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									                           Replacement Property Rules




Presented to: Fraser Valley CA Association

March 5, 2009

Presented by:   Steven Araki, CA
                David Metzger, CA


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Replacement property rules = tax deferral

Ways to defer taxes:
 Defer income (e.g. accruing bonuses, different
  year ends, completed contract method)
 Use of small business deduction
 Pay safe income dividends
 Claim reserves where not all proceeds received
  (income under 20(1)(n) or capital gain under
  40(1)(a)(iii))
 Replacement property rules:
      capital assets (today’s presentation)
      small business shares – S. 44.1 (post Oct 17/00)


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Technical references

Relevant sections of the Income Tax Act
 S. 44(1) – capital property
 S. 13(4) – depreciable property
 S. 14(6) – eligible capital property


Other reference sources
 IT-259R4 Exchanges of Property
 IT-491 Former Business Property




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Replacement property rules – when apply?

   Disaster

   Relocate business




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Requirements

   Amount has become receivable by taxpayer as
    proceeds of disposition

   Taxpayer acquires a “replacement property”
    within the required time

   Taxpayer elects in their tax return




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“Replacement property” means:

   Acquired to replace the former property
    (purpose test)

   Have the same or similar use as the former
    property

   Be used in the same or similar business as the
    former property (if applicable)




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Types of dispositions

   Involuntary
       compensation for property unlawfully taken
       compensation for property destroyed
       compensation for property taken under statutory
        authority (or intention to be taken)
       replacement must be acquired within 24 months
        following the year of disposition
   Voluntary
        “former business property” – capital property that was
        real property used primarily for the purpose of gaining
        or producing income from a business
           excludes real property used to generate rent other than
            property leased to a related person and used principally
            for any other purpose
       replacement must be acquired within 12 months
        following the year of disposition

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Making the election

   If disposition and replacement in the same year, then
    filing the correct calculations constitutes the election

   If replacement in a subsequent year, elect by attaching a
    letter to tax return in the year acquired
       should include description of properties, calculations and
        request for adjustments


   If replacement acquired in a year prior to disposition,
    attach a letter to tax return in the year acquired
       should included description of properties
       can late file with tax return for year of disposition if it’s
        evident that new property qualifies


   Can also late file under Taxpayer Relief Provisions
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Example

   Former property:
              Cost       UCC      Proceeds
    Land    $250,000    $     -   $425,000
    Building 150,000     75,000    125,000
            $400,000    $75,000   $550,000

   Replacement property:
    Land    $400,000
    Building 150,000
            $550,000

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Example (cont)

S. 44(1)(e) gain on land:
                    No replace With replace
    Proceeds         $425,000   $425,000
    Cost              250,000    400,000
    Capital gain     $175,000   $ 25,000

   ACB of land     $400,000    $250,000




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Example (cont)

S. 13(4) recapture on building:
                       No replace               With replace
    UCC                $ 75,000                 $ 75,000
    LCP                 125,000         125,000
    Reduction                           (50,000)
                                                  75,000
    Recapture           $ 50,000                $       -

    UCC for bldg        $150,000                $100,000

Notes:
LCP = Lesser of cost ($150,000) and proceeds ($125,000)
Reduction = Lesser of recapture ($50,000) and replacement cost
    ($150,000)
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Summary of example results

Without replacement property rules:
 Capital gain on land = $175,000
 Recapture on building = $50,000


With replacement property rules:
 Capital gain on land = $25,000
 Recapture on building = $0


New ACB of replacement land = $250,000

New UCC of building = $100,000
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44(6) Reallocate proceeds

   Applies to capital gains, but not recapture
   Reallocate proceeds between land and buildings
   Match up allocation with replacement costs
   Minimize building proceeds to minimize grind on
    UCC
   Elect in year replacement property is acquired




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44(6) Example

   Before 44(6)
               Cost     Proceeds   Excess
    Land     $250,000   $425,000   $175,000
    Building 150,000     125,000          -
             $400,000   $550,000   $175,000

   After 44(6)
                        Proceeds
    Land                $400,000
    Building             150,000
                        $550,000
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44(6) Example (cont)

S. 44(1)(e) gain on land:
                    No replace With replace
    Proceeds        $425,000   $400,000
    Cost              250,000   400,000
    Capital gain    $175,000   $      -

   ACB of land    $400,000    $250,000




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44(6) Example (cont)

