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© Copyright: 2014 by the UBC Real Estate Division, Sauder School of Business, The University of British Columbia. Printed in Canada. ALL RIGHTS RESERVED. No part of this work covered by the copyright hereon may be reproduced, transcribed, modified, distributed, republished, or used in any form or by any means – graphic, electronic, or mechanical, including photocopying, recording, taping, web distribution, or used in any information storage and retrieval system – without the prior written permission of the publisher.
LESSON 6 Taxation of Real Estate Investments Note: Selected readings can be found under "Online Readings" on your Course Resources webpage
Assigned Reading 1.
Real Estate Division. 2011. Real Estate Investment Analysis and Advanced Income Appraisal. Vancouver: UBC Real Estate Division. Chapter 7: Taxation of Real Estate Investments
Recommended Reading 1.
Appraisal Institute of Canada and Appraisal Institute (US). 2010. The Appraisal of Real Estate, Third Canadian Edition. Vancouver: UBC Real Estate Division. Chapter 27: Appraisal Review and Appraisal Consulting [pp. 27.5-27.7]
2.
Brooks, S.M. 2006. Canadian Real Property: Theory and Commercial Practice. November 1, 2006. Toronto: Real Property Association of Canada (REALpac). Chapter 9: Leasing Space in Canada: Realty Tax by a Landlord from a Tenant
3.
Canada Revenue Agency. Index to Interpretation Bulletins. These provide detailed, current information on the Canada Revenue Agency's (CRA's) tax rules and how they are applied.
4.
Kason, D.J., Harris, G., and Farina, S. 2008. "Financing Alternatives". CA Magazine. 141(9). pp. 45-48. Sale leaseback transactions and the triggering of a current tax liability on the sale of the property to a landlord at fair market value if the property has appreciated in value.
5.
Louis, David (Editor). The TaxLetter. MPL Communications.
Learning Objectives After completing this lesson, the student should be able to: 1.
Describe the fundamentals of the Canadian Income Tax System.
2.
Identify whether a gain realized on the disposition of real estate will be treated as business income or as a capital gain.
3.
Identify the characteristics and allocation of expenditures.
4.
Apply the basic rules of capital cost allowance (CCA) as applicable to real estate investment, including calculating CCA claims with and without tax loss restrictions.
5.
Calculate CCA on leasehold interests.
6.
Define soft costs and describe their current status.
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6.2
Lesson 6
7.
Calculate cash flows upon disposition of real property, including CCA recapture and capital gains, or capital losses and terminal losses.
8.
Explain how apportionment affects taxes paid upon disposition.
9.
Describe the taxation of non-resident income from Canadian real estate.
10.
Identify the impact of GST/HST on real estate transactions.
11.
Discuss how real estate may be used as a tax shelter and how this influences the value of incomeproducing property.
12.
Explain the basics of property taxes and real estate taxes.
Instructor's Comments Government policy and case law drive the taxability of income. Property consultants need to understand the policy implications and technical aspects of tax shelters and allowances to help real estate investors choose amongst alternative investments. However, the property consultant adds considerable client value when they can interpret taxability issues and relate them to real estate in the context of the client's business environment. As Stephen Roulac puts it, "For real estate to command sufficient market support to generate the requisite rental revenue to justify its purchase and/or development, it must make a corresponding and consistent value contribution to the business economics of those enterprises that occupy and utilize that real estate." (emphasis added).1 Such value contributions can be inconsistent and short-lived if they rely on tax shelters, rather than viable income from the real estate's operation and appreciation. In the absence of those fundamentals, investors can experience significant losses as many have found from relying only on tax shelters such as those available in the 1980s for multiple-unit-residential buildings (MURBs). The following comments explore links between tax shelters and allowances, trends in financial reporting, and real estate as an integral part of the business enterprise.
Capital Cost Allowance and Meaningful Financial Reporting The course manual describes the importance of capital cost allowances (CCA) in deferring income taxes. CCA is a means of reducing income (and therefore income tax) by recognizing that assets like buildings depreciate over the course of their estimated useful lives. While such allowances may be helpful in deferring income tax, this rather arbitrary allocation of value loss based on the historical cost of the acquired real estate obscures the meaning of assets on the entity's balance sheet. Where real estate forms a substantial part of a corporation's assets, the reporting of depreciated historical cost can substantially undermine the perceived value of the associated business enterprise. Let's consider the example of McDonald's Restaurant B a real estate company that sells burgers and fries on the side. McDonald's owns about 75% of the buildings and 40% of the land at its 31,000 locations worldwide. The land alone has a book value of $4 billion, but is roughly estimated to have a market value of more than $12 billion (before tax). By harkening back to its roots, McDonald's could exploit that value through a sale-and-leaseback program.2 What may seem surprising about McDonald's is that it has always enjoyed 1
Roulac, S.E. 1999. "Real Estate Value Chain Connections: Tangible and Transparent". Journal of Real Estate Research. 17(3): pp. 387-404.
