Principal Issues: [TaxInterpretations translation] (1) Can renovation expenses for two housing units in a rental building, including expenses for the addition of a third housing unit, be capitalized to the cost of the building? (2) If the property is resold within one or two years of its acquisition, how will the gain from the disposition be treated?
Position: Questions of fact. If the expenditures provide a lasting benefit, they can likely be capitalized. The cost of adding a third housing unit appears to be of a capital nature. If the taxpayer intended to resell the property at a profit when it was acquired, the gain from the disposition of the property will generally be income from a business.
Reasons: The Income Tax Act.
XXXXXXXXXX 2010-037717
February 11, 2011
Dear Madam,
Subject: Nature of expenses incurred in respect of a rental building
This is in response to your letter of June 30, 2010, in which you requested our comments with respect to the situation described below. I apologize for the delay in answering your question.
Unless otherwise identified, all statutory references in this document are to the provisions of the Income Tax Act (the "Act").
Specifically, you indicated that you are able to purchase an income property, which you intend to resell within a year or two. The building in question contains two housing units that must be renovated before being rented to tenants. You may also add a third unit in the basement of the building, provided you obtain the necessary authorizations from your municipality.
You asked us the following two questions:
(1) If the renovation work, including work to add a third housing unit, is done by your spouse and the work is billed at fair market value, you wish to know if the expenses related to this work can be capitalized to the cost of the building. For the purposes of this question, we have assumed that you are the sole owner of the building.
(2) If you sell the property within one or two years of its acquisition, will the proceeds of disposition constitute a capital gain or should they be included in income?
OUR ANALYSIS
It is a question of fact as to whether expenses are of a capital or current nature and there are various cases on this subject that form the basis of the guidelines described in Interpretation Bulletin IT-128R, Capital Cost Allowance - Depreciable Property (the "Bulletin"). Ultimately, as the Supreme Court of Canada stated in Johns-Manville Canada Inc. v. R., "[i]t is a commonsense appreciation of all the guiding features which must provide the ultimate answer." (footnote 1).
Paragraph 4 of the Bulletin provides six criteria to assist taxpayers in determining the nature of an expenditure. The following criteria are the ones we consider most relevant to your situation:
- Enduring Benefit - Decisions of the courts indicate that when an expenditure on a tangible depreciable property is made "with a view to bringing into existence an asset or advantage for the enduring benefit of a trade", then that expenditure normally is looked upon as being of a capital nature.
- Maintenance or Betterment - Where an expenditure made in respect of a property serves only to restore it to its original condition, that fact is one indication that the expenditure is of a current nature. Where, however, the result of the expenditure is to materially improve the property beyond its original condition, such as when a new floor or a new roof clearly is of better quality and greater durability than the replaced one, then the expenditure is regarded as capital in nature.
- Relative Value - The amount of the expenditure in relation to the value of the whole property or in relation to previous average maintenance and repair costs often may have to be weighed. This is particularly so when the replacement itself could be regarded as a separate, marketable asset. On the other hand, the relationship of the amount of the expenditure to the value of the whole property is not, in itself, necessarily decisive in other circumstances, particularly where a major repair job is done which is an accumulation of lesser jobs that would have been classified as current expense if each had been done at the time the need for it first arose; the fact that they were not done earlier does not change the nature of the work when it is done, regardless of its total cost.
- Anticipation of Sale - Repairs made in anticipation of the sale of a property or as a condition of the sale are regarded as capital in nature. On the other hand, where the repairs would have been made in any event and the sale was negotiated during the course of the repairs, or after their completion, the cost should be classified as though no sale was contemplated.
In this case, with the exception of the expenses that will be incurred for the addition of a third housing unit, it is not possible for us to determine whether the renovation expenses you will incur are of a capital nature or whether they can be deducted as current expenses. Indeed, we are not aware of the nature and extent of the renovation work that will be undertaken on the housing units. However, to the extent that this work creates a lasting benefit for your rental activities and/or is an improvement over existing housing units, we are of the view that the expenditures could be added to the capital cost of the building. Obviously, the expenses incurred for the addition of a third housing unit can be capitalized.
With respect to your second question, a gain from the sale of an immovable may be considered income from business, income from property or a capital gain.
The Act does not specify under what circumstances gains from the sale of an immovable should be treated as income or capital gains. However, in making such determinations, the courts have considered factors of the kind listed below. Interpretation Bulletin IT-218R -- Profit, Capital Gains and Losses from the Sale of Real Estate, Including Farmland and Inherited Land and Conversion of Real Estate from Capital Property to Inventory and Vice Versa, lists some of these factors:
(a) the taxpayer's intention with respect to the real estate at the time of its purchase;
(b) feasibility of the taxpayer's intention;
(c) geographical location and zoned use of the real estate acquired;
(d) extent to which intention carried out by the taxpayer;
(e) evidence that the taxpayer's intention changed after purchase of the real estate;
(f) the nature of the business, profession, calling or trade of the taxpayer and associates;
(g) the extent to which borrowed money was used to finance the real estate acquisition and the terms of the financing, if any, arranged;
(h) the length of time throughout which the real estate was held by the taxpayer;
(i) the existence of persons other than the taxpayer who share interests in the real estate;
(j) the nature of the occupation of the other persons referred to in (i) above as well as their stated intentions and courses of conduct;
(k) factors which motivated the sale of the real estate;
(l) evidence that the taxpayer and/or associates had dealt extensively in real estate.
The taxpayer's intention at the time of purchase of the immovable is an important factor to consider in determining whether a gain from its sale will be treated as business income or a capital gain. At the time of acquisition of the immovable, the taxpayer may have a secondary intention to resell it at a profit if the taxpayer’s original intention is abandoned. If the secondary intention is realized, any gain realized on the sale will usually be taxed as income from business.
Thus, if you purchase an immovable with the intention of reselling it at a profit within a few years, the gain from the disposition of the immovable will generally be considered to be income from a business.
Access to Information
For your information, unless exempted, a copy of this memorandum will be severed using the Access to Information Act criteria and placed in the Canada Revenue Agency's electronic library. A severed copy will also be distributed to the commercial tax publishers for inclusion in their databases. The severing process will remove all material that is not subject to disclosure, including information that could disclose the identity of the taxpayer. Should the taxpayer request a copy of this memorandum, they may request a severed copy using the Privacy Act criteria, which does not remove taxpayer identity. Requests for this latter version should be made by you to Ms. Celine Charbonneau at (819) 994-2898. In such cases, a copy will be sent to you for delivery to the taxpayer.
We hope that these comments are of assistance.
François Bordeleau, Advocate
Manager
Business and Partnerships Section
Income Tax Rulings Directorate.
FOOTNOTES
Due to our system requirements, footnotes contained in the original document are reproduced below:
1 [1985] 2 S.C.R. 46