Module 6: Capital gains and losses

Transcription

1 Module 6: Capital gains and losses Overview Taxable capital gains and allowable losses are included in income under paragraph 3(b). However, the detailed rules governing capital gains and losses are found in subdivision c of Division B of the ITA, which encompasses sections 38 to 55. The rules for calculating capital gains or losses are numerous and sometimes complex. You will not study all the rules for the purposes of this course. You will learn the most significant aspects of the tax treatment of capital gains and losses. First, you will study why capital gains are subject to a preferential tax treatment. Then, you will study the basic concepts and rules for the recognition and computation of capital gains and losses. You will learn that in order to reduce or defer income tax, taxpayers may sometimes defer taxation of capital gains by establishing a capital gains reserve where proceeds of disposition are not due until a future year. Next, you will see that the tax treatment of capital gains and losses is also influenced by the nature of the property in question and that there are many restrictions on the deduction of capital losses. You will also examine special rules, such as those relating to a principal residence, changes in use of a property, and replacement property. This module concludes with a computer illustration that incorporates the topics covered in the lesson. Test your knowledge Begin your work on this module with a set of test-your-knowledge questions designed to help you gauge the depth of study required. Module Introduction to capital gains 6.2 Capital property and disposition 6.3 General rules for determining taxable capital gains and allowable capital losses 6.4 Specific provisions for capital gains and losses 6.5 Special rules: Principal residence exemption, change in use, and replacement property 6.6 Computer illustration 6.6-1: Determining capital gains and losses Learning objectives 6.1 Explain why capital gains and losses are treated differently from other types of income. (Level 1) 6.2 Describe what types of property and what circumstances give rise to capital gains or losses. (Level 1) 6.3 Calculate taxable capital gains, allowable capital losses, and the allowable capital gains reserve. (Level 1) 6.4 Describe specific rules that apply in the calculation of capital gains and losses, including the treatment for identical properties and depreciable property, and the restrictions on the deduction of capital losses for personal-use property, listed personal property, superficial losses, and business investment losses. (Levels 1 and 2) 6.5 Explain the special rules for the principal residence exemption, changes in use, and replacement property. (Level 2) 6.6 Use Cantax to calculate and report capital gains or losses on disposition of capital properties. (Level 1) file:///f /Courses/ /CGA/TX1/06course/m06intro.htm[11/10/2010 4:41:56 PM]

2 Assignment reminder: Assignment #2 (see Module 7) is due at the end of week 7 (see Course Schedule). You may wish to take a look at it now in order to familiarize yourself with the requirements and to prepare for any necessary work in advance. Module summary Print this module file:///f /Courses/ /CGA/TX1/06course/m06intro.htm[11/10/2010 4:41:56 PM]

3 6.1 Introduction to capital gains Learning objective Explain why capital gains and losses are treated differently from other types of income. (Level 1) Required reading LEVEL 1 Text: 7,010; 8,020 to 8,035 (Level 1) ITA: 3 (Level 1) Historically, capital gains were not subject to Canadian income tax because they were not considered as income under the "source" theory (section 4 of the ITA). Under this theory, income can only originate from a productive source. The metaphor of the fruit and the tree is used to illustrate the source theory: income represents the fruit and capital represents the tree. Any gain realized on the disposition of the tree is capital since only the fruit is income. Under the 1971 tax reform, starting in 1972, only one-half of capital gains were included in income for tax purposes. The required reading covers the history of the inclusion rates for capital gains and the legislative intent behind the taxation of capital gains. The source theory was not abandoned with the 1971 tax reform as is illustrated by the structure of sections 3 and 4 of the ITA. Income from a source is included in income for tax purposes under paragraph 3(a), while capital gains are included under paragraph 3(b). Capital gains are subject to a different tax treatment that is generally more favourable than the treatment of source income; accordingly, they are dealt with separately. Capital gains receive preferential treatment in the following respects: Only one-half of the gains are included in income. The taxable capital gain is equal to zero when certain capital property is gifted to a charity or other qualified donee (applicable after May 1, 2006). The taxable capital gain is equal to zero when certain securities are gifted to a private foundation (applicable after March 19, 2007). The taxable capital gain is equal to zero when certain exchangeable shares are gifted to a charity or other qualified donee (applicable after February 26, 2008). Gains are included in income only when they are realized, not on an accrual basis (the realization principle). The gain on the disposition of a principal residence may be exempted from tax. For individuals, the gain on the disposition of shares of a small business corporation, farm property, or fishing property may be exempted from tax up to a maximum of $750,000 (taxable portion $375,000). Capital losses are subject to numerous restrictions: When capital losses are deductible, they are generally only deductible against capital gains. file:///f /Courses/ /CGA/TX1/06course/m06t01.htm[11/10/2010 4:41:57 PM]

