Chances are that you’re well aware that the housing market in many parts of Canada has seen strong growth over the past couple of years. As well, regional housing booms in parts of Ontario and Vancouver have received a lot of media attention and the federal and provincial governments have made an effort to cool these markets.
Some of the changes include tightening of the mortgage rules, mandatory reporting of the sale of a principal residence, and imposing certain new rules on foreign buyers of residential properties. While the long-term impact of these measures remains to be seen, purchasing real estate may still be an attractive option for many investors. Whether you are contemplating the purchase of real estate or are already invested, in this article, we will discuss some of the income tax implications associated with the sale of a home.
Selling a home when there is a gain
Generally, when a Canadian resident taxpayer sells their home for more than its cost, the difference is a gain. To the extent that the home is the taxpayer’s principal residence, all or part of any capital gain can be sheltered from income tax by claiming the principal residence exemption (PRE). For more information on the PRE, read our insights titled “Did You Report Your 2016 Principal Residence Disposition?” and “Changes to the Principal Residence Exemption Announced”.
Perhaps one of the most common misperceptions regarding real estate sales, however, is that whenever an individual disposes of a home, the associated gain will always be on account of capital and only 50% of the gain (to the extent that it is not sheltered by the PRE) is included in income. It’s important to understand that this is not always true. In certain cases, a gain resulting from a sale of real estate will be considered business income and 100% of the gain will be taxable. Take note that the word “business” is defined for tax purposes and includes “an adventure or concern in the nature of trade”. This may include an infrequent business transaction involving real estate, depending on the situation. When a determination is made that a sale of a home is an adventure in the nature of trade, the taxpayer selling the real estate is not entitled to declare the profits as a capital gain.
Because there is no legislative guidance to help determine when a sale of real estate is on account of either income or capital, the courts and the Canada Revenue Agency (CRA) rely on the following factors:
- the taxpayer’s intention with respect to the real estate at the time of its purchase;
- feasibility of the taxpayer’s intention;
- geographical location and zoned use of the real estate acquired;
- extent to which intention has been carried out by the taxpayer;
- evidence that the taxpayer’s intention changed after purchase of the real estate;
- the nature of the business, profession, calling or trade of the taxpayer and associates;
- the extent to which borrowed money was used to finance the real estate acquisition and the terms of the financing, if any, arranged;
- the length of time throughout which the real estate was held by the taxpayer;
- the existence of persons other than the taxpayer who share interests in the real estate;
- the nature of the occupation of the other persons who share interests in the real estate as well as their stated intentions and courses of conduct;
- factors which motivated the sale of the real estate;
- evidence that the taxpayer and/or associates had dealt extensively in real estate.
One key factor that is considered by the courts and the CRA is the taxpayer’s intention with respect to the property at the time of its purchase. For example, if an individual purchases a home with the intention to sell or “flip” the property, the gain on sale will generally be considered business income. In addition, even if the taxpayer’s primary intention was not to flip the property, its sale may still be taxed on account of income if the secondary or alternate intention at the time of purchase was to sell it at a gain if the primary intention did not pan out.
According to the CRA, “people, including real estate agents, who buy and resell homes in a short period for a profit are engaged in property flipping”. As a result of the rising number of property flips in recent years, the CRA has identified three categories of people engaged in property flipping:
- Professional contractors or renovators – individuals who buy property and sell after a short period of time to make a gain.
- Speculators or middle investors – individuals who purchase a property and then assign the right to purchase the property to another buyer, also referred to as “shadow flipping”.
- Individual renovators – individuals who buy homes, renovate while living in them, and then claim the principal residence exemption when they sell. Individuals who do this repeatedly are also commonly referred to as “serial flippers”.
Although the facts of each case will determine the appropriate tax treatment, in general, the gains arising from flipping property are 100% taxable as business income.
While the CRA acknowledges that real estate flipping is not an illegal activity, they have expressed concern that this type of transaction is not properly reported by taxpayers. To that end, the CRA has “dedicated resources to ensure compliance with the tax rules for property sales and other real estate transactions”. In addition, they have indicated that they acquire and analyze third-party data to monitor real estate transactions. Specifically, the CRA uses a risk-based approach in detecting and addressing non-compliance and takes into account developing trends in the real estate market. As a result, it would not be surprising for taxpayers involved in certain real estate transactions to face increased scrutiny.
You may be wondering what the tax consequences are if a taxpayer rents out a property for a period of time before selling it. Let’s consider a simple scenario where a taxpayer purchases a condo and rents it out for many years as a means of providing a steady stream of income. In this case, the condo will generally be considered a capital property and the rental income earned will be fully taxable. Keep in mind that the individual can deduct any reasonable expenses that were incurred to earn rental income, such as amounts for maintenance and repairs and mortgage interest. The two basic types of expenditures are current expenses and capital expenses. While we won’t get into a detailed discussion on current versus capital expenses in this article, take note that generally, expenditures that provide an enduring benefit would be considered capital in nature. While the entire purchase cost of the rental property and related capital expenditures (such as improvements or large appliances) can’t be deducted in a single year, capital cost allowance (or tax depreciation) can be claimed at predetermined rates on these depreciable capital expenditures to reduce income taxes. Note that the portion of a real estate purchase that represents the cost of the underlying and adjacent land is not depreciable (applicable to condos as well).
When capital cost allowance has been claimed against rental income and the taxpayer later sells the rental property, they may also have to pay tax on the portion of the gain that represents previously claimed depreciation. For instance, if proceeds from the sale of the property exceed the undepreciated capital cost of the rental property, the excess, up to the original cost, is taxed as recaptured depreciation in the year of sale. This recapture is taxed at a 100% inclusion rate. It is also important to take note that even though the property generated rental income, the gain in excess of recapture realized on the eventual disposition may or may not be on account of capital. In fact, the sale of a rental property will require consideration of the various factors noted above, including the taxpayer’s intention at the time of purchase.
Understanding the tax implications and reporting requirements associated with investments in real estate can quickly become a complex exercise. Your BDO advisor can help you navigate the various tax issues and filing obligations related to your real estate investments. Contact us to learn more.
The information in this publication is current as of July 5, 2017.
This publication has been carefully prepared, but it has been written in general terms and should be seen as broad guidance only. The publication cannot be relied upon to cover specific situations and you should not act, or refrain from acting, upon the information contained therein without obtaining specific professional advice. Please contact BDO Canada LLP to discuss these matters in the context of your particular circumstances. BDO Canada LLP, its partners, employees and agents do not accept or assume any liability or duty of care for any loss arising from any action taken or not taken by anyone in reliance on the information in this publication or for any decision based on it.
BDO Canada LLP, a Canadian limited liability partnership, is a member of BDO International Limited, a UK company limited by guarantee, and forms part of the international BDO network of independent member firms.