For a very long time, seasoned real estate investors and house flippers paid only half the tax owed to the taxman.
Technically, that loophole that allowed flippers to avoid all taxes owed (by just paying capital gains tax) was closed as of January 1, 2016 — after the Federal Government introduced changes to income tax reporting. Announced on Oct. 3, 2016, all property sold during and after the 2016 tax year must be reported to the Canada Revenue Agency. Prior to this change, anyone who sold their principal residence did have to report the sale. Now, all property sales must be reported, however, the principal residence exemption (where you don’t owe capital gains tax on the profit earned from selling your primary home) remains in place.
So, how does this impact property investors? First, it just got a whole lot harder to hide profit from the sale of a property. Second, the CRA is started to scrutinize every property sale — the idea being that not every property is taxed using the capital gains tax.
The advantage of capital gains tax
According to the Canada Revenue Agency, profit on assets and investments are taxed in a variety of ways, including as a capital gain, as interest, as personal or business income or as a dividend. Each tax has its own rules and its own rate. Personal income is taxed heaviest, followed by interest and business income. Dividend and capital gains income are considered the most advantageous as both receive preferential tax treatment. When it comes to real property, including assignment sales, capital gains tax is typically applied, until, however, the CRA considers the profit earned on a property sale to be part of business income.
So, how does the CRA make this distinction? In Canada, if a property grows in value the appreciation is known as a capital gain. Capital gains are subject to only half-the-tax. This means the profit on a property sold in Canada is only charged half the marginal tax rate of the seller. For example, if you sold your cottage (which is your secondary residence), you’d pay capital gains tax on the appreciation of that property, not income or business tax. If the profit was $100,000 you’d only owe tax on $50,000. If your marginal tax rate was around 30%, that would mean you only owe $15,000 in taxes on that profit. If you’d been charged personal or business income tax, you would’ve had to pay $30,000 (assuming the same marginal tax rate; more if this income pushed you into a new tax bracket).
For your property to qualify for the preferential capital gains tax rate, you must not be in the business of investing in real estate.
How business income relates to profit from property sales
What about real estate investors who purchase property with the intention of selling it for a profit? Can they shelter a portion of their profit by paying capital gains tax rather than income or business tax? According to Ottawa-Gatineau tax firm, Marcil Lavallée, some types of gains “fall close to the line.”
In the Income Tax Act, the definition of the term “business” includes “an adventure in the nature of trade.” According to the CRA, if a person or legal entity purchases property with the intention of selling it, then this purchase is considered to be an “adventure in the nature of trade.” As a result, any profit earned on this property purchase is not a capital gain but rather business income and should be taxed accordingly.
The CRA started cracking down on real-estate investors over half a decade ago and the federal agency doesn’t intend to stop now.
In February 2016, CTVNews reported that the CRA was investigating the sale of 128 homes in B.C., solely to discover whether or not the sellers were sheltering their profits using capital gains tax. “The CRA told CTV News it’s concerned sellers may not be properly reporting house flips and paying the taxes they should.”
In July 2017, headlines proclaimed that the CRA was going after developers — looking for presale information to see if those trading in assignment sales were skipping out on all taxes owed.
In October 2017, there were more headlines about condo presales and the CRA casting a wider net to catch tax cheats.
What you need to know
If you purchase real estate with the intent of selling it again for a profit, you better get professional tax advice. This is particularly true if the timeline of the purchase and intended sale is relatively short (a few years or less), or if you are buying and selling pre-sale condos (sales known as assignment sales — assignments are contracts that give you the right to own or sell ownership rights to a property that is still in the process of being built).
Also, create a solid plan for how you intend to report the investment. Are you in the business of real estate investments? Or are you investing in real estate with the intention of earning a profit? Why is this important? Because you cannot mix apples and oranges. According to tax specialists, an investor cannot claim business expenses against a capital gain. Property expenses can only be used to reduce income earned on a property, such as rental income, they cannot be used to reduce an overall capital gain. That means if you sell a condo the same year you are required to pay for a special assessment, you may only claim the cost of the assessment against the rental income earned — you cannot use the expense to reduce the capital gain earned on the property.
To keep it simple, just remember: The only way to reduce a capital gain is a capital loss. A capital loss occurs when you sell an asset for a loss.
In the final analysis, you should always know before you purchase a property what the short-term and long-term goal is for that property. Do you intend to be a landlord and create your own dividend-like income stream? Or is your intention to buy and sell based on market movements? In the former, your property purchase would be treated as a property investment where appreciation is secondary to the investment plan and, as a result, the sale of the property would trigger capital gains owed. In the latter, the appreciation of the property is the sole motive for investing in the property and, as a result, you are engaging in the “adventure of trade.” As a result, your profit should be taxed as personal or business income — you cannot shelter the profits by paying capital gains tax.
The CRA started cracking down on real estate investors a few years ago, but in the years to come, we can expect more audits and back-taxes paid by real estate investors on the wrong side of that capital gains tax.