Capital gain vs business income
When flipping a house, people usually prefer to have the profit treated as capital gain which is only 50% taxable at their individual tax rate, compared to business income which is 100% taxed.
There are some situations where business income may be preferred. For example when a sale of a property results in a loss. I know, these days it is hard to believe that someone can incur a loss in real estate. But if it did, a business loss would be preferred over a capital loss since 100% of the loss can be used to reduce income from all sources. Whereas, only 50% of the loss is available, with a capital loss which can only be used to reduce capital gains, not income from other sources.
Defining capital gain vs business income
A capital asset is used for the purpose of renting to others (in other words, for generating income) and are not intended for sale. The profit from selling an income generating asset would result in a capital gain. Compared to profit from selling an asset ‘available for sale’ which would be business income.
When determining whether the profit from the sale is a capital gain or business income, CRA will look at many factors.
What was your intention at the time the property was purchased? Was it to ‘flip’ the property and make a quick sale after buying it? Like when someone (which seems like everyone and their uncle these days) buys a new construction home from a builder and intents to sell it after the possession date. This would be classified as “an adventure in the nature of trade” and therefore treated as business income. Or was the intention to hold the property and rent it out to generate rental income over time. In this situation the sale of the property would be considered a capital gain.
Note that your accounting records might be used as evidence of your intention. Are the properties clearly segregate in your account records as long-term rental properties or available for sale? The latter would more likely be classified as a capital gain. Is there documentation and/or agreements between individuals which outline the fact that the intention of the purchase of the property is to sell it at some point in time? This would clearly be classified as business income by CRA.
You may have an intention to hold a property for the long term, but you may also have thought of the possibility of selling the property if your intention of renting it out fails for some reason. I have heard some people say, if I can’t rent it out or it’s too much trouble to manage, I will just sell it and make a profit. The fact that you thought of this secondary intention could be considered by CRA enough to say that the profit should be taxed as business income. Consider whether this secondary alternative was a factor in your decision to purchase the property in the first place.
Is the property zoned for commercial use? Did its use change from residential to commercial after the purchase? In these situations the sale of the property will likely be classified as business income.
Repairs and Maintenance work.
Were repairs and maintenance done on the property to make it more sellable? There is no shortage of TV shows about people flipping houses. Purchasing run done ‘fixer-upper’ properties, spending thousands on renovations and improvements for the purpose of selling the property for profit right after the improvements are made. These types of situations will result in the sale being classified as business income.
Was the purchase of the property highly leveraged (a large amount borrowed to purchase)? Or was a large down payment of your own money used to purchase the property? A highly leveraged purchase is more likely to be viewed as business income.
Nature of your business or profession
Are you a builder or real estate agent? The closer your other employment or occupation is related to the buying and selling of properties, the higher the possibility of CRA viewing the gain on selling as business income rather than a capital gain. If the sell is considered business income you cannot claim the principal residence credit.
Length of the period you owned the property
The longer you own a property the higher the chance of it being classified as a capital gain. With longer ownership the greater chance of earning rental income. Compared to a short ownership which could be classified as business income.
Frequency of selling real estate
Do you have little or no other sources of other income and are buying and selling many properties? CRA will likely classify the sells as business income because it would seem that the buying and selling of real estate is for the purpose of making a profit. Remember that even if the purchaser does not frequently buy and sell properties, it can still be classified as business income if the intention was to sell the asset.
What where the circumstances responsible for the sale of the property? Was the property sold because of a health issue or loss of job requiring the need of cash? In this situation, there is a higher chance it would classified as a capital gain.
Most sales of real estate must be reported on your personal tax return, including the capital gain realized and recapture. I strongly recommend use of the services of a Chartered professional Accountant, such as Zabana CPA Professional Corporation, as the tax on sale can be complicated.