Please note that the following document, although believed to be correct at the time of issue, may not represent the current position of the CRA.
Prenez note que ce document, bien qu'exact au moment émis, peut ne pas représenter la position actuelle de l'ARC.
Principal Issues: Whether the farm land was converted from capital property to inventory.
Position: Yes.
Reasons: IT-218R, paragraphs 5, 23 and 24, and case law.
June 24, 2008
Ottawa Taxation Services Office André M. Gallant
Audit Division (613) 957-8961
Attention: Mr. David Papineau
2008- 027545Conversion of Real Estate from Capital to Inventory
This is in response to your email of April 16, 2008, and is further to our telephone conversation, regarding whether farm land was converted from capital property to inventory.
Our understanding of the facts is as follows:
1. Mr. and Mrs. B (the "parents") owned and operated a family farm on XXXXXXXXXX acres of farm land from XXXXXXXXXX to sometime in the XXXXXXXXXX . Part of the farm land was then leased to an arm's length farmer. The parents still reside on part of the farm land today.
2. During XXXXXXXXXX , the parents through their agent (XXXXXXXXXX ) applied to the local township office to have XXXXXXXXXX acres severed from their farm land into XXXXXXXXXX individual building lots. Approval in principle from the local township was received in XXXXXXXXXX , while written approval was received in XXXXXXXXXX .
3. On XXXXXXXXXX , a trust was settled, the settler being a non-related person, and the trustees and beneficiaries being the adult children of the parents (the "children").
4. On XXXXXXXXXX , all of the farm land (XXXXXXXXXX acres, including the residence) was sold for $XXXXXXXXXX from the parents to the trust. As a result of the sale, the parents used up approximately $XXXXXXXXXX of their combined $XXXXXXXXXX capital gains exemption.
5. During the months of XXXXXXXXXX , a main access road and driveways to each lot were constructed to enable the lots to be accessed. Hydro was added around the same period. While no sewers and watermains were added, you believe that the reason is that the township would be serviced by wells and septic tanks to be installed by contractors, and not sewers or watermains.
6. During the months of XXXXXXXXXX the lots were sold to arm's length persons. A XXXXXXXXXX lot was sold in XXXXXXXXXX . The trust was represented by a real estate agent for all XXXXXXXXXX sales. While there is no precise information concerning exactly how much advertising was done by the real estate agent or how many enquires the agent received for each of the XXXXXXXXXX lots, it is presumed that the real estate agent would have advertised and actively promoted the sale of the lots and answered any inquiries of prospective purchasers.
7. The net profit from the sale of the XXXXXXXXXX lots totalling $XXXXXXXXXX was reported by the trust as a capital gain.
Your question concerns whether the trust's gains totalling $XXXXXXXXXX from the sale of the XXXXXXXXXX lots should be treated as capital gains or ordinary income.
Position of the Ottawa TSO
The Ottawa TSO proposes that the profit from the sale of the XXXXXXXXXX lots should be on account of income and not on account of capital based on the criteria established in Interpretation Bulletin IT-218R and jurisprudence. The TSO has accepted that the sale of the farm land from the parents to the trust was a disposition of capital property, and not of inventory.
Position of the Trust
The trust also relies on IT-218R to argue that merely filing a subdivision plan and selling lots thereunder, without installing major improvements such as sewers and watermains, do not affect the status of the lots as capital property and the treatment as a capital gain of the gain realized when the lots are sold. The trust further argues that, had the property not been transferred to the trust, the farm land would have kept its status as capital property. The trust's representative agrees, however, that had the trust acquired the farm land from an arm's length third party, the XXXXXXXXXX lots that were sold would then have been classified as inventory, resulting in their gains being treated as ordinary income.
For the reasons explained below, we agree with your opinion that the profit from the sale of the XXXXXXXXXX lots should be on income account. This conclusion is justified under two approaches.
Under the first approach, which we would prefer over the second one discussed below, the reason for treating the gains from the sale of XXXXXXXXXX lots as ordinary income is that the trust purchased the lots with the primary intention of improving the lots (adding driveways and hydro) to increase their value and selling them at a profit shortly thereafter. This view is consistent with paragraph 5 of IT-218R which states:
"5. A taxpayer's intention at the time of purchase of real estate is relevant in determining whether a gain on its sale will be treated as business income or as a capital gain. It is possible for a taxpayer to have an alternate or secondary intention, at the time of acquiring real estate, of reselling it at a profit if the main or primary intention is thwarted. If this secondary intention is carried out any gain realized on the sale usually will be taxed as business income."
We note that the trust's representative concedes that had the trust acquired the land from vendors who were arm's length third parties (as opposed to from the parents of the beneficiaries of the trust), the trust's gains from the sale of the XXXXXXXXXX lots would correctly be treated as ordinary income. The representative distinguishes this treatment from the capital gains treatment the representative would like to accord to the gains in the situation under review simply because the trust acquired the land from the parents of the beneficiaries, instead of from arm's length third parties. We do not believe that a different tax treatment of the gains is warranted in the present situation, considering that the trust is a separate taxpayer for tax purposes and is not simply a devise to be used to trigger the crystallization of the capital gains for the benefit of the parents but to be ignored for other purposes.