S. 44(1)(e) gain on building:
                    No replace With replace
    Proceeds        $125,000   $150,000
    Cost             150,000    150,000
    Capital gain    $       -  $      -

   Capital cost   $150,000    $125,000
   UCC            $150,000    $ 75,000




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To elect or not to elect

   Generally, elect to defer recapture as 100%
    taxable

  Consider not electing if have a capital gain on
   land and shareholder considering withdrawing
   cash from company:
                  Non-elig
                  Dividend      Capital gain
Draws             1,000,000     1,000,000
Tax rate                33%          22%
Taxes               330,000       220,000

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Misc. planning points

   If acquire more than one replacement property,
    grind the one that will be held the longest to
    defer the capital gain the longest.

   If sell former property in year 1 and acquire
    replacement property in year 2, don’t pay capital
    dividend in year 1 as CDA disappears once
    make replacement property election.

   Land acquired for resale cannot qualify as not a
    capital property.

   Can acquire replacement property prior to
    disposition of former property.
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Misc. planning points

   Facts:
       Opco owns real property used in business (Prop 1)
       Opco acquires another property to replace Prop 1
        (Prop 2)
       Intend to lease out Prop 1, but will sell it before Prop 2


   Plan:
       Opco sells Prop 1 to a Sub and triggers capital gain
       Opco purchases Prop 2
       Opco uses replacement property rules to defer capital
        gain on Prop 1 by using Prop 2’s replacement cost




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Acquiring shares of a company

   Shares probably cannot qualify as replacement
    property - Dallas [2005] 1 C.T.C. 47 (FCA)

   Property acquired on the winding-up of a
    company may qualify – IT-259R4 p. 22

   Land transfer tax applies on winding-up, but not
    on amalgamation

   Is property “acquired” on an amalgamation?

   Work around?
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Partnerships

   A partnership can use the replacement property
    rules – IT-259R4 p. 23

   A partner’s property used by the partnership
    may qualify for the replacement property rules –
    IT-259R4 p. 23

   Former partners who have an undivided interest
    in former partnership property may be able to
    use the rules to “swap” properties so each
    partner can become the sole owner of a
    property – IT-491 p. 12

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Property must be used, not just acquired

   Vacant land is not “used” therefore, a capital
    gain from its sale cannot be deferred using the
    replacement property rules – TI 2004-0088421E5

   Klanten Farms Ltd. [2007] 5 C.T.C. 2384 (FCA) –
    property acquired on wind-up of subsidiary not
    used in farming as leased out

   Depaoli [2005] 1 C.T.C. 47 (FCA) – owner
    arranged for local farmers to cultivate, plant and
    harvest crops. The purpose of the cultivation
    was to keep the land clean and workable.
    Qualified as “used”.
                                                         22
Same or similar use

   Generally bear same physical description
   Warehouse = manufacturing building
   Retirement home cannot replace a motel
    because the use and business are different – TI
    2003-0053261E5
   An RV park can “replace” a motel if it includes
    similar services – TI 2006-0173181E5
   May be able to defer capital gain on a cottage if
    involuntarily disposed of – use is non-income
    earning purpose – IT-259R4 p. 16



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Same or similar business

   Businesses will be considered similar if they
    both fall within the same category
   See IT-259R4 p.18-21 for categories:
       Farming
       Merchandising (retail/wholesale)
       Manufacturing and processing
       Etc.
   OK to change category if produce same product
   Service industries:
       Depends on facts
       CRA to interpret “similar business” reasonably broadly


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Business expansion

   “…the fact that a property is purchased under a
    business expansion will not, in and by itself,
    mean that the property cannot be considered a
    replacement property.” IT Tech News No. 25
   Must be some correlation or direct substitution,
    that is, a causal relationship between the
    disposition of a former property and the
    acquisition of the new properties.
   Must review the facts of each situation
   Minimize overlapping operations
   2002-0156414; 2003-0006993


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Leased property

   A building situated on leased land can be a
    “former business property” since it is an
    interest in real property – TI 2002-0173815

   Leasehold improvements are depreciable
    property; therefore may qualify – TI 2006-
    0156171E5




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How you can help your clients

   Time limit
   How much to spend on land/building
   Modeling tax impact of electing vs. not electing
   Preparing election
   Revising prior year’s tax returns
   Similar use/business issues




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