asper, I. H. The Benson Iceberg:. A c r i t i c a l analysis of the White Paper on tax reform i n Canada, Toronto: Clarke, Irwin & Company, 19 70. Canadian Income Tax Act 39 E d i t i o n , Don M i l l s , Ontario: C. C. H. Canadian Limited, 19 70. Canadian Master Tax Guide 26 E d i t i o n , Don M i l l s , Ontario: C. C. H. Canadian Limited, 1971. Canadian Tax Reform B i l l C-259 1971, Don M i l l s , Ontario: C. C. H. Canadian Limited, 1971. Capital Gains - Tax Reform and You, Department of National Revenue - Taxation, Government of Canada, 1972. Corporate Tax Guide, Department of National Revenue -Taxation, Government of Canada, 19 72. Explanation of Canadian Tax Reform, Don M i l l s , Ontario: C. C. H. Canadian Limited, 1972. Hughes, Percy F. & Tingley, K. R. Taxation of Capital Gains  Second E d i t i o n , London: Taxation Publishing Company Limited, 1969. McDonald, John G. Capital Gains and Losses - Canadian Royal  Commission on Taxation, Toronto: Butterworth & Co. (Canada) Ltd., 1968. McDonald, John G. Income and Deductions - Canadian Royal  Commission on Taxation, Toronto: Butterworth & Co. (Canada) Ltd., 1968. Smith, Dan T. Tax Factors i n Business Decisions, Englewood C l i f f s , New Jersey: Prentice H a l l , 1968. Tomorrow's Taxes, Toronto: Clarkson Gordon & Co. for The Canadian Institute of Chartered Accountants, 19 72. Ward, David A. Current Tax Planning, Toronto: The Carswell Company Limited, 1972. 

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