4 Capital losses on personal-use properties are not deductible or, in the case of listed personal properties, can only be claimed against capital gains realized on other listed personal properties. Capital losses on some transactions specified in the ITA are not deductible, or their deductibility is deferred until a specific event occurs. The reasons justifying the special treatment of capital gains may be summarized as follows: The preferential treatment of capital gains promotes investment, particularly in risky ventures, by giving the investor a potentially higher yield on investment. The gain realized on property that is held for some years is caused mainly by inflation. To adjust the gain to take into account the inflation component would be very complex. It is better, in terms of certainty and simplicity, to have a universal rule such as the one-half inclusion rule. However, this general rule applies whether property is held for many years or only for a few months. In the case of short-term capital gains, the reduced rate of inclusion causes inequity between taxpayers who realize capital gains that are only one-half taxable and taxpayers who earn other types of income. Capital gains are taxed when realized, and not on an accrual basis. This is because of the difficulty that taxpayers, as well as the tax authorities, would have in valuing all capital properties annually in order to determine accrued capital gains. Also, taxing capital gains on an accrual basis could create financial problems for taxpayers who would have to pay taxes when they have not yet cashed in their gains. However, the taxation of capital gains when realized means that the accumulated gain is taxed in the year of disposition and may be taxed at a higher marginal tax rate for individuals than it would have been taxed if recognized as it accrued. The principal residence exemption stems from a presumption that no real economic gain is realized when a home is sold and another is purchased. While this could apply to capital gains on other personal-use property, the government has chosen to exempt gains on a taxpayer's principal residence only. But even when a new home is not purchased and there is no economic reason not to tax the gain as any other gain, it is a widely-accepted proposition that the gain from the sale of a home should not be taxed. The idea that home ownership must be supported because it promotes community stability is the basis for this principle. The capital gains deduction (section 110.6) on small business corporation shares, farm property or fishing property was introduced to encourage entrepreneurial risk taking and to support investments in these businesses by Canadians. Over the years, these reasons were often criticized on the basis that the preferential treatment infringes on horizontal and vertical equity. Horizontal equity requires taxpayers who have similar economic power to bear the same tax burden. From an economic point of view, there is no reason for a different tax treatment of a dollar earned as salary and a dollar derived from a capital gain. Vertical equity requires that taxpayers who have a higher ability to pay tax are taxed more than those with a lower ability to pay. Since mostly high-income taxpayers derive capital gains, they are the ones who benefit from the preferential treatment of capital gains, and thus, vertical equity is affected. The preferential treatment is also criticized on the grounds that it invites tax avoidance schemes. Taxpayers may try to devise transactions to transform income from a source into capital gains. Complex anti-avoidance rules are therefore needed. This adds to the complexity of the ITA and imposes administrative costs to the government to ensure compliance with these rules. These costs are supported by all taxpayers and not only by those involved in the transactions under scrutiny. It has also been suggested that the preferential treatment of capital gains may be a disincentive to use resources in the most productive way. Since capital gains are taxed only when realized, taxpayers can control the timing of the recognition of these gains. Taxpayers may be reluctant to sell property and pay tax when file:///f /Courses/ /CGA/TX1/06course/m06t01.htm[11/10/2010 4:41:57 PM]

5 substantial gains have accrued on the property, even though more productive investments are available. As you can see, the tax treatment of capital gains is controversial. The government has chosen to consider capital gains and losses as a special type of income for tax purposes for the reasons outlined earlier. Whether or not these reasons are valid in the present context is subject to debate. Nonetheless, taxpayers have to abide by the rules contained in the ITA. The tax treatment of capital gains is also complex because, for policy reasons, the tax rules vary, depending on the type of capital property that is disposed. Keeping in mind the preceding comments on the tax policy behind the ITA rules concerning capital gains and losses, you will now study these rules. file:///f /Courses/ /CGA/TX1/06course/m06t01.htm[11/10/2010 4:41:57 PM]

6 6.2 Capital property and disposition Learning objective Describe what types of property and what circumstances give rise to capital gains or losses. (Level 1) Required reading Optional reading LEVEL 1 Text: 7,012; 7,018; 7,020 (Level 1) Text: 7,040 (Level 2) ITA: 39(1)(a), 40(1)(a) (Level 1) ITA: 39(4), 39(5), 39(6) (Level 2) ITA: Definitions, 54: adjusted cost base, capital property, listed personal property, personal-use property, proceeds of disposition (Level 1) ITA: Definitions, 248(1): disposition (Level 1) IT: 460 Capital property introduction Capital gains and losses can only be realized on capital property. In determining what is a capital property, the definition in section 54 of the ITA is not really helpful. The definition provided for in section 54 states that capital property means: depreciable property or non-depreciable property, the disposal of which gives rise to a capital gain or loss Some indication is given in the ITA as to what is not a capital property, since no capital gains or losses can be realized on the following types of properties, as provided for in paragraph 39(1)(a): eligible capital properties certain cultural properties Canadian and foreign resource properties insurance policies timber resource properties interest of a beneficiary under a qualifying environmental trust Except for these references, the ITA provides little guidance in determining if a given property is capital property, the disposition of which will give rise to a capital gain or loss, or if the property is inventory, the disposition of which will give rise to business income or loss. One must turn to the case law to find the main criteria for distinguishing capital gains from business income. The annual volume of reported tax cases on the issue of capital gains versus business income leads one to conclude that the tax objective of certainty has not been achieved in respect of distinguishing capital property from other types of property. While uncertainty undoubtedly plays a part in the number of court cases, file:///f /Courses/ /CGA/TX1/06course/m06t02.htm[11/10/2010 4:41:57 PM]

