Principal Issues: What is the tax treatment of a capital gain realized by spouses who are undivided co-owners on the sale of their real estate property?
Position: Tax treatment will depend on what are the legal transactions under private law. Based on the assumptions that one of the spouses made a donation or a loan to the other spouse, attribution rules should apply.
Reasons: Donation or loan between spouses.
FEDERAL TAX ROUNDTABLE 7 OCTOBER 2021
2021 APFF CONFERENCE
13. Sale of an undivided co-owned property
A and B are spouses.
A and B were co-owners of a cottage that they purchased for $400,000 in 2010. The purchase contract and their undivided co-ownership agreement did not refer to each person's undivided share. Pursuant to Article 1015 of the Civil Code of Québec (footnote 1), they were therefore presumed to each own 50% of the cottage. The $100,000 down payment was paid solely by A.
As to the balance, A and B received a mortgage loan of $300,000, for which each was solidarily liable to the lending institution.
At the time of purchase, the spouses entered into an undivided interest agreement providing that, as between them, each would be responsible for repaying half of the mortgage loan. Consequently, each was responsible for 50% of any payments made to the lender, whether as principal or interest, including any prepayments.
A and B sold their cottage in April 2021 for $700,000, without any sales commission. The mortgage loan was repaid in full before the sale (50% each). Neither spouse claimed the principal residence exemption.
First situation: the undivided co-ownership agreement did not contain any specific clause regarding the possible sharing of the price in the event of a sale of the cottage.
In the absence of such an agreement, the sale price of the cottage was divided as follows between the two spouses:
- A (50%): $350,000
- B (50%): $350,000
Each spouse's adjusted cost base ("ACB") was allocated as follows:
- A (50%): $200,000
- B (50%): $200,000
Second situation: the undivided co-ownership agreement provided that if the cottage was sold, the net sale price would be divided as follows between the two spouses:
- A: priority right to receive the sum of $100,000 (the down payment), plus a predetermined return.
- A and B: each was then entitled to receive 50% of the balance of the net sale price.
Questions for CRA
(a) In the first situation, since the down payment was fully paid by A, A will be considered to have made a gift of $50,000 to B at the time of purchase (50% × $100,000). Would this gift be subject to the s. 74.2(1) attribution rule regarding the capital gain?
Instead, could the ACB of each be allocated as follows?:
A : $250,000 ($100,000 + (50 % × $300,000))
B : $150,000 (50 % × $300 ,000)
b) In the second situation, in CRA's opinion, pursuant to Art. 1015 C.C.Q. of the Civil Code, will each be required to report the following proceeds of disposition and ACB in 2021
A (50 %) : $350,000 - $200,000
B (50 %) : $350,000 - $200,000
Is it then reasonable to conclude that the $100,000 priority payment to A actually includes the repayment by B of a loan made to B by A at the time of purchase, being 50% of the $100,000 down payment, or $50,000? Alternatively, would the return paid to A on 50% of the down payment be considered fully taxable income to A in 2021 (interest income)?
CRA Response
Tax law is an accessory law whose effects are based on the rights and obligations arising from the applicable private law, in particular as regards the effects of contracts. Tax law is therefore generally only involved in determining the tax consequences of the effects of contractual transactions.
In the two situations described, the tax treatment will depend on the analysis that can be made of the transactions carried out and their legal effects for the parties, according to the applicable private law, in this case Quebec civil law. We have assumed that those legal transactions are governed by the law applicable in the province of Quebec, i.e., by the Civil Code of Quebec.
The issues of whether co-owners are equal and whether an unequal down payment constitutes a gift, loan or other transfer are questions of fact and law, on which the CRA will not provide an interpretation. It is not the CRA's role to undertake the legal analysis that would be required regarding the transactions described. Those issues could potentially only be determined in the context of an audit or advance ruling request (submitted in accordance with the terms of Information Circular IC 70-6R11) in respect of proposed transactions.
We can, however, make certain assumptions in order to provide general comments on the applicable tax treatment that may be useful in these hypothetical situations.
Assumptions
As a preliminary matter, we have assumed that the undivided interests in the cottage are not depreciable property to either A or B. We also have assumed that A and B are Canadian residents and common-law partners throughout the period described.
In the first and second situations, it seems reasonable to assume that the presumption set out in Article 1015 C.C.Q., in the absence of any indication of fact to the contrary, could apply, so that the shares of the co-owners, A and B, in the cottage would in fact be equal. Indeed, even in the second situation, the fact that the undivided co-ownership agreement referred to an amount that would be paid in priority to A from the proceeds of the sale as a "return" seems to indicate the existence of a loan rather than different shares in the immovable.