2
The Economist. 2003. "Business: Did Somebody Say a Loss? McDonald's" The Economist. 367(8319). p. 67.
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higher profits from its real estate than from its restaurant operations. The following excerpt regarding the McDonald's story captures the importance of reporting "fair value" versus historical depreciated cost on balance sheets, and provides a fine example of how real estate can support the business enterprise: In 1958, McDonald's had 38 restaurants and a net worth of only $24,000. It had lost $7,000 two years before. The company nearly missed payroll and was forced to borrow money from its suppliers. What saved McDonald's then, and what continues to separate it from other fast-food chains today, is its real estate strategy. That was devised by Harry Sonneborn, Kroc's chief financial officer, alter ego, and right-hand man. Sonneborn figured out that if McDonald's formed a separate real estate company – Franchise Realty Corp. – it could lease property and stores from local landlords and then turn around and sublease to the franchisee. Harry Sonneborn couldn't have cared less about hamburgers. He was a finance man, and his solution worked brilliantly. Collecting rent brought McDonald's predictable profits on stronger margins, gave pinched operators comfortable 20-year leases they could not have obtained on their own, and encouraged the kind of new-store growth that would later separate McDonald's from its peers. As long as the new stores stayed in business, McDonald's was in a position to make a good profit – from traditional royalties, plus rent calculated as a percentage of sales, plus a $7,500 security deposit on each new store (which Sonneborn then turned toward acquiring ownership of the leases) without taking on much risk. But to get the scheme on its feet, Sonneborn had to borrow money, and to borrow money McDonald's needed to show a higher net worth (emphasis added). Sonneborn hired ex-accountants from the IRS to devise a way to show that future rent payments from franchisees had a present value for the corporation and could be reported as an asset. Accounting principles at the time said nothing on the subject, but it was an aggressive move. According to John F Love's history, "McDonald's: Behind the Arches", Sonneborn's team did it in a footnote titled "Unrealized Increment from Appraisal in Valuation of Assets" (emphasis added). The line represented $5.8 million in capitalized leases, quadrupled the company's total assets, and allowed it to report ten times the previous year's net income. "It was the greatest accounting gimmick ever devised," Sonneborn said – a trick so good, he bragged, that it turned McDonald's from a hamburger company into a real estate company.3 Since McDonald's restaurant has fallen on troubled times in recent years, it has flirted with ideas related to its substantial real estate holdings to keep its operations afloat. These range from creation of a McREIT, to leasing restaurant sites, and letting franchisees own the buildings.4 The point here is that analysts need to get beyond traditional considerations of tax shelters, depreciation allowances, and strictures of "book value" accounting practices "to move real estate into the mainstream of corporate financial management by more effectively managing and holding real estate to satisfy broader corporate objectives. One of those objectives, of course, is more effective utilization of tax laws".5
3
Grainger, D. 2003. "Can McDonald's Cook Again?" Fortune. 147(7). pp. 120-129.
4
Gallun, A. 2003. "Real Estate Holdings More than Side Dish for Fast-Food Giant". Crain's Chicago Business . 24(18): p. 18.
5
Miles, M., Cringle, J., and Webb, B. 1989. "Modelling the Corporate Real Estate Decision". The Journal of Real Estate Research. 4(3): p. 49.
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6.4
Lesson 6
In a post-Enron world where accounting transparency is paramount, and in a globalized environment where consistent, accurate, and reliable standards are critical to attract investors, several professional organizations are advocating more meaningful financial reporting systems and international valuation standards. For example, the International Accounting Standards Board provided as of January 1, 2001 that an enterprise, when reporting on investment property, must choose either:
A fair value model – investment property should be measured at fair value and changes in fair value should be recognized in the income statement, or
A cost model – investment property should be measured at depreciated cost (less any accumulated impairment losses). An enterprise that chooses the cost model should disclose the fair value of its investment property.6
Not only will "fair value" reporting make financial statements more meaningful to investors and shareholders, it will also substantially increase demand for property consulting services. For further discussion and comparison of historical cost and fair value reporting, readers may wish to review material on the website of the US Financial Accounting Standards Board.7
Real Estate Tax Shelters Real estate tax shelters are instruments of government policy. Their policy objectives are broad ranging – they can be used to encourage investment and promote development in different geographic areas, provide housing incentives for various socio-economic groups, promote the conservation of a broad range of properties from heritage buildings to wet lands, or endorse legacy gifts to educational institutes.8 Tax shelters simultaneously provide investment incentives and present investor risks because they can shift with the political wind. Tax shelters are of interest to appraisers and analysts for a variety of reasons. Their consideration can provide different conclusions for similar properties for investment analysis and for appraisal purposes. They can affect the investor's (or developer's) choice of ownership structure. Of course, if you are a non-taxable pension fund, tax shelters are of little interest to you. But mainly, real estate tax shelters are of interest to property consultants because they influence the behaviour of players in the marketplace. Subsequent course material demonstrates the importance of tax shelters to the investment analyst and the appraiser. The investment analyst considers the impact of after-tax accounting practices that incorporate tax shelters, and which can substantially change the individual investor's return on equity (ROE), dependent on their specific tax position. On the other hand, the appraiser may find a different value conclusion for similar properties because calculations consider earnings-before-interest-taxes and depreciation (EBITD) for the typical investor. Ownership structures are considered later in the course material. At this point, it is sufficient to briefly describe a few aspects of the most common ownership structure that offers tax advantages used by the average investor in today's marketplace. The real estate investment trust, or REIT is a vehicle that "securitizes" large real estate investments for purchase by individual investors in smaller dollar amounts. 6
International Accounting Standards Board. "IAS 40: Investment Property". Website: www.ifrs.org. Retrieved May 17, 2011.
