By George E. Dube, CPA, CA
Selling a property is an opportunity for you as an investor, but it can also be an opportunity for the Canada Revenue Agency (CRA). A relatively recent court case provides an interesting read for real estate investors on this very point. The case focuses on income versus capital treatment, but more importantly provides two key lessons for real estate investors on the importance of reliable records and integrity.
Property Sale Leads to Court Case
Belcourt Properties Inc. (Belcourt) took the position that the sale of some commercial units sold within a predominantly residential condo development, despite being sold relatively shortly after the development and shortly after the sale of the residential units, should be treated as capital versus income. Effectively, Belcourt was looking for a capital gain, which was only 50% taxable, as compared to full income inclusion (being taxed on the entire proceeds of the sale). The CRA reassessed Belcourt, after which Belcourt brought the matter to court after losing their objection with the CRA and the original auditor.
Capital versus Income
The judge provided a summary of the major criteria determining whether the sale of a property should be considered a capital or an income transaction. The focus of these criteria is determining the initial intention of the taxpayer. More specifically:
- whether taxpayers should be considered to be in the business of buying and selling real estate
- whether the intention was to acquire the property and earn income from the rental income, or
- if the property transactions could be classified as “an adventure in the nature of trade” and thus be considered income.
With regards to an adventure in the nature of trade, the judge quoted well-recognized court cases providing the historical guidance still used today: Was the asset acquired by the taxpayer as an investment or was it not? From a tax perspective this recognizes that someone may not be in the business of regularly selling real estate, for example. But, even an isolated transaction which is done with the intent of selling the real estate as compared to earning rental income over the years can be designated as “an adventure in the nature of trade” and thus treated as income.
Some of the criteria listed in determining whether a gain is from income or capital include:
- Nature of the property sold (raw land on the outskirts of a city, for example, are more challenging to realize rental income)
- Length of period of ownership (the longer it is, the more likely it’s intended for long-term ownership/realization of rents)
- Frequency or number of other similar transactions (your past is an indicator of your future)
- Work expended on or in connection with the property realized (efforts to make property more saleable or efforts to sell property/find buyers)
- Circumstances responsible for sale of property (emergencies such as health concerns or need for cash, or opportunities such as an unsolicited offer)
- Motive (the intention of the taxpayer at the time of acquisition primarily weighed by the facts of the case and further noted as the most important of all criteria, i.e. Did the taxpayer intend on making profits from rental income or sale proceeds?)
We often speak about intention and its importance in determining whether a sale should be treated as capital versus income. What was your intention for the purchase of the property? To sell it? To rent it?
Intention however has what I call an evil twin - the concept of “secondary intention”. This essentially covers whether you, at the time of acquisition, had a secondary plan of selling the property if the first intention of renting the asset fails to be realized for whatever reason. I’ve yet to meet a serious investor who hasn’t considered a worst case scenario of selling a property which is why I call secondary intention the evil twin.
So, then, you must ask whether this “alternative” thought process was important to the decision in originally acquiring the property.
Belcourt Wins: Reliable Records and Integrity Rule
Overall, the judge specifically noted that the CRA failed to properly argue the criteria of secondary intention. The judge viewed the taxpayer and witness testimony as credible and ruled in favour of Belcourt. Although each side presented many facts and had the opportunity to win or lose, proper accounting and record keeping allowed Belcourt to confidently make the arguments needed. Belcourt’s integrity also helped to carry the day.
10 Key Points for Investors from the Belcourt Case
What can you as an investor learn from the Belcourt Case about protecting yourself? Make note of these 10 key points. I have highlighted the ones specifically related to Integrity and Credibility and Reliable Records:
- Reliable Records: The accounting records clearly segregated the properties designated as long-term rental properties from those available for sale.
- Integrity and Credibility: Although Belcourt had a history of selling properties, they also had a history of owning and renting properties during one owner’s 60 year history of dealing with real estate.
- Integrity and Credibility: The CRA failed to produce evidence related to the period of ownership but rather focused on the time between the last residential unit sold and the following commercial unit. This was potentially a gift for the taxpayer as no link was established to the taxpayer’s thoughts at the time of acquisition.
- The fact that the taxpayer had a business of buying and selling real estate doesn’t mean they cannot have property for rental purposes.
- The properties in question were in good locations for rental purposes and over the ownership period showed increasing rental revenues.
- The CRA did not specifically allege the possibility of “secondary intention” when assessing the taxpayer nor when completing initial pleadings. As a result, the taxpayer was spared the requirement to defend this argument but rather forced the CRA to establish that a secondary intention existed.
- Integrity and Credibility: The judge placed a degree of reliance on the perceived integrity of the taxpayer and witnesses, and gave their positions more credence.
- Integrity and Credibility: The taxpayer was able to position the sales as unforeseen opportunities or requirements versus being the result of an initial plan.
- Reliable Records: The CRA attacked the inconsistent, and possibly unknowledgeable, tax and accounting reporting of a co-venturer whose accountant treated the transaction as income.
- Credibility: The CRA appeared confused about standard practises related to joint-venture agreements. This hurt their case and provides more evidence of the benefits to you of having specialized knowledge.
View the case here.
George E. Dube, CPA, CA is a veteran real estate investor and accountant. He has spoken, written various articles, and co-authored two books on real estate accounting. Reach George at: firstname.lastname@example.org or @georgeEdube.