7 taxpayer motivation is also a factor. Taxpayers generally prefer capital gains with a 50% inclusion rate compared to other types of income included at 100%. Disposition Capital gains and losses are not taxed on an accrual basis. As the tax on the gain is deferred until the gain is realized, a tax preference occurs, allowing taxpayers to take advantage of the time value of money. This realization rule has its downside since, in the year the gain is realized, there is a "bunching up" in income, of past years' accrued gains. Therefore, the gain may be taxed at a higher rate of tax than if the accrued gains had been taxed on a yearly basis. An advantage of the realization basis is that it allows taxpayers to control the timing of the gain. For example, taxpayers may decide to sell capital property on which a substantial gain has accrued in a taxation year in which they incur losses in order to reduce the tax liability on the gain. The realization basis is introduced in the ITA by providing that capital gains are taxed when a "disposition" occurs, as confirmed by the opening words of paragraph 40(1)(a). Therefore, it is very important to have a good knowledge of what constitutes a disposition in order to be able to recognize when a capital gain becomes taxable and, if possible, to control the timing of the taxation of the capital gain. To understand the extent of the first item in the definition of "disposition" in section 248(1), you must review the definition of "proceeds of disposition" in section 54. It then becomes clear that a disposition includes not only voluntary dispositions, such as a sale of property, but also involuntary dispositions such as its expropriation, damage, destruction, or loss when the taxpayer receives compensation. A disposition can also occur when a creditor takes a property in payment of a debt. The definition in section 54 is not exhaustive (note the use of the word "includes" in the definition), which means that a disposition may occur in situations not mentioned, such as when property is destroyed and there is no compensation. In order to prevent the indefinite postponement of the taxation of capital gains, several provisions of the ITA deem a disposition to occur if a specified event occurs, even though the property is not really disposed. Section 7,020 of the text provides some examples of deemed dispositions for tax purposes along with the corresponding ITA provision. file:///f /Courses/ /CGA/TX1/06course/m06t02.htm[11/10/2010 4:41:57 PM]

8 6.3 General rules for determining taxable capital gains and allowable capital losses Learning objective Calculate taxable capital gains, allowable capital losses, and the allowable capital gains reserve. (Level 1) Required reading LEVEL 1 Text: 7,110 to 7,125; 8,110; 8,130 (Level 1) Text: 7,910 (Level 3) ITA: 3, 38, 39, 40(1), (1.1), 40(2)(a), 53(1)(j), 53(2)(k) (Level 1) ITA: Definitions, 248(1): allowable capital loss, capital gain, capital loss, taxable capital gain (Level 1) ITAR: 20(1), 26(3) (Level 2) Capital gains and losses: General formula When you have determined that a disposition of a capital property has occurred, you must compute the taxable capital gain or the allowable capital loss. First determine the gain or loss in accordance with subsection 40(1), then follow section 39 to characterize the gain or loss amount as a capital gain, capital loss, or business investment loss, if none of the restrictions apply. For example, you cannot have a capital gain or capital loss on the disposition of eligible capital property nor can you have a capital loss on depreciable property. You then determine the taxable capital gain or allowable capital loss in accordance with section 38, applying the relevant inclusion rate. Only a fraction (1/2 for 2010) of the capital gain or loss is taxable or allowable. These qualifiers (taxable capital gain, allowable capital loss) are very important because they refer to the amount of capital gain that is included when computing income or the amount of capital loss that may be deducted in calculating income under paragraph 3(b). Pay close attention to these qualifiers so you fully understand their significance. A reference to a capital gain is quite different from a reference to a taxable capital gain. Similarly, a capital loss is different from an allowable capital loss. Adjusted cost base The additions and deductions to the cost base of non-depreciable property under section 53 are intended to prevent double taxation. Additions to the cost base are usually amounts paid that were not deductible, or amounts received that have already been taxed or were not taxable. For example, when employees acquire shares of a corporation under a stock option plan and a benefit is included in their employment income under section 7, the amount of the benefit is added to the adjusted cost base (ACB) of the shares acquired [paragraph 53(1)(j)]. Another example is the subsection 18(2) denial of interest and property taxes as a business expense on vacant land. Paragraph 53(1)(h) allows the amount denied under subsection 18(2) to be added to the ACB. Deductions are often amounts received on a tax-free basis. For example, when a taxpayer acquires a property and receives a government subsidy for the acquisition of this property, the ACB of the property will be the price paid less the amount received as a subsidy [paragraph 53(2)(k)]. Many adjustments under subsections 53(1) and (2) are very technical and will not be studied in this course; however, the majority of capital transactions require no adjustments under subsections 53(1) or (2) in determining the ACB of the disposed property. file:///f /Courses/ /CGA/TX1/06course/m06t03.htm[11/10/2010 4:41:58 PM]

9 Disposition costs When capital property is sold, various costs can be incurred for the purpose of selling the property and as a result of its sale. These amounts, along with the ACB of the property, are deducted from the proceeds of disposition (POD) in calculating the gain or loss [subparagraph 40(1)(a)(i)]. There is no definition of disposition costs in the ITA. If these costs are not otherwise deductible in computing income and are incurred for the disposition of the property, the items are deducted from the POD to calculate the gain or loss. Example Guylaine Doyon disposed of a non-depreciable capital property that was used to earn business income. That property was disposed of for $10,000. The selling costs totalled $500 and the original cost of the property for Guylaine was $4,000. POD $10,000 Less: Cost of property $4,000 Selling expenses 500 (4,500) Gain $5,500 As the property disposed of was a non-depreciable capital property, the amount of the gain under section 40 is equal to the capital gain under section 39. Activity Taxable capital gains In this activity, you calculate the taxable capital gain for a non-depreciable capital property. LEVEL 3 Cost of assets owned on December 31, 1971 The rules for calculating capital gains for property held on December 31, 1971 differ depending on whether or not the capital property in question is depreciable. On disposition of a depreciable capital property acquired before 1972, the median rule does not apply. Instead, under ITAR 20(1), if the capital cost of the depreciable property is less than both the FMV on valuation-day (V-day) and the POD, the POD is deemed to be the total of the capital cost of the property and the POD less FMV on V-day. The capital gain is therefore calculated using the deemed POD. LEVEL 1 Gains reserve For individuals, the prescribed Form T2017, Summary of Reserves on Dispositions of Capital Property, must be filed to claim a capital gains reserve. The (b) portion for the reserve formula may be restated as: in the year of disposition: first year after disposition: second year after disposition: third year after disposition: fourth year after disposition: 4/5 of the capital gain 3/5 of the capital gain 2/5 of the capital gain 1/5 of the capital gain nil Thus, whatever the unpaid balance of the selling price, at least one-fifth of the capital gain must be recognized in each year the reserve is claimed on a cumulative basis. file:///f /Courses/ /CGA/TX1/06course/m06t03.htm[11/10/2010 4:41:58 PM]