7
Willis, D.W. Financial Accounting Standards Board. "Financial Assets and Liabilities — Fair Value or Historical Cost?". Also see FASB Concepts Statement No. 7," Using Cash Flow Information and Present Value in Accounting Measurements". Website: www.fasb.org. Retrieved May 17, 2011.
8
For example, readers may wish to review tax shelter availability under Environment Canada's Ecological Gifts Program on their website: www.ec.gc.ca. Note the provision for tax credit based on the "fair market value" of the "ecogift".
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Taxation of Real Estate Investments
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For tax purposes, an investment in a REIT qualifies as a mutual fund trust, although they are not mutual funds as defined by securities legislation. Here is how one Canadian REIT describes the tax benefits: As a real estate investment trust, CREIT is structured to achieve tax efficiency for its investors. REITs are not generally required to pay Canadian income tax if they distribute all of their net income for tax purposes on an annual basis to unitholders. CREIT, in accordance with its Declaration of Trust, distributes a large percentage of its cash flow, which exceeds taxable income due in part to capital cost allowance (depreciation) deductions for tax purposes. This excess is generally not taxed currently in the unitholders' hands, but is treated as a return of capital with the tax deferred until the units are disposed of. REIT units are usually qualified investments for registered plans such as RRSPs, RRIFs, DPSPs, RESPs, and TFSAs. In general, when a unitholder disposes of a REIT unit it gives rise to a capital gain (or loss) equal to the amount by which the proceeds, net of disposition costs, exceeds (or is less than) the tax cost of the unit. Under the current tax rules in Canada, the unitholder in effect, need only include one-half of the capital gain in his/her taxable income. Commencing in 2005, non-resident unitholders are subject to withholding tax at a rate of 25% (or less if reduced by Tax Treaty) on the distribution paid and allocated as other income or capital gains. In addition, 15% tax must be withheld on the portion of the distribution that is a return of capital, with no treaty reductions available. 9 REITs are discussed in more detail in Lesson 10. The Tax Shelter Marketplace
Because of the secrecy in the tax shelter business, it is impossible to accurately estimate how big it is. However, one economist estimated that corporate tax shelters cost the US Treasury as much as $30 billion annually. Accounting firms were the initial players in the tax shelter industry, but investment banks got into the business when their regular work started slowing down in the late 1980s. Investment banks had two big advantages over accountants: the ability to actively sell the securities, and the power to raise capital. Legal firms are also key players in the tax shelter business. Sometimes they come up with new ideas and then market them with accounting firms or investment banks. However, their primary role has been in writing opinion letters vouching for the legality of the deals. The nature of tax shelters has changed over the years, and fewer of today's tax-avoidance measures require owning "hard assets", such as real estate. In fact, the collapse of many real estate tax shelters and limited partnerships has created "rollups". A rollup consolidates several partnerships into a "super" one, partly with the intention to reduce costs. The type of property used in real estate tax shelters has also changed over time. Hotel properties were once popular, but the limited partnership investment market became somewhat saturated with inexpensive hotels that were not profitable. Tax shelter schemes incorporating tourist resort properties were also common at one time, with locations ranging from Kelowna, BC to Tampa, Florida. These investments offered an element of tax relief, but were also often sold with a "right of use". That is, each year the investor was allowed a week or two when they could use the property personally.
9
Canadian Real Estate Investment Trust. "About REITs: Tax Benefits". Website: www.creit.ca/tax.cfm. Retrieved May 17, 2011.
