Taxing Topics - Dwyer Tax Law Canadian Tax Law Articles: July 2015

Monday, July 27, 2015

Canadian Tax Primer 7: Depreciation of Rental Buildings

Tax is triggered by specific events. For example, the sale of an investment or other asset will often trigger tax.

Assume that you buy some shares for $100 and later sell the shares for $500. You will have a $400 profit on the sale. If you make a business of buying and selling shares, the $400 increase in value will be taxed as ordinary income. If you bought the shares as an investment, the $400 increase in value will be taxed as a capital gain. As discussed in Tax Primer 6, whether you are in the business of buying and selling shares or merely an investor is a question of fact.

The comments in this chapter will assume that you are an investor.

If you are an investor, you will realize a capital gain when you sell an investment that has increased in value. The sale of certain types of investments, however, may result in the taxation of both a capital gain and ordinary income. For example, assume that you purchase a building for $1 million and rent it to tenants. Income tax law allows you to depreciate the cost of the building (but not any associated land) over specific periods of time (a bit each year). You claim this depreciation expense (in tax jargon, capital cost allowance) as a deduction against rental income, thereby reducing the tax payable on the rental income. For the purposes of this example, assume that you have claimed $400,000 in total depreciation on the building over your years of ownership. Eventually, you get tired of being a landlord and decide to sell the building. If you sell the building for $1.4 million, you will pay tax on two different amounts. As you probably expect, you will have a capital gain of $400,000 (the $1.4 million sale price less the $1 million cost). However, you will also have ordinary income of $400,000 (equal to the past depreciation claims). Since the building did not in fact go down in value, you have to “recapture” the depreciation deductions that you claimed in the past.

When depreciating a building for income tax purposes, remember that the income tax saved through the depreciation claims will have to be repaid to the government at some future date. Think of that tax “saving” as a form of interest-free loan. It makes sense to invest the tax savings to earn more income. If you use the tax savings for personal consumption (such as a vacation), remember that the tax savings might have to be repaid some day. The tax savings is not really a savings – just a deferral.

If the asset actually depreciates in value over time at a rate that is at least equal to the depreciation claimed for income tax purposes, no recapture will arise on sale of the asset. This is the case with most cars, for example.

When you claim depreciation for income tax purposes, the depreciation is called capital cost allowance. The cost that has not yet been depreciated is called the undepreciated (as in not yet depreciated) capital cost of the asset.

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The above article provides general commentary of an educational nature. It does not constitute advice for any specific person or any specific set of circumstances. Because circumstances vary, readers should consult professional advisers in order to obtain advice that is applicable to their specific circumstances.

Wednesday, July 15, 2015

Canadian Tax Primer 6: Intentional Capital Gains

In the Canadian Tax Primer 5 article, we pointed out that a lower tax rate applies to a capital gain as compared to ordinary income. But what is a capital gain?

It is sometimes difficult to distinguish between a capital gain and ordinary income. Much of the distinction has to do with the purpose behind the acquisition of the asset. Characterization depends on specific facts, as illustrated by the following simplified examples.

Assume that you find that perfect piece of real estate and buy it for $100,000. You plan to build your dream cottage on it, but not right away. You are just starting a business and want the business to be established before you take on the cost of building the cottage. As it turns out, the business takes more and more of your time and you realize that you do not have the time to make the trek to a far-off cottage. After 15 years, you decide to sell the property for $500,000 and you use the cash to install a much more accessible swimming pool in the backyard of your home. In this case, the $400,000 increase in value should be taxed as a capital gain.

Assume that you purchase the same piece of real estate because you anticipate that you will be able sell the property for a tidy profit once the area becomes a cottage haven. You have to wait for 15 years, but events turn out as you anticipate. The cottage building frenzy finally starts and you sell the real estate for $500,000. In this case, the $400,000 increase in value should be taxed as ordinary income.

The only difference between these two examples is your intention when you buy the real estate. In the first example, you buy the real estate for the purpose of building a cottage on it but you never actually build the cottage. In the second example, you buy the real estate for the purpose of reselling it.

