When Expectation Becomes Intention
January 27th, 2017
Owning rental property has long been a popular investment, particularly when losses from the property can be deducted against other income. However, Canada Revenue Agency (CRA) sometimes attacks rental-related expenses and denies the deductions.
Over the years, a number of special provisions have been introduced into the Income Tax Act to limit taxpayers’ ability to claim rental losses. For example:
Regulation 1100(11). Under this provision, a rental loss can’t be created or increased by claiming the Capital Cost Allowance (CCA). All rental properties owned are pooled for purposes of this regulation. The result is that a taxpayer can only claim the CCA if total rental revenue exceeds total rental expense, and then, only enough to reduce income to zero.
Subsection 13(21.1). When land and buildings are sold together, any terminal loss on the building is reduced to the extent of any capital gain on the land. So, you can’t manipulate the amount of the deduction of a terminal loss at 100% and report a capital gain taxable at 50%.
The tax agency also has a long history of denying rental losses due to a taxpayer having no “reasonable expectation of profit”. But in two Supreme Court rulings described below, the court struck down the expectation of profit test and said the tax agency should use a two-pronged approach to losses:
- If the taxpayer’s activity is “undertaken in pursuit of profit,” the income is deemed to be from a business or property and losses will be allowed. Where there is no personal element, the CRA shouldn’t second guess a taxpayer’s business decisions.
- If the enterprise has a personal element, the tax auditors must consider whether the taxpayer had an “intention to profit” from a business operated in a “sufficiently commercial manner.” (Stewart v. The Queen, 2002, SCC 46 and Walls v. The Queen, 2002, SCC 47).
While “sufficiently commercial” wasn’t defined, all circumstances surrounding the activity should be considered in making that determination.
So Finance Canada added a more restrictive and onerous test aimed at eliminating many real estate investments (including tax shelters). A loss on a property is only allowed if it is reasonable to assume that the taxpayer will realize a cumulative profit from the property during the time the taxpayer has held, or can be reasonably expected to hold, the property.
In addition, the expected profit has to come from renting the property. It can’t come from a capital gain due to the increase in value of the property. The legislation specifically provides that there is no source of income from capital gains, and therefore no profit from a capital gain.
The test is to be applied every year a loss is deducted. On the other hand, if the property starts to make a profit – even if there previously had been no reasonable expectation of profit – the profit will be taxable in the year it is made. (It doesn’t appear a taxpayer will be allowed to go back and amend prior years’ returns to deduct losses not previously deductible.)
If you have leveraged investments in real estate where the rental revenue isn’t expected to exceed the expenses for many years, consult with your advisor and review these four points:
- Have there been profits or losses in the past?
- How does your training and background affect the situation?
- What is your profit intention?
- Is there any personal element? For example, do you or family members use or reside on the property?
The Landmark Cases Stewart v. The Queen.
The taxpayer invested in four condominium units and the investment had no element of personal use.
He incurred losses from the beginning because the purchase was financed almost entirely with debt and he had significant interest expenses. Losses were projected to continue for up to 10 years. The CRA disallowed the losses using the “reasonable expectation of profit” test, arguing there was no source of income. The deduction for interest expenses was also disallowed.
The Supreme Court of Canada ruled that Stewart was entitled to deduct his losses since his rental property lacked any element of personal use and was clearly a commercial activity.
Walls v. The Queen. A limited partnership invested in a warehouse business. The partnership paid service charges, management fees, and 24% annual interest on the purchase price of $2.2 million.
The taxpayers then deducted their share of the losses. The CRA again disallowed the losses based on real expectation of profit but the Supreme Court ruled:
” . . . there was no evidence of any element of personal use or benefit in the operation. Where, as here, the activities have no personal aspect, reasonable expectation of profit does not arise for consideration. Although the respondents were clearly motivated by tax considerations when they purchased their interests in the partnership, this does not detract from the commercial nature of the storage park operation or its characterization as a source of income.”