Author: Michael Cadesky, FCPA, FCA, FTIHK, CTA, TEP (EMERITUS).
The gain on a sale of residential real estate can result in business income (fully taxable) rather than a capital gain (half taxable or tax free under the principal residence exemption). This Tax Alert will help you avoid becoming a victim of unexpected and adverse tax consequences.
For sales of residential property from 2023 on, a gain will be fully taxable as business income (unless an exception applies) if the property is not held for 365 days. There are exceptions listed at the end.
If real estate is held short term, and the dominant purpose of buying the real estate is sale at a profit, business income will result. The concept is referred to as an adventure in the nature of trade. The sale of real estate used as a principal residence or held for income and investment (e.g., rental) will not normally result in business income. Instead, a capital gain will arise on sale. For a principal residence, the gain may be exempt under the principal residence exemption.
To target speculation, a holding period of 365 days is now required (absent on exception) or the gain will be fully taxed as business income. While this may seem reasonable in concept, the new rule has several unexpected traps. Below, we give several examples.
The new rule applies to the sale of a housing unit located in Canada. This includes anything from a simple condominium or house used by the owner as a residence, to a rental property held for investment. It also includes large residential buildings held by a corporation whose business is earning rental income. So, the rule is not restricted to just a principal residence.
This rule, known as the flipped property rule, is deeply flawed.
The 365-day holding period restarts each time there is a new owner (i.e., there has been a disposition). The examples below show the traps that can result.
Example 1: Albert
Albert owned his principal residence for 20 years. For probate and estate planning, he transferred the principal residence to a trust under which he was the life beneficiary (an alter ego trust). Within 365 days, sadly Albert died. The trust has a gain at that time. The trust did not hold the principal residence 365 days.
Result: The gain is fully taxable to the trust. The gain is not a capital gain, and the principal residence exemption cannot be claimed. Consideration should be given to electing out of the automatic “rollover” rule in section 73 to step-up the tax cost of the property to the trust.
Example 2: Bob
Bob purchased a residence for rental. He renovated the property and obtained a tenant. Within 365 days, the tenant made Bob an unexpected offer to purchase the property.
Result: Bob does not meet the 365-day holding period and has business income not a capital gain.
Example 3: Cathy
Cathy has a residential rental property held for 15 years. There is a gain of $1,000,000. Cathy has an investment holding company, C Co with capital losses over $1,000,000. Cathy decides to transfer the property to C Co on a rollover basis (tax-free under section 85), and sell it from C Co. The capital gain on sale would be offset by the capital losses of C Co.
Result: Because C Co fails the 365-day holding period test, the gain is business income to C Co. The capital losses of C Co cannot be used against the resulting business income.
Example 4: Darren
Darren signed a purchase contract for a residential condominium in 2016, to be ready in 2018. Due to delays, the condominium is not completed until 2023. Meanwhile in 2020, Darren closed on another condominium and has since lived there. On closing in 2023, Darren moves in and occupies the original condominium for long enough – 100 days – to claim the principal residence exemption against the gain he will realize of $800,000. The sale occurs in late 2023. Darren’s period during which he had the purchase contract (7 years) does not count for 365-day ownership period. The ownership period is counted separately.
Result: Darren has business income and cannot claim the principal residence exemption. Rather than the gain being exempt, it is fully taxable. Instead of paying no tax, Darren has about $400,000 of tax owing.
Example 5: E-Realty Corporation
E-Realty Corporation is a large corporate group with various corporations each owning a large rental high-rise building. A sale has been negotiated for sale of a building, held 20 years, for $80 million with a gain of $60 million. Innocently, and for non-tax reasons, the corporation holding the particular building is amalgamated with another company in the group (possibly just to simplify the corporate structure). Because the amalgamated corporation is deemed to be a new corporation, it appears a new 365-day holding period begins.
Result: The gain is business income not a capital gain. Not realizing this, Amalco pays a tax-free capital dividend from the 50% non-taxable half of the (supposed) capital gain. This capital dividend was to be tax-free to the shareholders. The capital dividend is disallowed and either must be recharacterized as a taxable dividend or the corporation faces a penalty tax of 60%.
Example 6: F-Realty Group
F-Realty Group has two corporations, F1 and F2. F1 owns 100% of F2, which holds three residential buildings held for a long term and are of equal value. F1 is owned by three brothers who, by way f a tax-free Butterfly transaction, now plan to go their separate ways and split up the companies so each owns one building via a new holding company. The first step is to combine F1 and F2 via a wind-up or amalgamation, the latter selected because it is simpler.
Result: When the real estate is moved out in the butterfly transaction, the gain on hand is recognized as business income rather than a deferred capital gain. The real estate has become inventory to the new company (due to the 365-day holding period not being met) and cannot be transferred without the gain being treated as income.
Example 7: George Estate
George died 20 years ago. He transferred residential real estate to his estate to be held for 20 years. Now his children will receive the properties. The estate distributes the properties which the children promptly sell. The distribution from the estate to the children is tax free. They expect to have a capital gain on sale.
Result: Unless the properties are held by the children for 365 days, the gain from the dispositions will be business income.
The new rules on flipped property can have many unexpected and adverse applications. Be sure to carefully consider any sales of residential property that have not been held for 365 days by the specific person selling.
Don’t be a victim of this rule because you did not get professional advice.
We intend to bring these issues to the attention of the Minister of Finance and ask that amendments be made. There is no policy reason, in our view, for the adverse result in each of the 7 examples.
But until a change is made (if it is made), be careful!