10 You may recall another reserve under paragraph 20(1)(n), which you studied in the calculation of business income (Topic 3.4). Do not confuse the reserve for proceeds outstanding for business income with the section 40 reserve where you are calculating a gain. This distinction highlights for you the importance of understanding what type of property you are dealing with to determine the correct tax consequences. Activity Taxable capital gains reserves In this activity, you calculate the capital gains reserve for a property. Donations of capital property Where a taxpayer directly gifts certain capital properties to a registered charity or other qualified donee [as defined in subsection 149.1(1)], the taxable capital gain is zero per paragraphs 38(a.1) and (a.2). Where a taxpayer directly gifts certain securities to a private foundation, the taxable capital gain is also zero per paragraphs 38(a.1) for gifts subsequent to March 18th, Finally, where a taxpayer directly gifts certain exchangeable securities to charity or other qualified donee, the taxable capital gain is zero under certain conditions (for gifts subsequent to February 25, 2008). Investments that are eligible for this tax treatment include shares, bonds, bills, warrants, futures, and exchangeable shares. Mutual funds may also qualify. This will only benefit a taxpayer when the donation of the capital property is made directly to the qualified donee. If the capital property is sold and the proceeds donated to the donee, the zero inclusion rate will not apply. If there is no accrued gain on the capital property, donating shares will have the same result as donating cash. file:///f /Courses/ /CGA/TX1/06course/m06t03.htm[11/10/2010 4:41:58 PM]

11 6.4 Specific provisions for capital gains and losses Learning objective Describe specific rules that apply in the calculation of capital gains and losses, including the treatment for identical properties and depreciable property, and the restrictions on the deduction of capital losses for personal-use property, listed personal property, superficial losses, and business investment losses. (Levels 1 and 2) Required reading Optional reading LEVEL 1 Text: 7,210 to 7,220; 7,270 to 7,285; 7,710; 8,200; 8,300 (Level 1) ITA: 3(b), 39(1)(b), 41(1) and (2), 46(1), 47(1), 111(1)(b) (Level 1) ITA: Definitions, 111(8): net capital loss (Level 1) Text: 7,330 to 7,340; 7,710 (review); 7,720 (Level 2) ITA: 3(d), 38(c), 39(1)(c), 40(2)(g), 50(1), 53(1)(f) (Level 2) ITA: Definitions, 54: superficial loss (Level 2) ITA Definitions, 248(1): small business corporation (Level 2) IT: 387R2 (Consolidated), 484R2 Personal-use property and listed personal property In order to achieve neutrality, the tax system should not differentiate between business and investment decisions. Whether a taxpayer invests his discretionary savings in common shares, a boat, or a piece of art, tax rules should not favour certain types of investments. If gains on personal-use property (PUP) and listed personal property (LPP) were not taxed, taxpayers who choose to invest in income-producing property would be penalized, while individuals who invest in personal property could end up with a tax-free increase in wealth. A broader tax base for the taxation of capital gains supports the neutrality objective. The overall intent of the taxation of capital gains is to tax economic income, regardless of the type of property held. The text refers to a minimum amount of $1,000 as the deemed cost and proceeds of disposition applicable to personal-use property, including listed personal property dispositions. This is known as the de minimus rule. Example 1 Jody Wyatt bought a used motorcycle for $1,800. What is her taxable capital gain if she sells it for Solution a. $500 b. $2,000 Under the ITA, the calculation of both the gain (called a "net gain") and the taxable portion of the net gain (called a "taxable net gain") for listed personal property are found in subsections 41(2) and 41(1) respectively, rather than in sections 39 and 38. Note that clause 3(b)(i)(B) brings the taxable net gains from LPP for the year into income separately from taxable capital gains from the disposition of other property. Other allowable capital losses can be used to file:///f /Courses/ /CGA/TX1/06course/m06t04.htm[11/10/2010 4:41:58 PM]

