Did you know that in some cases, you can postpone or defer adding a capital gain or recapture of capital cost allowance (CCA) to income? (some of you may be wondering what this means). When you sell a depreciable property for an amount more than the original capital cost, this triggers capital gain. However, if the sales proceeds exceed the undepreciated capital cost (UCC) at the time of sale, it may trigger both capital gain and CCA recapture, which has to be added to business income.
To determine if there is a recapture, you subtract the lesser of the proceeds of disposition or the capital cost of the property from the UCC and if the result is negative, then you have a recapture, which has to be included in business income. But if positive, you have a terminal loss, which can be deducted from business income. (future articles will address CCA recapture and terminal loss in detail).
A simple illustration may help here:
Mr. A buys a building for $70,000 (original capital cost) and the Undepreciated Capital Cost (UCC) is $50,000. He sells it for $100,000 (proceeds of disposition) and because this amount is more than the original capital cost, Mr. A has a capital gain of $30,000. In this situation also, the UCC is $50,000, so he subtracts $70,000 (the lesser of the proceeds of disposition of the property and the capital cost of the property) from his UCC and is left with a recapture of CCA of $20,000 ($50,000 – $70,000) that he has to include in his business income.
However, if you sell a business property and replace it with a similar one, or your property gets stolen, destroyed, or expropriated (this is when a government authority of takes a property from its owner for public use or benefit) and you replace it with a similar one, you can defer tax on the sale proceeds if you reinvest in replacement property within a reasonable period of time. But if you choose not to replace the property, then you become liable to pay tax on any capital gain from the disposition.
The Income Tax Act ( subsections 13(4) and 44(1)) permits a taxpayer to choose to defer the recognition of income or capital gains where a “former property” is involuntarily disposed of, or a former property that is a “former business property” is voluntarily disposed of, and a “replacement property” is acquired.
For income tax purposes, the expropriation of property, or its destruction or theft, is deemed to be a disposition giving rise to a capital gain or recapture of capital cost allowance (depreciation). If a taxpayer receives the insurance proceeds on destroyed or stolen property, or expropriation proceeds from the government which is expropriating, and keeps those funds without replacing the property, then it is appropriate for tax to be paid on any capital gain or recapture. However, if the taxpayer goes out and acquires a replacement property, then the tax can be deferred until he chooses not to replace the property any longer.
DO THESE RULES APPLY TO YOUR SITUATION? THE STEPS BELOW WILL HELP YOU FIND OUT
Determine whether your property qualifies for the replacement property rule
There are two major factors that need to be taken into consideration here:
- The nature of the property disposed of
- How the disposition occurred.
Voluntary disposition – assets disposed of voluntarily (by sale, for example) do not qualify for replacement property unless they are real property (land and fixtures) and the property is not a “rental property”. Real property that is a “rental property” will not qualify under the replacement property rules unless the property has been rented by a related party), and the related property did not use the property for the purpose of earning rental income.
Involuntary disposition – when assets are disposed of non-voluntarily either by theft, fire, or expropriation, they qualify for the replacement property rules. The assets include all forms of real property, including rental property, and it may also include depreciable properties such as machinery & equipment.
Determine whether you are within the qualifying period for the rule to apply
When a taxpayer disposes of a qualifying property described above, either voluntarily or involuntarily, the replacement asset must be acquired within a specified time period to be eligible for the tax deferral. 1. For voluntary dispositions, the asset must be replaced within one year from the end of the taxation period when the disposition occurred and
- For involuntary dispositions, two years from the end of the taxation period when the disposition occurred.
Determine whether the acquired property is a qualifying replacement property
The property acquired as a replacement must meet the following criteria to qualify for the tax deferral:
- The replacement property acquired must have been acquired to replace the former business property. A “former business property” as defined in the income tax act, subsection 248(1) is capital property that is real property or an interest therein that is used by the taxpayer or a person related to the taxpayer primarily for the purpose of gaining or producing income from a business but generally does not include rental property.
- The replacement property must be used for the “same or similar” use as the former property. Where the former property was used for the purpose of earning income, the replacement property must also be used for producing income from that business or a similar business.
- The cost of the replacement property must be greater than or equal to the proceeds of disposition of the former property for full tax deferral. Otherwise, a partial capital gain may be triggered. So, say Mr. A in the illustration above bought a replacement property for $90,000, remember that the sales proceeds from the former property was $100,000, a partial capital gain would be triggered as the unused $10,000 would be subject to capital gains. The same rule will also be applied where the replacement property is acquired from insurance proceeds or proceeds of expropriation (in the case of involuntary disposition).
The fact that the specific funds received for the former property are used to acquire another property is not enough to determine whether or not the acquired property constitutes a replacement. Where a taxpayer temporarily invests such funds pending a decision on the acquisition of a replacement property, the temporary investment does not itself constitute the replacement.
The above discussion is a general overview of the replacement property rules and does not constitute any form of tax advice. For your specific circumstance, please contact our office.