We see a growing number of investors who are acquiring real estate beyond the traditional buy-and-hold strategy or, even more popular, using a mix of techniques. Two examples of such techniques include using Agreements for Sale (AFS) and Rent-to-Own (RTO) agreements.
But, one critical note for these strategies is that the tax implications associated with such agreements are unique to the specific agreements used. In other words, tweaking the legal agreements can provide radically different tax results. This, in turn, can also impact the accounting treatment for financial statement disclosure. To say that the Income Tax Act is somewhat murky on these agreements is something of an understatement.
Agreements for Sale
While AFSs are structured in different ways, and have an assortment of provisions, we tend to see these as agreements to purchase a property over a period of time while legal ownership remains with a vendor until a final balance is paid. Typically, an existing mortgage will stay in place so the purchaser provides less initial funding.
In an AFS, the big question from a tax perspective is essentially who has beneficial ownership of the property and when? Who has the rights to occupancy, profits, and is subject to the risk of loss? The Canada Revenue Agency (CRA) has expressed the general conclusion that having an enforceable AFS will constitute ownership of the particular property, in the case of a principal residence for example. In other words, legal ownership may still rest with the vendor. However, from a tax perspective, the purchaser now owns the property. Interestingly, the conclusions from a tax perspective can also depend on provincial law which may define when ownership passes, and effectively overrides the conclusions which would otherwise be drawn from beneficial ownership.
However, this is not to say that the property has been disposed of by the vendor despite the fact it was sold from a tax perspective. The CRA has a relatively restrictive definition for capital and depreciable property which requires an amount receivable. Once the vendor is entitled to the sale price, the tax implications of the sale come into play.
As to when the beneficial ownership has passed, again, the CRA asserts that you must consider different factors, including, but not limited to:
- The date funds required to be paid on closing were actually paid
- The date that the title was conveyed
- The date of adjustments of insurance premiums, rentals, mortgage interest, realty taxes, etc.
- The date of possession by the purchaser
The above being said, however, a series of payments with a final balloon payment will still result, in most cases, as a purchase and sale right from the start. A reserve may be available depending on the particular facts. For a period of time, this can defer the total income or capital gain from the property.
A host of tax issues surface for vendors in working with RTO agreements.
Is the upfront option price typical of many agreements taxable now or at some later point of time? Generally speaking, most real estate investors must bring this into their income immediately as the funds are non-refundable should the option to acquire fail to be exercised. Furthermore, because the property is considered inventory to the investor, in most cases, the general rules exempting certain option payments from being included into income will not always apply in the particular case.
Many investors are shocked to learn that the ultimate disposition of the property will often result in straight income as compared to a capital gain. The intention of the vendor is the primary determining factor of segregating income versus capital treatment. So, it will be difficult to explain away to the CRA that as an investor you put into writing an agreement specifically announcing your intention to sell the property to a tenant/buyer. Other reasons to make the sale straight income are also often applicable such as the history of the investor, real estate or special knowledge, and comparing profits from the rental versus sale of the property.
If the investor is really in the business of selling real estate (or an adventure or concern in the nature of trade) this implies then that the investor really does not have a normal depreciable asset in the form of a building with some allocation typically to land. Instead, they have a piece, albeit larger than most, of inventory. From a tax perspective, additional rules come into play as to what deductions can be taken with real estate inventory. Keep in mind that were prohibited from taking depreciation or capital cost allowance on inventory.
As a last major point related to RTOs, when corporations are involved, you must now distinguish between active and inactive income. There are sharp contrasts in how these are taxed and at what rates of tax. Depending on your particular situation, how these are determined will be a combination of preferences, pros and cons. Far better to plan in advance as to how these will impact your structure, remuneration planning and investment strategies.
Getting Through the Quagmire
Unfortunately, the Income Tax Act fails to clearly define the tax implications of AFS and RTO agreements. Plus, I havent even addressed GST/HST implications. Although frequently straightforward, the outliers are often the ones that cause us the problems. Rather, we must review a series of rules, interpretations and court cases to see the interrelationships between various sections of legislation and their respective modern interpretation. Looking at small aspects in isolation frequently results in misleading conclusions, particularly when looking for the quick answer.
Weve seen a variety of instances where people have found through their review of rules and calls to the CRA that the quick answer they thought was correct for their AFS or RTO results in a big Oops! from a tax perspective.
Lets resolve to stay clear of the Oops! category by taking the time to develop appropriate agreements that effectively combine legal, financing and tax perspectives. Ensure the relevant advisors are helping you draft agreements that meet these requirements, and still do what YOU are looking for from an investment and business perspective.
As always, please ensure you seek the advice of a qualified real estate accounting and tax advisors before assuming you know how the transactions will be treated.
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.