The same question arises with publicly-traded investments. If you buy a share of Bell Canada and hold those shares for a year or so, sale proceeds will usually be treated as a capital gain – even though making a profit on resale gain is usually one of the purposes in buying shares. This has to do with the nature of investments, as everyone hopes that the investments will grow in value over time. But not all sales of Bell Canada shares will give rise to a capital gain. If you are a day trader who buys and sells shares on a daily basis, your profit will likely be treated as ordinary business income. Unlike the ordinary investor, a day trader is in the business of buying and selling shares.

While you may know what your intention was in purchasing an asset, it may be difficult to prove that intention to the Canada Revenue Agency (the “CRA”) if that should become necessary. The CRA will determine your intention on the basis of external manifestations of that intention, the nature of the property involved and the amount of time you held the property. No one factor will be determinative – characterization will depend on the combined impression created by all the relevant factors.

If the CRA reassesses a capital gain and treats the gain as ordinary income, the onus of proof will be on you to establish otherwise. Keep any evidence that may be relevant to establishing your intention. For instance, in the cottage example discussed earlier, keep any building sketches that you may have made for the cottage you never ended up building.

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Friday, July 3, 2015

Canadian Tax Primer 5: Different Tax Rates on Different Types of Income

Besides varying by province (see the Canadian Tax Primer 2 article), Canadian tax rates vary by the type of income earned. The 2015 rates referred to below are for an individual resident in British Columbia and paying income tax at the top marginal rate (has over $150,000 of taxable income). If the individual has a lower level of income, she will have correspondingly lower tax rates.

The highest rate (about 46%) applies to employment income, business income, interest income and dividends received from non-Canadian corporations.

A lower rate applies to dividends received from taxable Canadian corporations. This is not an example of government generosity, however, or an example of the government encouraging investment. The shareholder is merely paying part of the tax on the income. In order to pay the dividend, the corporation had to earn income and likely had to pay income tax on that income. Payment of a dividend is not a deductible expense for the corporation, so the dividend has to be paid out of the corporation’s after-tax income.

(a) If the corporation pays the dividend out of active business income that has been taxed inside the corporation at the (lower) active business rate, tax on the dividend is about 36% of the dividend. The shareholder will pay this tax.

(b) If the dividend is paid out of corporate income that has taxed at the (higher) general corporate tax rate, tax on the dividend is about 29% of the dividend. The shareholder will pay this tax.

When the corporate and personal taxes are combined, the overall tax should (in theory) be about the same as an individual would have paid if the individual had earned the income directly (rather than through a corporation). This integration of the corporate and personal tax rates never works out perfectly in real life, but that is the overall goal of the system.

The lowest tax rate (about 23%) applies to capital gains. For example, assume that you buy a long-term investment for $100 and sell the investment down the road for $500. In this case, you would have a capital gain of $400 and would pay tax of about $92 (23% of $400). This is a simplified way of expressing the rate. As a technical matter, you bring only half of that $400 gain into income and you pay tax at the normal 46% rate on that $200 income inclusion. But for our purposes, 46% of half is the same as 23% of the whole.

The 23% tax rate on capital gains is only part of the story, however. The capital gain will have arisen over a period of time. During that time, inflation will have eroded the purchasing power of a dollar. In order to determine whether a $1 capital gain actually increases your purchasing power on an after-tax basis, you need to take inflation into account. The Canadian tax system does not attempt to adjust for inflation other than by taxing capital gains at a lower rate. This is a rough form of adjustment and might over- or under-compensate for inflation, depending on the period of time involved.

For example, assume that you purchased an investment in 1985 for $100 and sold that investment for $201.92 in 2015. On paper, you have doubled your money and have made a capital gain of $101.92. In fact, however, your purchasing power has merely stood still over the 30 years in question. The increase in value is attributable solely to inflation: see the Bank of Canada inflation calculator at http://www.bankofcanada.ca/rates/related/inflation-calculator/?page_moved=1. Even though you have made no real economic gain, you would still be obligated to pay capital gains tax on the inflation-induced capital gain. After payment of the tax, you would have lost on the investment – because your purchasing power would have declined by the amount of the tax. In order to have an actual after-tax economic gain, you need a rate of return that is equal to inflation plus the tax payable on the capital gain.

Inflation has to be taken into account in respect of any form of income – such as interest and dividends – if you are looking at returns over an extended period of time. As indicated, interest is taxed as ordinary income and so is subject to a larger tax bite as well as the usual erosion of purchasing power through inflation.

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