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6.6
Lesson 6
Any potential investment in tax shelters also needs to consider the General Anti-Avoidance rule (GAAR), found in the Income Tax Act. Where a transaction is an avoidance transaction, the tax consequences may be determined as is reasonable in the circumstances to deny the tax benefit that would otherwise result. An avoidance transaction includes any transaction that would result directly or indirectly in a tax benefit, unless the transaction may reasonably be considered to be undertaken or arranged primarily for bona fide purposes other than to obtain a tax benefit. Although a transaction may be an avoidance transaction, GAAR will not be applicable unless there is a misuse or abuse of the Act read as a whole. The next sections will examine some recent examples of tax shelters which have been introduced and then eventually disallowed by the Canada Revenue Agency (CRA). Tax Shelter Court Cases
Two court cases are particularly relevant to the issue of real estate tax shelters as it relates to the concept of "reasonable expectation of profit" (REOP). That is, in order to deduct losses incurred from real estate related activities against the income from other sources, it must be established that the predominant intention was to make a profit from the activity, and that it was completed in a businesslike behaviour. This test originated in the prior court case of Moldowan v. The Queen10 where the judge stated that: Although originally disputed, it is now accepted that in order to have a "source of income", the taxpayer must have a profit or a reasonable expectation of profit. These cases are both Supreme Court of Canada decisions and therefore can be assumed to have a high level of precedent. Brian J. Stewart (Appellant) v. Her Majesty the Queen (Respondent)11
This case involved an experienced real estate investor who purchased four condominiums from which he earned rental income. Only a small portion of the total purchase price was paid in cash, and the remainder was financed on a highly levered basis. The purchase was arranged through a developer, and the developer projected negative cash flows (and therefore income tax deductions) for the next ten years for each of the four condominiums. The properties were part of a syndicated real estate development and were sold as a "turnkey" operation — i.e., management would be provided, a rental pooling agreement would be entered into, and the developer would also arrange financing. The CRA disallowed the rental loss deductions claiming that the investor had no REOP, and instead had purchased the properties as a tax shelter. This case was initially heard in the Tax Court of Canada and then the Federal Court of Appeal before being finally heard in the Supreme Court of Canada. The Tax Court found in favour of the tax department, and concluded that the requirements needed to meet the REOP test had not been demonstrated. The court reasoned that since there was no source of income existing for which the interest expense had been incurred, that interest expense was not deductible for purposes of the Income Tax Act.12 The Federal Court of Appeal also dismissed the investor's further appeal. The Appeal court found that there may have been an expectation of a capital gain, but not a rental profit, and there was also no realistic plan to produce a profit.
10
77 DTC 5213 (1978) 1 S.C.R. 480.
11
2002 DTC 6969.
12
Section 20 (1)(c).
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In the Supreme Court of Canada decision, however, the taxpayer's appeal was allowed. The Court found that the REOP test was problematic due to its vagueness and uncertainty of application. In its reasoning, the Supreme Court explained a two-stage approach in determining whether a taxpayer's activities constitute a source of business or property income, as follows:
first, has the activity been undertaken in pursuit of a profit, and secondly, if it is not a personal endeavour, is the source of income from a business or a property?
The judge found that although REOP is a factor to be considered for the first test, it is not the only factor, nor is it conclusive. It is also incorrect to second-guess the business judgment of the taxpayer. In summary, where the activity contains no personal element and is clearly commercial, no further inquiry is necessary. Only when the activity is considered a personal pursuit must a determination be made on whether or not the activity is being carried on in a sufficiently commercial manner to constitute a source of income. REOP is only one of several considerations to be considered in determining whether the activities are personal or commercial. Her Majesty the Queen (Appellant) v. Jack Walls and Robert Buvyer (Respondents)13
This case also dealt with the concept of REOP, but in this instance the structure of the tax shelter was by way of a limited partnership arrangement. Two investors were limited partners in a partnership formed to acquire and operate a mini-warehouse. Similar to the Brian J. Stewart case (discussed above), the purchase was arranged with only a small portion payable in cash and the remainder by way of an agreement for sale with interest payable at 24% per annum. The tax department reduced the partnership losses deducted by the investors on the assumption that the fair market value of the mini-warehouse was actually lower than claimed ($1.18 million versus $2.2 million) and that the interest expense should have been calculated at 16% per annum, not 24%, which was considered excessive. The Minister also argued that the partnership was not carrying on a business with REOP, and therefore the partnership's losses were not losses from a business. The Federal Court (Trial Division) dismissed the investor's initial appeal, but the further appeal to the Federal Court of Appeal was allowed. The Appeal court concluded that there was no personal element in the case, and the fact that the purchase had been driven, in part, by favourable tax considerations did not detract from the commercial nature of the investment. The Minister appealed to the Supreme Court of Canada, but their appeal was dismissed. The Supreme Court found the issues in this case similar to that of the Stewart case, and pointed out that where an activity is clearly commercial, the taxpayer is considered engaged in the pursuit of profit. The precise effect of these cases on the future structuring of real estate investments remains to be seen, but what is clear is that the REOP argument has been severely curtailed and the ability to deduct losses relating to these investments has been enhanced as a result. Tax Scheme Examples
Two separate examples are discussed below on how creative use of real estate can result in interesting tax sheltering. Both cases were challenged by CRA, however, and ultimately defeated, in part. The first example is relatively simple.14 A corporate taxpayer entered into a lease agreement that provided for a rent-free period of fourteen months, but the entire term of the lease extended over 15 years. In most 13