12 offset these taxable net gains from LPP. The carryback and forward provision is also found in subsection 41(2), and is part of the calculation of the "net gain" from LPP for the year, and thus in income for the year. This is different from net capital losses, whose carryback and forward provision is found in subsection 111(1), and occurs in the calculation of taxable income. The government allows the limited deduction of capital losses on LPP because it recognizes that they may have some economic value. Example 2 Moira Levesque sold the following items: Sales price Cost Painting $ 3,000 $ 900 Set of stamps 1,500 1,200 Diamond ring 2,000 3,500 Assuming there were no disposition costs related to any of these transactions, determine Moira s tax consequences. Solution General limitations on capital losses Capital gains are subject to preferential treatment, but as a counterpart, capital losses are subject to many restrictions. Some of these restrictions are of a general nature, while others are related to specific transactions or categories of property. The general rule concerning the deductibility of allowable capital losses is that they can only be deducted against taxable capital gains [paragraph 3(b)]. If allowable capital losses for a year exceed the taxable capital gains for the year, the net capital losses may be carried back three years and forward indefinitely to offset the excess of taxable capital gains over allowable capital losses for those years [paragraph 111(1)(b) and subsection 111(8), "net capital loss"]. This is done in the calculation of taxable income, not income (in other words, net income). The basic reason why allowable capital losses are not deductible against other sources of income is that the realization basis of capital gains taxation enables taxpayers to choose the timing of the realization of capital gains or losses. The restriction on the deductibility of capital losses is intended to limit planning opportunities that would allow taxpayers to dispose of capital property at a loss to reduce their income, while continuing to hold other capital property on which capital gains have accrued. Identical properties Taxpayers will often purchase identical properties (for example, the same security or the same bond) at different times and for different prices and sell them at different times for different prices. The ITA does not define an "identical property." To be identical, the properties must be identical in all respects. So, two common shares in the Bank of Nova Scotia are identical properties. But a common share is not identical with a class A share (even if it is a common class A share), nor with a preferred or special share. Two townhouses are not identical properties, even though they are in the same complex. Depreciable property Capital losses may never be claimed in respect of depreciable property [39(1)(b)(i)]. Because such property depreciates over time, any decline in value is deemed to be normal depreciation and is therefore not considered to be a capital loss. Furthermore, if this type of property is sold for less than its capital cost, the rules on capital cost allowance will apply to recognize a terminal loss, recapture of capital cost allowance, or to reduce the UCC of the class in which the property was included. To claim a capital loss would in fact be double file:///f /Courses/ /CGA/TX1/06course/m06t04.htm[11/10/2010 4:41:58 PM]

13 counting. LEVEL 2 Superficial losses Taxpayers with realized substantial capital gains in a taxation year may wish to recognize capital losses on other property that they do not really want to dispose of, by selling and repurchasing the same property in a very short period of time. To address the situation where the disposition is solely tax-motivated (deduction of the loss), the rules on superficial losses prevent the recognition of a loss when the taxpayer has not actually given up equity in the property. A superficial loss is one realized by a taxpayer, where an identical property (referred to as substituted property ) is acquired or reacquired by either the taxpayer or an affiliated person (for example, a spouse) within 30 days before and 30 days after the disposition. At the end of that period the taxpayer or affiliated person still owns a portion of the substituted property. The superficial loss that is denied is added to the adjusted cost base of the property repurchased (that is, substituted property). Allowable business investment losses (ABILs) The legislative intent for the special treatment of ABILs is intended to promote investment in small and medium-sized business corporations in Canada, by reducing the after-tax risk of investing in these businesses. To have an ABIL there must first be a disposition (or deemed disposition of property) giving rise to a loss under subsection 40(1). The disposition of the capital property then must qualify as a business investment loss (BIL) under paragraph 39(1)(c). Finally, paragraph 38(c) creates the deductible or allowable portion. In the definition of a small business corporation (SBC), CRA interprets "all or substantially all" to mean 90% or more and "principally" to mean 50% or more. Where it is an actual disposition, the ITA requires that it be to an arm s-length person. Often in the case of an SBC there is no market for the debt or shares and therefore no real disposition is possible. Section 50(1) allows a taxpayer to elect to be deemed to have disposed of the property. A deemed disposition occurs for POD of zero. The election can be made for any debt that is a bad debt, and for shares where the corporation is bankrupt or being wound-up; or is insolvent and no longer carries on business, and it is reasonable to expect that it will be wound-up or dissolved. Where an election under subsection 50(1) is made, the taxpayer is deemed to have reacquired the property at an ACB of nil. Therefore, any future recovery of the investment is a capital gain. file:///f /Courses/ /CGA/TX1/06course/m06t04.htm[11/10/2010 4:41:58 PM]

14 Example 1 solution a. Sale for $500 Deemed POD [46(1)] $ 1,000 ACB (1,800) Loss $ (800) The $800 loss is deemed to be zero under subparagraph 40(2)(g)(iii). b. Sale for $2,000 POD $ 2,000 ACB (1,800) Gain $ 200 Taxable capital gain (1/2) $ 100 file:///f /Courses/ /CGA/TX1/06course/m06t04sol.htm[11/10/2010 4:41:59 PM]

15 Example 2 solution Painting POD $ 3,000 Deemed ACB [46(1)] (1,000) Gain on disposition of LPP $ 2,000 Set of stamps POD $ 1,500 ACB (1,200) Gain on disposition of LPP $ 300 Diamond ring POD $ 2,000 ACB (3,500) Loss on disposition of LPP $ (1,500) Net gain on the disposition of listed personal property [41(2)] $2,000 + $300 $1,500 = $800 Taxable net gain on the disposition of listed personal property [41(1)] 1/2 $800 = $400 The $400 is included in income under clause 3(b)(i)(B). file:///f /Courses/ /CGA/TX1/06course/m06t04sol2.htm[11/10/2010 4:42:00 PM]

