These days, it seems as though buying a property and then reselling it at a higher price is all the rage. On the surface, it seems like a terrific idea – buy a property, perhaps spend a little time and money fixing it up, and then sell it for a tidy profit. In today’s still-fragile economy and with the decline of the real estate market in many areas, it may seem that trying to make money in this manner seems risky, and in some ways this is true — but it still can be a worthwhile investment option as long as you have an understanding of the types of profits and most importantly, taxes on flipping Canadian real estate.
Capital Gains & Business Income – Defined
When you sell a stock, you owe taxes on your gains — the difference between what you paid for the stock and what you sold it for. The same is true with selling a home, but there are some special considerations that potential investors need to be aware of. Unfortunately, the majority of investors sell properties and automatically assume a capital gain has resulted, which is not necessarily the case. So what is a capital gain, and what is business income, and what taxes are associated with each?
Generally speaking, we can think of a capital gain as the profit from selling an income-generating asset. Business income on the other hand is typically generated where we sell an item or asset available for sale. With respect to taxes on flipping Canadian real estate, only 50% of the profits from a capital gain are taxed; consequently, many Canadian taxpayers are now trying to take advantage of the system by opting for the more favourable capital gains tax treatment. How is the determination of business income versus capital gains made?
Factors CRA Uses to Determine Capital Gains vs. Business Income
A profit arising from the sale of Canadian real estate can be considered to be business income, or a capital gain. However, most investors are unaware of the factors that the Canada Revenue Agency (“CRA”) considers in deciding how to categorize real estate profits – either as a capital gain or business income. The factors are follows:
1. Primary Intention. The way that CRA will view your intentions (at the time the property was purchased) is crucial when trying to assess the taxes you may face with flipping Canadian real estate. If your primary intention was to ‘flip’ the property (i.e. make a quick sale after buying it), then this in indicative of an income intention. On the other hand, if you planned to hold the property and receive rental income over time, the profit realized on the sale of the property will be classified as a capital gain. Since intention is very hard to prove (i.e. the CRA can’t read your mind), other factors are applied, as discussed below.
2. Zoning. The CRA looks to the zoning of the property as one of the determining factors. If the property is zoned for commercial use, or is changed from residential use to commercial use after the purchase, then the profit realized on the sale of the property will likely be classified as business income.
3. Repairs and Maintenance. Repairs and maintenance performed on the property by the taxpayer is also an important factor. If a property is purchased as a ‘fixer-upper’ and substantial renovations / improvements are made prior to the sale, the profit made on the sale will be categorized as business income.
4. Nature of your business or profession. Other employment or trade activities may influence the way CRA views your transactions – meaning the more closely a taxpayer’s occupation (e.g. builder, real estate agent) is related to selling or buying properties, the more likely it is that any profit from a property sale will be considered business income rather than a capital gain, and then taxed accordingly when flipping the property in Canada.
5. Money borrowed. The amount of money borrowed to purchase the property is another factor the CRA uses. If you are highly leveraged, meaning you borrowed heavily to buy the property, income treatment is more likely. On the other hand, if you used most of your own money to acquire the property, capital gains treatment is more likely.
6. How long you owned the property. If you owned the property you later sold for a profit for a very short period of time, then the profit will be classified as business income. However, if you held the property for a
7. Frequency of selling real estate. If for example you’re acquiring several properties within a year and you have little to no other sources of income, then CRA will likely determine that your activities are primarily geared toward turning a profit and as a result, the property changes from a capital gain to a means of producing income that is subject to ordinary tax rates. On the other hand, if you have never bought and sold real estate before, then capital gains treatment is more realistic.
The factors that the CRA uses in respect of assessing taxes on flipping Canadian real estate must be examined as a whole. Any single factor by itself is not sufficient to draw a conclusion on whether a profit from the sale of Canadian real estate should be classified as a capital gain or business income.
Real Life Example that Went to Tax Court
In order to assess the way these factors come into play in determining the taxes you may face when flipping Canadian real estate, we will look to a real case that went to a Canadian tax court, where the judge decided that the appellant’s profit from his disposal of three buildings in 2004 and 2005 was business income, and not capital gain. This classification was made through the consideration of various factors, among them the appellant’s work as a construction/renovation contractor, his history of selling buildings for profit, a track record of performing maintenance and repair work himself on the buildings sold, and no ability to prove that he intended to keep the buildings for the long term. The appellant also did not live in any of the buildings sold during the aforementioned time period, nor did he declare any rental income for any of the properties.
The appellant was obviously upset with the Judge’s ruling. Remember, when it comes to taxes associated with flipping Canadian real estate, a capital gain is only half taxable, whereas business income if fully taxable.
Selling Your Own Home for a Profit
What happens when you sell your own home for a profit? Is the profit considered taxable business income, or is it a capital gain?
Principal Residence Exemption is Not Automatic
For most individuals that sell their primary residence (in which they live), the profit on the sale will be classified as a capital gain. However, the principal residence exemption can be claimed, which as the name infers, will exempt the capital gain from tax.
Note that the principal residence exemption is not automatic. You must demonstrate that you ordinarily lived in your home before it can be treated as your principal residence.
Some taxpayers try to outsmart the system, by claiming the principal residence exemption for the entire gain realized on the sale of a home, even though they lived in the home for a fraction of the time they owned it. The CRA has specific rules in place from stopping this abusive practice. One of the rules stipulates that you can only claim the principal residence exemption for the years that you lived in the property. For example, if you lived in a property for 3 of the 5 years that you owned it, then only 60% of the capital gain on sale can be exempted from tax.
Renovators and the Principal Residence Exemption
Certain taxpayers have been abusing the principal residence exemption to avoid paying taxes on flipping Canadian real estate. More specifically, these taxpayers purchase a home that they live in for a short period of time, make substantial renovations to the home, and then sell it for a profit while claiming the principal residence exemption. Once the property is sold, they immediately buy another home and start the process over again.
The CRA is cracking down on renovators who flip properties and claim the principal residence exemption each time. Instead of allowing capital gains treatment on the profits made, the CRA is treating the profits as fully taxable business income on which the principal residence cannot be claimed. In order to avoid this treatment by the CRA, you need to prove that you have another source of income, have consistently lived in the home that you sold, and that you did not purchase the home with the sole intention of selling it. Otherwise, CRA will have no reason to believe that you did not purchase or sell the property with the sole purpose of generating income from it, and which will not be considered to be a capital gain but rather business income and you will be taxed at twice the rate.
The information provided on this page is intended to provide general information. The information does not take into account your personal situation and is not intended to be used without consultation from accounting and financial professionals. Allan Madan and Madan Chartered Accountant will not be held liable for any problems that arise from the usage of the information provided on this page.