2002 DTC 6960.
14
Buck Consultants Limited (Appellant) v. Her Majesty the Queen (Respondent). 2000 DTC 6015.
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6.8
Lesson 6
cases corporations complete their financial statements according to Generally Accepted Accounting Principles, or GAAP, as a starting point in calculating their taxes owing, and from this amount various adjustments are made to account for specific differences in treatment according to the provisions of the Income Tax Act. In this case, the taxpayer deducted notional (but unpaid) rent that was calculated according to an amortization formula. More specifically, the corporation amortized the benefit of the rent-free period over the 15-year life of the lease and argued that a liability had been therefore incurred from the date of entering into the lease. According to GAAP, therefore, you could argue that the rent applicable to the rent-free period was an expense incurred in that period. However, the CRA denied the deduction. This example is an illustration on the different interpretation of what constitutes an outlay or expense that was "made". On the one hand the lease itself clearly indicated that there was no obligation to pay any rent during the rent-free period. On the other hand, the amortization approach used was quite possibly the most appropriate to adopt for accounting purposes. The second example is slightly more complex, involving two separate partnerships, and ultimately GAAR.15 The Minister applied GAAR to a series of transactions which enabled the taxpayer to hold a three-apartment property through the partnerships rather than directly, and thereby enabled him to defer the taxation of income earned for two years. This structuring also had the effect of permitting the deduction a greater amount of capital cost allowance (CCA) than otherwise possible. The specific facts of the case include the following: C
Two taxpayers purchased a three-apartment property for investment purposes paid for with a combination of cash and mortgage financing. Since the mortgage financing was incurred for investment purposes it was deductible against the rental income earned.
C
CCA could also be claimed against the rental income, but could not either create or increase a loss on the property.
C
Two general partnerships were formed, each with a different year-end. As the rules then existed, partnerships were able to have year-ends other than calendar year-ends, and the income/loss from a partnership would be recognized by the individual partners in the calendar year in which the partnership year ended.
C
Ownership of the properties was transferred to Partnership #1, but the related mortgage debt was still held personally. Partnership #2 held an ownership interest in Partnership #1. For accounting purposes, Partnership #1 had a fiscal year-end of February 28th and Partnership #2 had a fiscal year-end of January 31st. The rental income for the months from July (inception) to December of Year 1, therefore, was taxable in Year 2. (February 28th year-end). Since the February 28th yearend fell during Partnership #2's fiscal year ending January 31st, the rental income was not ultimately taxable under Year 3, for a total deferral of income for two years.
The Minister felt that this arrangement was clearly tax avoidance, and applied the provisions of GAAR for reassessment purposes. It was argued that in acting as he did, the taxpayer enabled the Partnerships to earn artificially inflated rental income which would have been reduced to zero if the partnership had to deduct the interest expense that the taxpayer continued to pay personally. In doing so, the partnerships were able to claim higher CCA than otherwise possible. Also, the interest continued to be deducted on the basis of a calendar year, whereas the reporting of rental income was deferred for two years through the use of the two partnerships.
15
Englebert Fredette (Appellant) v. Her Majesty the Queen (Respondent). 2001 DTC 621.
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The judge found only partially in favour of the tax department, coming to the conclusion that the staggering of the year-ends of the partnerships was done mainly to obtain tax benefits, that is, the deferral of taxation of rental income. Therefore, these transactions were found to constitute avoidance transactions. The correct adjustment was to tax the rental income in Year 2, not Year 3, and no other adjustments with respect to interest expense or CCA was recommended. Students should recognize, however, that for fiscal periods commencing after 1994, a partnership's fiscal period will end on December 31 unless specific conditions are met. A partnership otherwise compelled to have a calendar year fiscal period may elect to maintain a noncalendar fiscal period provided that each member of the partnership is an individual and the partnership is not a member of another partnership.