16 6.5 Special rules: Principal residence exemption, change in use, and replacement property Learning objective Explain the special rules for the principal residence exemption, change in use, and replacement property. (Level 2) Required reading Optional reading LEVEL 2 Text: 7,230 to 7,255; 8,175; 8,210 (Level 2) ITA: 40(2)(b), 44(1), (5), (6), 45 (Level 2) Definitions, 54: principal residence Text: 8,180 (election for additional deferral) IT: 120R6 Principal residence exemption Personal-use property includes a personal residence owned by a taxpayer, such as a home, condominium or cottage. While gains on personal-use property are taxable, paragraph 40(2)(b) provides an exemption for a taxpayer s principal residence as outlined in the text. Capital losses on a principal residence are not allowed, as the property is a personal-use property. Prior to 1982, a taxpayer and spouse (and a child, if the child were an owner) could each designate a housing unit as a principal residence during the same period. This was especially attractive to taxpayers with a home and a cottage. However, after 1981, only one principal residence for each family unit can be designated for each year. Transitional rules [subsection 40(6)] still allow a family unit to designate two principal residences for years prior to Essentially, only gains since 1981 are included in income where a property is designated as a principal residence before 1982, but not after. The gain is based on the actual proceeds less the fair market value of the property at December 31, Change in use When taxpayers acquire property for their personal use and later on begin to use the property to earn income, or vice versa, they are deemed to have disposed of the property for POD equal to the FMV of the property at the time the change in use occurred [subsection 45(1)]. For example, there is a change of use if a taxpayer begins to rent out a house that was previously used for personal use. When the use of the property changes from personal to income producing, an election [subsection 45(2)] may be made to defer the deemed disposition. Under this election, the taxpayer is deemed not to have changed the use of the property until the election is rescinded. Therefore, the taxation of the taxable capital gain on the property may be deferred until the election is rescinded or the property sold, whichever occurs first. When the use of the property changes from income producing to personal, the election to defer the gain is only available if the property becomes a principal residence of the taxpayer [subsection 45(3)]. For either election to apply, the taxpayer must not have claimed any CCA on the property when it was used for income producing purposes [subsection 45(4)]. file:///f /Courses/ /CGA/TX1/06course/m06t05.htm[11/10/2010 4:42:00 PM]

17 Replacement property Where a taxpayer realizes a capital gain on the involuntary disposition of a capital property or on the voluntary disposition of a former business property, the taxpayer may elect, in the year the property is replaced, to defer that gain. The gain may only be deferred to the extent that the taxpayer reinvests the proceeds of disposition in a replacement property within a certain time frame. The replacement property rules parallel the exchange of property rules for the disposition of depreciable property [subsection 13(4)]. Under subsection 44(5), to qualify for the deferral, a replacement property must meet these criteria: be put to the same or similar use, by the taxpayer or a related person, as the former property; and be used by the taxpayer or a related person in the same business or a similar business. Essentially, the taxpayer may elect to reduce the adjusted cost base of the replacement property to the extent of the capital gain, or part thereof, reinvested in the replacement property. Any excess of the proceeds of disposition over the replacement cost remains a capital gain. On the disposition of land and a building, the taxpayer may elect, in the year of replacement [subsection 44(6], to reallocate the excess proceeds of disposition between the components so that less capital gain or recapture will be reported. This is further explained in text section 8,040, which is optional reading and non-examinable. file:///f /Courses/ /CGA/TX1/06course/m06t05.htm[11/10/2010 4:42:00 PM]

18 6.6 Computer illustration 6.6-1: Determining capital gains and losses Learning objective LEVEL 1 Use Cantax to calculate and report capital gains or losses on disposition of capital properties. (Level 1) This computer illustration applies the rules for capital gains and losses studied in this module. It outlines the tax consequences for an individual who owns various types of property that have been disposed of in the current taxation year. You will calculate the tax consequences manually, then use Cantax to complete the T1 return. Follow the steps carefully to ensure you understand the calculations of each of the different items. Refer to the explanations in the course material if you do not understand the suggested solution. Description This is a continuation of Paul Merlin's income tax return. Paul carried out the following transactions in On November 12, 2009, Paul disposed of the following common shares of public taxable corporations: Corporation Number of shares Date acquired Proceeds of disposition Adjusted cost base Selling expenses ABD Inc $ 45,000 $ 30,000 $ 2,000 DEF Inc ,000 70,000 3,000 KING Inc , ,000 2,000 QUEEN Inc , , On January 15, 2009, Paul disposed of two houses in Vancouver that had been rental units since they were acquired on January 1, There was no rental income for 2009, as the properties were sold at the beginning of the year. Property Proceeds of disposition Adjusted cost base Selling expenses House 1 Land $ 300,000 $ 200,000 $ 5,000 Building 400, ,000 8,000 House 2 Land $ 180,000 $ 150,000 $ 2,000 Building 150, ,000 3,000 The houses were in the following CCA classes: Property UCC as at 1/1/09 Class House 1 building $ 200,000 3 file:///f /Courses/ /CGA/TX1/06course/m06t06.htm[11/10/2010 4:42:01 PM]

19 House 2 building 100, Paul disposed of the following properties in January: Property Proceeds of disposition Adjusted cost base Selling expenses Family cars 1 $ 15,000 $ 12,000 $ ,000 14,000 Paintings 1 30,000 2,000 1, ,000 8, Diamond ring 50,000 10,000 Home computer 900 2,000 Persian carpet 1, There was no loss carryover on listed personal property at the beginning of Required Solution a. Determine Paul's tax consequences of his 2009 transactions. b. Use Cantax to calculate and report Paul's transactions for file:///f /Courses/ /CGA/TX1/06course/m06t06.htm[11/10/2010 4:42:01 PM]

