The Income Tax Act does not specifically set out whether or not a gain or loss is capital in nature. The taxpayer is responsible for reporting the gain as income or capital gain. This report may then be challenged by the Canada Customs and Revenue Agency with the onus of proof on the taxpayer.
Over the years, Capital Gain Tax has been determined based on a number of factors such as the intention of the taxpayer, relationship to the taxpayer's business, frequency of transactions, length of time held, nature of the transaction and objects of the corporation. Should a debate proceed to the Tax Court of Canada, the Court will consider relevant factors concerning taxpayer conduct before, during, and after the period under appeal. Certain factors carry more weight in the process.
Consider these Capital Gain Tax facts:
What was the taxpayer's intention at the time the property was purchased?
When a property is purchased for investment, any resale profit could still be considered taxable as ordinary income, if the apparent intent was to resell for a profit at a future time. The Tax Court will consider such things as reasons for the sale, compelling necessity, change in circumstance and external factors.
Relationship to the Taxpayer's Business:
The Tax Court will undoubtedly classify profits as taxable under ordinary business income when a taxpayer uses expertise acquired in regular business activity to generate a profit on the purchase/sale of similar or related commodities. The court also looks at the time and attention the taxpayer spent on the transaction. Real Estate transactions of contractors, renovators, brokers, sales people, and appraisers have typically fallen under close scrutiny.
Frequency of Transactions:
Revenue Canada will assess how often the taxpayer engages in the sale of capital property. Usually, frequency of such occurrences suggests the carrying on of a business for profit. Assessment as ordinary business income will be the result. However, even an isolated transaction can be so judged, given the right set of circumstances.
Nature of Transaction and Assets:
Taxability as income may be indicated if the asset cannot normally be used either personally or for investments purposes. Mortgages are often judged under this test. If the mortgages are purchased at substantial discounts or have a short maturity date, the mortgagee may be viewed as being in a business that realizes profit from the transaction, thus invoking business income as opposed to capital gain.
Objects of the Corporation:
The Tax Court will look at the articles of incorporation to determine if a transaction falls under the objects of the corporation, and if it is part of usual business. However, the absence of this provision may not be deemed conclusive by the Court. Proving that a specific sale fell beyond the normal course of affairs of the company is difficult and once again the burden of proof rests with the taxpayer.
Real Estate Transactions:
Profits would likely be taxed as regular business income if a taxpayer buys and sells real estate on a regular basis. However, if the taxpayer can prove that these dispositions were a planned and necessary part of a total investment program, then there may be a case for capital gains treatment of the profit. In the case of farmlands, if the taxpayer purchased or inherited the land and lived on it for a period of time, a disposition of the property will most likely be regarded as a capital gain.
Further, if a sale of real estate is not planned, that is brokers are not employed, the property is not advertised, no sign or other visible evidence of active marketing is present, then the profit may be, but NOT always treated as a capital gain. In some cases the profit from an eventual sale of the property might be deemed as a capital gain where the taxpayer purchased real estate for a third party to whom her/she expected to transfer it without profit, and was then left with the property when the third party backed out of the transaction.
Exemptions to the payment of capital gains have varied throughout the past decades. A capital gain exemption for individuals (not corporations) can apply to certain sales of real property. The Federal Budget (February 1992) dramatically affected the exemptions by eliminating it for almost all property; however, capital gains accruing prior to March 1992 on qualifying small business corporation shares may still be eligible for the exemptions. Such issues go beyond the scope of the article and expert advice should be obtained.
The major exemption for real estate practitioners to consider involves a principal residence. A principal residence is defined as a house, apartment in a duplex, apartment building or condominium, cottage, houseboat, trailer or mobile home, or a share in a co-operative housing corporation.
To qualify as a principal residence certain criteria must be met:
- The taxpayer must own the housing unit, either jointly or solely.
- A family unit may only have one principal residence.
- The land upon which the housing unit sits cannot exceed one acre and any excess is not considered part of the principal residence unless the taxpayer can prove it is necessary for personal use and enjoyment.
- The unit must be ordinarily inhabited in the year by the taxpayer or by his/her spouse or common-law partner, former spouse or common-law partner, or child.
- The unit must be designated as the taxpayer's principal residence for the year.
Appropriate expert advice from a Chartered Accountant should be sought in regard to capital Gains issues and exemptions.