Conclusion Tax avoidance and tax deferral through vehicles such as real estate tax shelters and CCA are important considerations to property consultants. They can produce varying results in real estate appraisal versus investment analysis. The course material demonstrates how accounting methods consider tax shelters and show how to measure the impact on the return on equity (ROE) that is critical in investment analysis. On the other hand, the before-tax accrual accounting method used in appraisal analysis is based on EBITD for the typical investor that can result in substantially different value conclusions. Tax shelters can be attractive, but also become a source of risk for the investor. Investors need to remember that tax shelters are simply a reflection of government policy, which can change at a stroke of the legislative pen. One of the more memorable examples is the tax incentive program for multi-unit residential buildings (MURBs) that was discontinued in the 1980s. Happily for the appraiser/analyst, acquiring a greater understanding in, and proficiency at interpreting the impact of tax shelters on real estate can provide opportunities for valuation consulting. These opportunities have never been as apparent, or reliable advice so required, as in the post-Enron world. Corporations are increasingly required to present more meaningful information to potential investors, shareholders, and regulators. As a result, there is greater demand for knowledgeable property consultants who can interpret real estate (and intangible) assets on the balance sheet in the context of newer forms of corporate performance measurement such as economic value added (EVA) and revised accounting practices reflecting "fair value".
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6.10
Lesson 6
Review and Discussion Questions 1.
Define the following terms and provide a numerical example for each. (a) (b) (c) (d) (e)
2.
capital loss undepreciated capital cost terminal loss capital gain CCA recapture
Describe the optimal holding period for a real estate investment under five different assumptions: a perfect market, transaction costs, debt financing, straight line CCA, and accelerated CCA.
©Copyright: 2014 by the UBC Real Estate Division
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ASSIGNMENT 6 CHAPTER 7: Taxation of Real Estate Investments Marks:
1 mark per question.
THE NEXT THREE (3) QUESTIONS ARE BASED ON THE FOLLOWING INFORMATION: Jessie is opening a guitar shop and needs your help in deciding on a location. He has narrowed the choice down to three options: (i) (ii) (iii)
Rent a store which requires no immediate improvements and calls for annual rental payments. Purchase land and build a new store. Lease a currently existing building and renovate it to suit his needs. The lease would be prepaid for an 8-year term (with no renewal option) and the landlord has offered an allowance of 4 months free rent for any immediate improvements Jessie wishes to make to the building.
Jessie is very concerned with his income tax payable and wants to know how much each option will allow him to deduct from his taxable income. 1.
For the rental option, which of the following regarding Jessie's tax status is TRUE? (1) (2) (3) (4)
2.
For the purchase option, which of the following regarding Jessie's tax status is TRUE? (1) (2) (3) (4)
3.
The rent payments qualify as depreciable property under Class 13. The rent payments are subject to the "half-year" and "available-for-use" rules. The rent payments can be claimed as an expense against revenues. The rent payments can be claimed as a tenant inducement.
The building is depreciable using the declining balance method. The land is depreciable. CCA may be claimed as soon as construction is started. Only one-half of the potential CCA may be claimed in the first five years.
For the lease option, which of the following regarding Jessie's tax status is TRUE? (1) (2) (3) (4)
As the lease is less than 40 years, it does not qualify as depreciable property. The renovation allowance would be considered a tenant inducement for taxation purposes. CCA does not fall under the "half-year" and "available-for-use" rules. Tax on the tenant inducement would be due immediately.
***Assignment 6 continued on next page***
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6.12
Lesson 6
THE NEXT FIVE (5) QUESTIONS ARE BASED ON THE FOLLOWING INFORMATION: Shea Kahuna, a world-renowned professional surfer, decided eight years ago that he would like to live on Vancouver Island. He bought a beautiful home on waterfront property in Victoria for $400,000 and, although he purchased the house with the intention of living in it, eight years later he still has not left his home in Edmonton. The house in Victoria has been leased for the last 8 years to some local surfers, but Shea thinks it is now time to sell it. He set his price at $450,000 and received his asking price in the very first offer. However, since the purchaser wants to use this house as a revenue property, fierce negotiations have ensued over how this purchase price should be allocated between land and improvements. Shea wants $200,000 allocated to land and $250,000 to improvements, while Joe Purchaser wants $90,000 allocated to land and $360,000 to improvements. The negotiations appear to be stuck at this point. Other pertinent information regarding this property:
4.
of the $400,000 purchase price eight years ago, $60,000 was allocated to land and $340,000 to improvements the improvements consist of a single building which, for tax purposes, is listed as a Class 1 asset the building's current undepreciated capital cost is $250,000 Shea faces a 40% marginal income tax rate Shea is unsure whether the Canada Revenue Agency will classify his property on its sale as inventory, capital property, or as a principal residence. Which of the following statements regarding this classification is FALSE? (1) (2) (3) (4)
5.
