Replacement Property – Real Property
Has your business ever experienced a casualty event that resulted in an insurance claim, or disposed of property such as a building used in your business to purchase another one?
If so, the Income Tax Act provision contained within Section 44(1) could offer your business the opportunity to defer the capital gain on the disposition of the property as a result of the replacement event.
The Income Tax Act has specific rules for replacing capital property, which helps businesses when they need to replace property due to events such as fires, natural disasters, relocation, theft, or expropriations or when the business decides to dispose of and replace certain assets.
ITA 44(1) Deferral
Income Tax Act Section 44(1) offers a tax deferral opportunity for businesses that replace specific property that is a result of a Voluntary or Involuntary Disposition.
If the replacement is a result of an involuntary disposition, such as purchasing new equipment because of a fire, and the replacement occurs within 24 months after the end of the year in which the insurance proceeds were received, a deferral of the capital gains tax may be possible.
In the case of a Voluntary disposition, in other words, a disposition that is triggered by the business at its own discretion, the business may be able to defer the capital gains tax if the replacement occurs within 12 months after the year in which the proceeds for the disposed of property are received.
If the cost of the replacement is equal to or greater than the proceeds of disposition of the replaced property, there will be a 100% reduction of the capital gain.
Recapture
A similar provision relating to the Recapture of Capital Cost Allowance exists in the Income Tax Act Section 13(4). Recapture in basic terms, results when a capital asset is sold for more than what it was purchased for. The tax depreciation that was claimed, is effectively clawed back into income, and taxed as income. The amount of the proceeds in excess of the original cost results in a capital gain.
These rules allow you to delay paying tax as a result of Capital Gains or Recapture if your business meets the conditions.
Types of Dispositions
As noted above, there are two types of dispositions that can occur, Voluntary and Involuntary dispositions.
Involuntary Dispositions
• Examples of dispositions that are considered Involuntary dispositions include; theft, destruction as a result of natural or unnatural causes, and expropriation under statuary authority.
Voluntary Dispositions
• Most commonly involves a business relocation.
• The property being disposed of must meet the definition of a “former business property”. A former business property may include land or buildings. Depreciable property such as fixtures, or equipment will not qualify under this election.
Criteria for Eligibility
There are specific criteria that must be met to qualify for the deferral under ITA 44 (1):
- The new property purchase replaces the property that was disposed of.
- The new property serves a similar purpose as the old property.
- The new property was purchased to generate income from the same or similar business.
- The property must be replaced within specific time periods.
- Voluntary replacement: The purchase must occur within one year from the end of the tax year when the old property was sold.
- Involuntary Replacement: The replacement must occur within 12 months after the year in which the proceeds of disposition become receivable.
Replacements
When a capital property is disposed of either voluntarily or involuntarily the capital gain will be included in the net income in the year of the disposition. To reduce or eliminate the capital gain, the taxpayer needs to file an election under ITA 44(1). The election cannot be filed until the year the replacement property is acquired which could cause some taxpayers to have to file amended tax returns.
Election
An election must be completed in the taxpayer’s tax return in the year the replacement property was purchased. To defer the entire gain, the taxpayer must use all the funds from the sale of the former property to buy the replacement property.
The above article is meant to inform business owners of these provisions. It is important to always consult with a Tax Specialist to discuss your situation and facts.
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