20 Computer illustration 6.6-1: Suggested solution Part (a): Tax consequences on disposition of property Shares POD ACB Selling expenses Capital gain (loss) ABD Inc. $ 45,000 $ 30,000 $ 2,000 $ 13,000 DEF Inc. 50,000 70,000 3,000 (23,000) KING Inc. 40, ,000 2,000 (162,000) QUEEN Inc. 300, ,000 80,000 Total $ 435,000 $ 520,000 $ 7,000 $ (92,000) Allowable capital loss (1/2) $ (46,000) Houses Land 1 2 POD $ 300,000 $ 180,000 Less: ACB (200,000) (150,000) Selling expenses (5,000) (2,000) Gain and capital gain $ 95,000 $ 28,000 Taxable capital gain (1/2) $ 47,500 $ 14,000 Building POD $ 400,000 $ 150,000 Less: ACB (300,000) (170,000) Selling expenses (8,000) (3,000) Gain and capital gain $ 92,000 $ 1 Taxable capital gain (1/2) $ 46,000 $ The lesser of: POD net of selling expenses [13(21)] $ 392,000 $ 147,000 Capital cost $ 300,000 $ 170,000 $ 300,000 $ 147,000 Less: UCC 200, ,000 Recapture of CCA $ 100,000 $ 47,000 This recapture of CCA is included in rental income. Previously, Paul's CCA on his rental properties was restricted to $2,000, which was the rental income computed according to the information given at that time. Now Paul's rental income allows him to claim the maximum CCA on other rental properties he may have. 1 No capital loss is recognized on depreciable property. Personal-use property file:///f /Courses/ /CGA/TX1/06course/m06t06sol.htm[11/10/2010 4:42:01 PM]

21 POD ACB Selling expenses Capital gain Family car 1 $ 15,000 $ 12,000 $ 500 $ 2,500 Persian carpet 1,200 1, $ 16,200 $ 13,000 $ 500 $ 2,700 Taxable capital gain (1/2) $ 1,350 2 The ACB is deemed to be the greater of the following amounts [paragraph 46(1)(a)]: Notes: $1,000 cost: $ The disposition of family car 2 gives rise to a non-allowable loss [subparagraph 40(2)(g)(iii)]: POD $ 10,000 ACB (14,000) Loss $ (4,000) 2. The result is the same for the home computer: POD (greater of $1,000 or the POD) $ 1,000 ACB (2,000) Loss $ (1,000) [non-allowable subparagraph 40(2)(g)(iii)] Listed personal property POD ACB Selling expenses Net gain (loss) Painting 1 $ 30,000 $ 2,000 $ 1,500 $ 26,500 Painting 2 5,000 8, (3,400) Diamond ring 50,000 10,000 40,000 $ 85,000 $ 20,000 $ 1,900 $ 63,100 Taxable net gain (1/2) $ 31,550 Part (b): Paul's income for 2009 as determined by Cantax 1. Start Cantax and open file TX1M6P1. Save the file under your own initials. 2. At the Index, open the "Taxable capital gains" folder. Double click the form titled "T1-S3: Capital gains (or losses)." 3. Go to area 3 on the form, "Publicly-traded shares, mutual fund units, deferral of eligible small business corporation shares and other shares" and enter in the data for ABD Inc. In the first row of this schedule, type 200 in the "Number of shares" cell, ABD Inc as the Corporation name, 1995 as the Year acquired, as Disposition proceeds, as Adjusted cost base, and 2000 for Outlays & expenses. Cantax computes a Net gain of $13,000. Hit the Tab or Enter key and a second line will open automatically for you. 4. Repeat step 3 to report the dispositions of shares for DEF Inc., KING Inc., and QUEEN Inc., using the information given in the problem. When you have entered all four dispositions of shares, Cantax should report a net loss of $92,000 on the transactions. file:///f /Courses/ /CGA/TX1/06course/m06t06sol.htm[11/10/2010 4:42:01 PM]

22 5. Go to area 4 on the T1-S3, "Real estate, depreciable property, and other properties." 6. In row 1, enter Land 1 for the description, then enter BC for the province/territory, the acquisition date, the proceeds of disposition, the adjusted cost base, and the selling expenses. 7. In row 2, enter the details for Land In row 3, enter the details for Building Building 2 is a depreciable property for which there is a loss. Since a loss incurred on the disposition of depreciable property is deemed to be nil, there will be no loss reported on this schedule. 10. To complete the reporting of the real estate transactions, open the rental income schedule T776#01-1 and use Edit, Clone Form to create T776#04-1. Add the information for the two rental properties, Building 1 and Building 2. There is no rental income or expense, but the CCA schedules for each property must be completed. Building 1 and Building 2 have recaptured CCA of $100,000 and $47,000 respectively. 11. Return to T1-S3. Scroll to area 7, "Personal-use property." Enter the information for the disposal of family car 1 and the persian carpet. 12. Scroll to area 8, "Listed personal property" and repeat step 11 for the listed personal property that Paul sold during the year. Recall that net gains are reportable for LPP. Consider all dispositions, not just those on which gains were realized. 13. Go to the Tax summary, and verify that Paul's taxable capital gains for 2009 are $94,400. If you did not get this amount, print the forms listed below using the same steps as in prior lessons, and compare your results to those in the solution file TX1M6P1S. T1-1 to T1-4 T1 Jacket Pages 1 to 4 T1-S3 Capital gains T776#04-1 Rental statement 4 Income T776#04-2 Rental statement 4 CCA file:///f /Courses/ /CGA/TX1/06course/m06t06sol.htm[11/10/2010 4:42:01 PM]