Which of the following statements regarding the classification of a property as inventory is TRUE? (1) (2) (3) (4)
6.
A loss on the sale of a principal residence is one-half deductible, but only from other capital gains. A gain on the sale of a principal residence is exempt from taxation. Capital gains are only one-half taxable. Capital losses are one-half deductible, but only from capital gains.
Losses on real estate inventory are classified as business losses and are one-half deductible from other non-real estate income. Gains on real estate inventory which were accrued pre-March 1992 are exempt from taxation if an election for the lifetime capital gains exemption is filed with the taxpayer's tax return. Gain on the sale of inventory by a non-resident of a province is not subject to taxation under the Income Tax Act. Gains on real estate inventory are classified as business income and are fully taxable.
Which of the following factors would be the most important in the Canada Revenue Agency NOT classifying this property as Shea's principal residence? (1) (2) (3) (4)
Shea purchased the house with the intention of living in it. Shea never lived in the house and has lived for the last eight years in Edmonton. Shea purchased a plot of land which already had a building on it. The property is on the waterfront and is therefore classified as recreational property.
***Assignment 6 continued on next page***
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Taxation of Real Estate Investments
7.
Which of the following statements is TRUE? (1) (2) (3) (4)
8.
Joe prefers a higher allocation of the selling price to land in order to minimize recapture of CCA already claimed. Shea prefers a higher allocation of the selling price to the improvements in order to maximize his future CCA claims. The negotiation of allocation of the selling price is futile, since the Canada Revenue Agency will apply the same allocation percentage as Shea faced when he bought this property - 15% to land and 85% to improvements. The Canada Revenue Agency will abide by any allocation Joe and Shea agree upon, as long as it is deemed to be "reasonable" by the Canada Revenue Agency.
Assume that the only offer Shea received was for $280,000, with $60,000 allocated to land and $220,000 allocated to improvements. Which of the following statements is TRUE? (1) (2) (3) (4)
9.
Selling the property will characterize it as inventory and, because inventory is nondepreciable, Shea will have to pay back the CCA claimed over the last 8 years. For tax purposes, a capital loss is preferable to a terminal loss because a capital loss is only one-half taxed, while a terminal loss is fully deductible as a business expense. Because a capital loss cannot be realized on the sale of a depreciable asset, Shea would instead claim a terminal loss of $30,000. Shea can claim a capital loss of $120,000, which is deductible from any current or future capital gains.
The rule that soft costs must be capitalized DOES NOT apply to which of the following? A. B. C. D. (1) (2) (3) (4)
10.
6.13
Soft costs attributable to the period prior to commencement of construction or renovation Soft costs attributable to the period before completion of construction or renovation Soft costs related to development or renovation or ownership of land during construction or renovation period Landscaping costs and modification costs to assist the mobility of disabled people if paid in the year
Only Statements A and B. Only Statements B and C. Only Statements C and D. Only Statements A and D.
Which of the following statements concerning income from the disposition of real property is TRUE? (1) (2) (3) (4)
A transfer of a property through a lease or the refinancing of a mortgage is considered to be a disposal for capital gains tax purposes. The purchaser usually prefers a high allocation to the land to minimize recapture of CCA already claimed whereas; the vendor usually prefers a high allocation to the building because CCA is a deductible expense. The appreciation on highly-leveraged properties, particularly with short-term debt is generally not treated as business income. It is possible for a limited partner to have a negative adjusted cost base (ACB) with respect to the investment in the partnership at a particular point in time during the holding period.
***Assignment 6 continued on next page***
©Copyright: 2014 by the UBC Real Estate Division
6.14
Lesson 6
THE NEXT FOUR (4) QUESTIONS ARE BASED ON THE FOLLOWING INFORMATION: On January 1, 2008 Mick Goldberg invested in an apartment project in Prince George, BC on an all-equity basis with no debt financing. The property cost $1,700,000 with the following apportionment: Land: Structure: Furniture & Appliances: Paving & Sidewalks:
$ 350,000 $ 1,000,000 $ 300,000 $ 50,000
On January 1, 2014 Goldberg sold the investment for $2,750,000 with the following apportionment at the time of sale: Land: Structure: Furniture & Appliances: Paving & Sidewalks:
$ 1,000,000 $ 1,660,000 $ 50,000 $ 40,000
During the 6-year holding period he claimed the maximum CCA available, i.e., his CCA claim was not restricted by low income levels. Assume that Goldberg is in a 50% tax bracket, the price appreciation is treated as a capital gain (only onehalf taxable), and Goldberg has no capital gains exemption available. The applicable CCA rates are as follows: Structure (Class 1) is 4%, furniture and appliances (Class 8) is 20% and parking areas, roads, and sidewalks (Class 17 assets) is 8%. 11.
