Our guest columnist, Albert Luk, returns to provide commentary on relevant legal issues.
Imagine it is 2005 or 2007 or 2010. You purchased a pre-construction condo to live in or for investment purposes. However, either before the condo is registered or shortly after title is transferred, you sold the condo for a tidy profit. In your tax returns, you declare your profit as capital gains. Sounds simple, right?
Not so fast.
Tax lawyers and accountants have been a buzz lately about Canada Revenue Agency’s (“CRA”) “condo project.” Essentially, CRA has been reassessing taxpayers in the above situation and denying the capital gains claim, characterizing the profit as taxable income. To add insult to injury, gross negligence penalties are being assessed as well. Let’s take a general overview of how and why we got here.
(…if you want to cut to the chase and avoid some dense tax discussion, please skip to the bottom…)
Income or Capital Gains?
On a high level, the Canadian income tax regime can tax a transaction as income and not capital gains where (in the words of CRA) “[if] a person habitually does a thing that is capable of producing a profit, then he is carrying on a trade or business notwithstanding that these activities may be quite separate and apart from his ordinary occupation.”
Real estate flippers fall squarely within this principle (either flipping investment properties or aggressively using the principal residence exemption which is a type of audit also on the rise). However, even if not a serial real estate flipper, CRA continues and states “where such a thing is done only infrequently, or possibly only once, rather than habitually, it still is possible to hold that the person has engaged in a business transaction if, in accordance with the definition of “business” in subsection 248(1), it can be shown that he has engaged in ‘an adventure or concern in the nature of trade’.” (emphasis is my own)
The tax implications between capital gains (50% of the gain being taxed) and income (100% of the gain being taxed) is great enough that not surprisingly the phrase “an adventure or concern in the nature of trade” is frequently litigated. The courts tend to look at the following factors to determine if the transaction is an adventure or concern in the nature of trade and should be taxed as income: (1) nature of property; (2) length of ownership; (3) frequency or number of similar transactions; (4) work expended on the property; (5) circumstances giving rise to sale; and (6) motive.
The Condo Project
Our own experience and experiences gleaned from chat forums and discussions among tax professionals appear to indicate that, in certain reassessments, intention is being ignored in favour of results-based auditing. For example, imagine empty-nesters who decide to downsize and purchase a pre-construction condo in 2005 with proposed occupancy for 2009. The developer, not unlike most condo developers, delayed the occupancy date until 2011. In the meantime, the rightfully impatient couple decides to buy into an existing condo and sell their interest in the pre-construction unit for a profit in 2010, declaring it as a capital gain.
There is no intention at the time of acquisition to sell for a profit. However, a CRA auditor may look purely at the length of ownership and reassess the sale as income characterizing the transaction as an adventure or concern in the nature of trade. Is this analysis necessarily correct? Maybe not but the taxpayer will now have to negotiate with the auditor or fight this at reassessment/court.
…And this is where things get particularly messy. If CRA takes the position that the transaction should be taxed as income, does the taxpayer have the ability to introduce deductions to reduce the amount of taxable income? What happens to GST/HST paid? Will the re-characterization from capital to income trigger a GST/HST reassessment?
Confused? Scared? Thinking of buying a condo in Mexico now? There are a few key takeaways:
- Analyze each transaction. Don’t undertake lazy analysis and characterize all real estate transactions as capital gains. Be sure to have a thorough discussion with your accountant or lawyer regarding all transactions (The limitations of DIY accounting is most prominently displayed in complex fact situations so avoid the DIY solution if this applies to you). If contacted by the CRA, seek professional advice and avoid fighting this yourself. This is a complicated situation. Many of these disputes can and do get resolved well before tax court with the help of a professional.
- CRA is watching. I would lump taxpayers in the condo project into 3 categories: (i) aggressive taxpayers who have an uphill battle; (ii) innocent taxpayers who should hire qualified professionals to provide analysis and guidance; (iii) taxpayers in the grey zone who need to weigh cost-benefit.
- Keep accurate records. Legal disputes (especially against the CRA) often turn on who has the best evidence. Thus, keeping accurate records, such as: agreement of purchase and sale, invoices, correspondence etc is essential. In a self-reporting tax assessment regime, record-keeping can be the difference between a poor reassessment decision a taxpayer cannot refute and a positive outcome. As talented as your accountant or lawyer may be, they can only work on what you give them.
Albert Luk is a lawyer at Devry Smith Frank LLP, a Toronto based law firm who act as trusted advisors and advocates for corporations, individuals and small businesses. This blog was written with the assistance of Eldad Gerb, student-at-law. Albert can be reached directly at firstname.lastname@example.org or @acsluk on Twitter.
The above blog post is for general information purposes only and does not constitute legal or other professional advice or an opinion of any kind. Readers are advised to seek specific legal advice regarding any specific legal issues.