In the first situation, in the absence of any indication that A had made a loan to spouse B, it seems plausible that the $100,000 down payment ("down payment") made by A at the time of the purchase of the cottage was a gift to A's spouse for half of that amount. In the second situation, as discussed above, the reference to a return on the down payment originally paid by A seems to indicate the presence of a loan.
For the purposes of our comments, we have therefore assumed that, in the first situation, A paid the down payment for himself and his spouse, donating half of the amount to B.
We have also assumed that in the second situation A made the down payment for himself and his spouse, lending B half of that amount.
Finally, in the second situation, we have assumed that the return on the loan for half the amount of the down payment is interest.
Our Comments
The term ACB is defined in section 54. Paragraph (b) of that definition provides that the ACB of a property that is not depreciable property is equal to the cost of the property to the individual, adjusted in accordance with section 53.
The term "cost" is not defined in the Income Tax Act. Where a property is acquired in undivided co-ownership, it is the CRA's view that the cost of the property to a taxpayer is the cost of the taxpayer's undivided share in the property.
Where a taxpayer's outlay is paid for by a gift, money or loan that the taxpayer has otherwise received (or is considered to have received), that outlay forms part of the cost of the taxpayer's undivided share in the property.
Given the assumptions we have made, it would not be possible to determine the ACB of each spouse's undivided share by considering that the down payment was fully included in the acquisition cost of A's undivided share.
In both situations, the capital gain realized by A and B should therefore correspond to the excess of the proceeds of disposition of their undivided interest in the property over the ACB of that property, it being understood that, since they have equal undivided interests, their proceeds of disposition and ACB will be equal.
The second step would be to consider the application of the attribution rule in subsection 74.2(1) since A, at the time of the acquisition of the immovable, transferred or loaned property to his spouse, namely an amount of $50,000 and, at the time of the sale of the cottage, B realized a capital gain on the property substituted for that amount.
Subsection 74.2(1) provides, inter alia, that where an individual has lent or transferred property, either directly or indirectly, to a person who is the individual's spouse or common-law partner, the taxable capital gain (or allowable capital loss) realized by the recipient spouse on the disposition of the loaned or transferred property or property substituted therefor is deemed to be the individual's taxable capital gain or allowable capital loss.
In the second situation, where a loan was involved, subsection 74.2(1) would also apply, notwithstanding A's priority right to receive the sum of $100,000 (in consideration of the down payment made by A), plus a predetermined return. Subsection 74.5(2) provides that subsections 74.1(1) and 74.1(2) and section 74.2 do not apply to any loan for which the interest is calculated at a rate equal to or greater than the lesser of the following rates
- the prescribed rate;
- the rate that would, having regard to all the circumstances, have been agreed on between parties dealing with each other at arm’s length;
on the date the loan is made (paragraph 74.5(2)(a)), provided that all such interest is paid not later than 30 days after the end of each calendar year in which it became due (paragraphs 74.5(2)(b) and (c)).
It seems clear that the interest on the loan made in the second situation would not have been paid within the time limits set out in paragraph 74.5(2)(c) for all the years preceding the year of the disposition. Subsection 74.5(2) would therefore not apply.
Thus, in the first and second situations, and subject to the application of subsection 74.5(11), the attribution rule in subsection 74.2(1) would apply and one quarter of the taxable capital gain realized by spouse B, corresponding to the proportion of the amount donated or loaned by A to B over the cost to B of acquiring his or her undivided share of the immovable (i.e., $50,000/$200,000), would be attributable to A.
Finally, in the second situation, the interest paid to A from the proceeds of the sale of the cottage, in respect of the loan made to B for the down payment, would be taxable to A under paragraph 12(1)(c).
Michel Ostiguy
October 7, 2021
FOOTNOTES
Due to the requirements of our systems, the footnotes contained in the original document are reproduced below:
1 CQLR ("C.C.Q.").
2 CANADA REVENUE AGENCY, Information Circular IC70-6R11 "Advance Income Tax Rulings and Technical Interpretations", April 1, 2021 (French online: https://www.canada.ca/fr/agence-revenu/services/formulaires-publications/publications/ic70-6.html). (English online https://www.canada.ca/en/revenue-agency/services/forms-publications/publications/ic70-6/ic70-6.html)]