What is the taxable capital gain on the land and structure? (1) (2) (3) (4)
12.
What is the undepreciated capital cost for the structure, furniture and appliances, and paving and sidewalks, respectively, as at January 1, 2014? (1) (2) (3) (4)
13.
Land $325,000; Structure $330,000 Land $300,000; Structure $305,000 Land $650,000; Structure $660,000 Land $600,000; Structure $0
$749,124; $92,160; $34,387 $776,730; $83,728; $32,573 $719,159; $73,728; $31,636 $799,065; $88,474; $31,636
What is the CCA recapture for the structure and paving/sidewalks? (1) (2) (3) (4)
$180,841; $8,364 $221,007; $5,613 $200,935; $8,364 $176,343; $7,260
***Assignment 6 continued on next page***
©Copyright: 2014 by the UBC Real Estate Division
Taxation of Real Estate Investments
14.
6.15
What is the total reversion income tax payable? (Include taxable gains, CCA recapture, and terminal losses.) (1) (2) (3) (4)
$556,572 $412,913 $825,825 $385,239
THE NEXT TWO (2) QUESTIONS ARE BASED ON THE FOLLOWING INFORMATION: Glen Cooke invested in a limited partnership six years ago. At that time he purchased one limited partnership investment unit for $11,000. In the years since Glen purchased his investment unit, the partnership has undertaken several actions. Year
15.
1
the partnership allocated a $2,000 tax loss to each partnership unit
2
the partnership allocated a tax loss of $1,100 to each partnership unit
3
the partnership allocated a further tax loss of $1,100 to each partnership unit
4
(a) the partnership refinanced the debt on its investment and distributed $450 to each partnership unit (b) the partnership allocated taxable income of $250 to each partnership unit
5
(a) at the beginning of the year, Glen purchased an additional partnership unit for $11,000 (b) during the year, the partnership allocated $450 of taxable income to each partnership unit
6
(a) the partnership repaid $400 of equity to each partnership unit (b) the partnership allocated taxable income of $375 to each partnership unit
What is the adjusted cost base (ACB) of Glen's investment at the end of the sixth year? (1) (2) (3) (4)
16.
$18,450 $16,850 $19,000 $20,750
If Glen sold his interest in the partnership today for $10,000 per investment unit, what would be Glen's capital gain or capital loss on the sale? (1) (2) (3) (4)
17.
Action
$7,850 capital loss $575 capital gain $3,750 capital loss $1,550 capital gain
Which of the following statements is TRUE? (1) (2) (3) (4)
Soft costs are to be deducted as an expense. Capital losses can be claimed on depreciable assets such as buildings. The "half-year rule" is a restriction with respect to computing CCA when selling a property. None of the above statements are TRUE.
***Assignment 6 continued on next page***
©Copyright: 2014 by the UBC Real Estate Division
6.16
Lesson 6
THE NEXT TWO (2) QUESTIONS ARE BASED ON THE FOLLOWING INFORMATION: The following questions contain lists of goods and services related to real estate. Determine which are subject to the GST/HST and which are exempt. Assume all services are rendered by businesses with annual gross revenue greater than $30,000, all parties involved are Canadian residents, all purchasers are individuals, not corporations or other businesses, and none of the goods and services are zero-rated (taxable at 0%). 18.
Which of the following goods and services are exempt from the GST/HST? A. B. C. D. (1) (2) (3) (4)
19.
Only C is exempt from GST/HST. Only A and D are exempt from GST/HST. Only A, B, and D are exempt from GST/HST. None of the above are exempt from GST/HST.
Which of the following goods and services are exempt from the GST/HST? A. B. C. D. (1) (2) (3) (4)
20.
insurance provided by an insurance company sale of a 25-year old residential home which was newly renovated, but not substantially rent paid for a residential apartment with a 6 month lease maintenance fees received by a strata corporation
Only A is exempt from GST/HST. Only B and D are exempt from GST/HST. Only A, C, and D are exempt from GST/HST. All of the above are exempt from GST/HST.
Which of the following statements concerning the development of property is/are FALSE? A. B. C. D. (1) (2) (3) (4)
20
rent paid for use of a real estate office sale of a new $500,000 residential home sale of a recreational property fees for services rendered by a notary
GST/HST is only payable on substantially renovated housing which is purchased at a price of $450,000 or more. When developing property, all soft costs are expenses which can be immediately written off as expenses. When developing property, landscaping costs are expenses which can be immediately written off as expenses. CCA may be claimed for a building that is generally intended to earn rental income, up to the amount of the net rental income, while under construction.
Only Statements A and C are false. Only Statement D is false. Only Statements A and B are false. All of the above statements are false. Total Marks
***End of Assignment 6***
©Copyright: 2014 by the UBC Real Estate Division
