By George Dube
My rental property was destroyed in the Fort McMurray fires. We are expecting our insurance policy to cover the damages, but how do I record the losses and insurance money on my tax return?
The tax treatment of insurance money is one more thing to add to the list of many, many questions that have been coming from those affected by the Fort McMurray fires. While the Canada Revenue Agency (CRA) provides some technically complex rules covering situations where a property is destroyed, or substantially damaged, the result is generally in your favour as the taxpayer. However, the following article only highlights key points of the complex rules, many of which you need to be aware of now, even though the process of rebuilding will take many months. I highly recommend talking with your advisors.
Strange terms for a tough situation
First off, and as strange as this sounds, when your property is destroyed, you are deemed to have disposed of it (i.e. sold it). The proceeds of disposition are the insurance funds. So, your costs for calculating any capital gain or recapture (taking back into income previously claimed capital cost allowance or depreciation) are calculated in the same way they are when you sell a property. Absent special rules, someone can actually show a taxable profit when their property is destroyed.
Special rules for replacement property
But, the CRA has special rules that are designed to defer any taxes owing provided that a replacement property is acquired within 24 months after the tax year in which the involuntary disposition occurred.
Further, the replacement property must cost more than the insurance proceeds.
In tax speak:
Where the various requirements are met, the proceeds of disposition for the original property are reduced by the amount of the capital gain/recapture otherwise triggered. The deferred recapture and capital gains would reduce the capital cost or undepreciated capital cost (UCC) respectively of the replacement property.
But what does this mean in English?
The new property will have less capital cost allowance (CCA commonly thought of as depreciation) available with the reduction. But, the taxes that would be otherwise owing on the involuntary disposition are deferred. Similarly, the capital cost on the new property will be reduced by the deferred capital gain. This means that ultimately, when selling the replacement property in the future, you will effectively pay taxes on the normal capital gain youd otherwise pay on the property, plus the tax gain on the original property just as youll pay taxes on the old and new propertys recapture.
For you to benefit from these tax deferral opportunities, you must file a tax election for the CRAs approval.
Timing is everything
From a timing perspective, the date the property is deemed to have been involuntarily disposed is not necessarily the day of the disaster. Instead the date can be delayed to the earliest of a series of events/conditions, the most common of which are:
- The day you agreed to an insurance amount as full compensation
- The day on which your compensation is finally determined by a court or tribunal
- Two years following the day of the loss or destruction if no claim, suit appeal or other proceeding is launched by that date
These time frames are particularly important in considering when a replacement property is acquired so you have time to take advantage of the involuntary disposition and replacement property rules. Lets look at two scenarios:
- You buy or build the replacement property in 2017, the year after the property was deemed to be involuntarily sold, which happened in 2016. The 2016 tax return will show a capital gain and recapture on the deemed disposition. You have to pay any related taxes or provide security to the CRA that is acceptable. In the following period when the replacement property is acquired, the 2017 year tax return would consider the rules as if they were followed in the first place, the tax election is filed and the original 2016 return must be adjusted to then be refunded any taxes.
- You buy or build the replacement property in 2016, the same year the original property was deemed to be involuntarily sold. In this case, the deemed disposition, the tax election, and the application of the capital gains and recapture all occur on the 2016 tax return. This is clearly easier, particularly because you avoid the problem of paying the taxes on a temporary basis or providing acceptable security to the CRA.
Claiming deductions when vacant, under construction, or under major renovations
A word of caution about claiming deductions on a property for interest, utilities and property taxes, as examples, when the property is under construction or being renovated. The Income Tax Act forces the capitalization of soft costs (i.e. the costs must be added to the cost of the property and depreciated over time) in these cases. Generally if a rental unit is unavailable for rent, this rule applies. Vacancies can be red flags for these tax provisions. Repairs and minor renovations are excluded from these rules, but this application can be somewhat subjective, particularly with respect to defining the period of time the rules should be applied. These requirements preserve the total deductions otherwise available, but force you to take the deductions over time.
Please ensure you have discussed the specifics of the rules for your situation to avoid unexpected results or missed opportunities. The rules are complex, and the above is very general and intentionally omits some detailed requirements that may apply to you.
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 via email at: email@example.com or via Twitter @georgeEdube.