Are you a long term, flipper or short-term buy/sell investor? It’s important to consider your real estate investment style. Are you a long term rental property investor or a property flipper – a short-term buy/sell investor? What is your comfort level for risk and market conditions? If you have rental property investments, are you actively involved in the property management or do you use a property management company? Do you like all the aspects of what you are doing related to your real estate investments? Can you delegate some? What are your strengths and weakness? What is your time worth? Understanding your investment style is fundamental for you and for one of your most important supports for your real estate investment – your accountant.
Knowing this distinction is critical as the tax authorities treat flipping real estate significantly different than long term investing. For example, even if you are a long term investor and sell a property in a short time (a year or two after purchase) the tax authority may look at the property as inventory and lean towards treating the gain as business income vs. a capital gain. This can have a significant impact on your income and subsequent taxes. Recently, Canada Revenue Agency has made a point of focusing on the real estate investor and looking at this very important aspect of real estate investing.
Flipping a Property for Capital Gains?
Thinking of flipping a property and reporting the profit as a capital gain? You may want to think again. Capital gains are generally favorable to business or property income for tax purposes because of the fact that only half of your capital gains are subject to income tax. While the sale of a property held for the purpose of generating rental income would normally be considered a capital gain, this is not always a black and white scenario.
Use the analogy of an apple tree: An apple farmer purchases an apple tree in order to grow and sell apples. The apples are her inventory, while the tree is her capital property. When the farmer sells the apples she is generating business income, but if at some point down the road she decides to sell the tree, she is selling a capital property. If she makes a gain on the sale of the tree that would be a capital gain and taxed at only half her marginal tax rate. The same can be said for an income producing property. If you were to buy an income producing property, rent it out for a decade, profit during that rental period, then eventually sell the property at a gain, the rental profits would be taxed at the full rate and the gain on sale would most likely qualify as a capital gain (taxed at half your marginal rate).
The same cannot be said for short term property flips. When buying or selling a property on a short term basis for a profit (say buying, renovating, and then flipping) the CRA may consider the gains to be a type of business income rather than capital, thereby taxing the full gain at your marginal tax rate. Why is this? The law distinguishes between properties explicitly bought to generate rental income and those bought to profit on a sale. The former would normally be considered capital property to the taxpayer while the latter would be considered a type of business related inventory or more specifically an “adventure in the nature of trade.” While there are no concrete rules on whether a transaction is on capital account or an adventure in the nature of trade there are several indicators that the CRA and courts would take into consideration. Among these considerations are:
- Whether the property was bought and sold in a manner similar to a dealer in that property
- Whether the taxpayer has developed a pattern of buying and selling properties with short holding periods
- Whether or not the taxpayer’s intentions were consistent with a business transaction or adventure in the nature of trade.
The determination of whether or not the sale of a property is a capital gain or business income is complex and has been played out in the courts on numerous occasions.