23 Module 6 Self-test Additional review questions The text contains additional review questions, multiple choice questions, and exercises at the end of each chapter. The solutions can be found in the accompanying Study Guide. You may find the following end of chapter material helpful for additional practice of the concepts studied in Module 6: Chapter 7: Review Questions 3 to 5 and 7 Multiple Choice Questions 1 to 5 Exercises 4 to 11 Chapter 8: Review Questions 2 to 5, 9 and 12 Multiple Choice Question 1 Question 1 Explain why it is important to distinguish between income earned from holding property and the gains and losses that occur from the sale of non-depreciable property capital property. Solution Question 2 Describe the tax treatment for each of the following transactions: Solution Question 3 a. Irene and Alf Gonzola disposed of their Lake of the Woods cottage as well as their Winnipeg home and purchased a retirement cottage on Vancouver Island. Their home and cottage were both purchased in 1987 and both were sold for substantial gains. b. Martin won a new Toyota Land Cruiser in a raffle at the Calgary Stampede. He immediately sold the vehicle back to the dealer for its fair market value of $32,000 and purchased a Toyota Camry for $29,000. The cost of his raffle tickets totaled $15. c. Sacha sold five ounces of gold (commodity) for a total gain of $300. During the same taxation year, she sold her shares of H. Morris Ltd. for a total loss of $3,000. Sacha did not sell any other investments during the year. Distinguish between a net capital loss and an allowable capital loss for tax purposes. Solution Question 4 Distinguish between a capital loss on personal-use property and a capital loss on listed personal property. file:///f /Courses/ /CGA/TX1/06course/m06selftest.htm[11/10/2010 4:42:02 PM]

24 Solution Question 5 Discuss the various relevant factors in determining whether a gain or loss from sale of property is on account of capital or income. Solution Question 6 Zelda Fitzener inherited a large parcel of land in southwest Edmonton from her husband. Her husband had intended to subdivide the land into 20 residential lots and erect luxury estate homes. Zelda would prefer to retain the land in its natural green state. Reluctantly she agreed to sell the land, for a substantial gain, to private investors for development into a public nine-hole golf course. Zelda inherited the land at her late husband s cost amount. Explain how the gain will be treated for tax purposes. Solution Question 7 Three years ago, Shayne Bridges purchased 10,000 shares of Kindled Products Ltd. for $10,000. Last year, he purchased another 10,000 shares for $30,000. The shares are now worth $8 each and he would like to sell 10,000 shares to purchase a home. Advise Shayne as to which group of shares he should sell and what the tax consequences will be. Solution Question 8 Respond to the following client inquiries. a. Alex disposed of a set of coins in 2010 and received proceeds of $10,400. The cost of the coins in 1979 was $400. Alex has net capital losses from listed personal properties, carried forward from previous taxation years as follows: 2002 $8, $5,000 Determine Alex s 2010 net taxable capital gain from the disposition of his coins. b. Two years ago, Micheline loaned $20,000 to her friend s small business corporation. The corporation agreed to repay the loan, plus 10% interest, within 12 months. When the 12 months was up, the corporation could not repay the loan, but there was still a good possibility of repayment as soon as the corporation was beginning to show a small operating profit. Unfortunately, things did not go well and her friend closed the business this year, leaving many creditors, including Micheline, unpaid. The corporation has no assets. What are the income tax implications to Micheline of this outstanding loan? c. This year, Samara sold 15,000 shares of a publicly traded Canadian corporation. She inherited these shares from her grandmother 20 years ago, and has provided you with the following information: Grandmother s cost, including commission $ 11,000 Fair market value at date of inheritance $ 32,000 Proceeds of disposition $150,000 Disallowed superficial loss 1989 $ 3,000 file:///f /Courses/ /CGA/TX1/06course/m06selftest.htm[11/10/2010 4:42:02 PM]

25 In 1988, Samara sold the shares for a net loss of $3,000 and repurchased them within 20 days for $25,000. Her CGA at the time informed her that she had a non-claimable superficial loss. Calculate the amount of Samara s taxable capital gain or loss for the current year. Solution Question 9 Bonnie Unrah granted an option to Pete Wilson to purchase a parcel of land. The option agreement is as follows: Date of option agreement: January 2, Year 1 Consideration: Pete paid Bonnie a non-refundable amount of $2,500 (on January 2, Year 1) for the right to the option to purchase the land. Agreement: Parcel of land may be purchased by Pete Wilson for total proceeds of $50,000, which includes the $2,500 amount previously paid for the right if the option is exercised on or before June 30, Year 3. On June 30, Year 3, Pete exercised the option to purchase the parcel of land and paid $50,000 The ACB of the land to Bonnie is $10,000. Calculate Bonnie s capital gain for the appropriate years. Solution Question 10 This year, Nancy sold several acres of farmland to an arm s length party for net proceeds of $940,000. The cost of the land in 1996 was $240,000. According to the sales agreement, $340,000 was paid at the time the agreement was signed and $100,000 was payable at the end of each of the next six years. Compute the taxable capital gain Nancy must report in the current year. Solution Question 11 Explain how the tax treatment of capital gains encourages capital investment and risk taking. Solution file:///f /Courses/ /CGA/TX1/06course/m06selftest.htm[11/10/2010 4:42:02 PM]