Under the second approach, the reason for treating the gains from the sale of the XXXXXXXXXX lots as ordinary income is that even if the XXXXXXXXXX lots are assumed to be capital property in the hands of the trust at the point of acquisition, they were converted to inventory at some point prior to their disposition. According to paragraph 23 of IT-218R, the sale, en bloc or piecemeal, by a taxpayer of land inherited by the taxpayer will generally be on capital account, except where, for example, the taxpayer converts such land to a trading property. The concept of conversion is described as follows in paragraph 24 of IT-218R:
"Parcels of farming or inherited land referred to in 23 above may be difficult to sell en bloc and the land may be sold by subdividing it and selling the lots individually. It is the Department's view that the filing of a subdivision plan and selling lots thereunder does not in itself affect the status of the gain notwithstanding that such subdivision may enhance the value of such land. A gain on the sale of farming or inherited land will remain a capital gain if an examination of all other facts, both before and after subdivision, establishes this to be so. However, where the taxpayer goes beyond mere subdivision of the land into lots and installs improvements such as watermains, sewers or roads, or carries on an extensive advertising campaign to sell the lots, the taxpayer will be considered to have converted the land from a capital property into a trading property. Where such a conversion occurs see [paragraph 15 of IT-218R] for treatment of gains or losses arising from the ultimate sale of the property" [Emphasis added]
The position in paragraph 24 of IT-218R that conversion of land from capital property to trading property requires more than mere subdivision (such as installing utilities or carrying on an extensive advertising campaign) is consistent with jurisprudence.
In Moluch v. M.N.R., Cattanach J. concluded that the taxpayer had converted his farm land (50 acres) from capital property to inventory on the basis that the taxpayer had subdivided the land, added roads, sewers, water lines and arranged for power: 66 DTC 5463 (Ex. Ct.). The taxpayer, according Cattanach J., behaved in a business-like fashion despite the fact that he had used the land for farming for almost 10 years before selling the lots, had in no way advertised the sale of the land, had not a good record keeping system in place, had no efficient organization, had no real estate experience, and had not purchased and sold real estate prior to the taxation years in issue. The Moluch decision was cited with approval by the Federal Court of Appeal in Easton et al. v. The Queen et al., 97 DTC 5464.
Land (8.5 acres) was also considered to have been converted from capital property to trading property in Duthie Estate, even though the taxpayer was only on the verge of entering into long-term commitments (and did not in fact have signed commitments), the project was only at the preliminary stage, the taxpayer had only incurred $43,675 in costs out of $12 million of expected costs, and there were difficulties with financing: Duthie Estate v. The Queen, 95 DTC 5376 (FCTD), per Rothstein J. (now a Supreme Court judge). The land was initially purchased by the taxpayer's wife in the 1950s and conveyed upon the wife's death to the taxpayer in 1979. The business-like activities all occurred in 1981 (described below), and the taxpayer passed away in 1984 in an airplane crash.
In Duthie Estate, even though the project was at a preliminary stage, according to Rothstein J., the land was still converted from capital property to inventory for the following reasons: attending formal meetings to consider different ways to develop the land, retaining architect, obtaining a market analysis, hiring a project manager, reviewing preliminary design drawings, preparing a preliminary development concept, estimate sheet and draft service agreements for development management, and still trying to ensure that the municipality would not preclude the development although the taxpayer had financing problems. As for the $43,675 incurred in expenditures, although it may have been minimal when compared to the total estimated cost of $12 million, it was significant when compared to the taxpayer's income from his medical practice: $76,625 in 1980 and $59,579 in 1981.
In the present case, the facts would support a Moluch-like result: the sale of the XXXXXXXXXX lots from the trust to the XXXXXXXXXX unrelated parties should be on income account, taking into account the nature of improvements made to the lots and the organized effort trough a real estate agent to sell them.
Where land is converted from capital property to a trading property the taxpayer will have a notional capital gain on the date of conversion. However, this notional capital gain will not be considered to give rise to taxable capital gains until the taxation year during which the ultimate sale of the property occurs. Such capital gains must be reported in the year of sale, as discussed in paragraph 15 of IT-218R. In our view, the date of conversion would be when the decision was made to improve the lots by adding an access road, driveways and hydro. Based on the limited facts provided, the conversation date would likely be in XXXXXXXXXX (prior to the making of improvements in XXXXXXXXXX ). Since XXXXXXXXXX is also the month in which the trust acquired the land, effectively the accrued gain on the XXXXXXXXXX lots since the date of acquisition by the trust would be considered ordinary income when the lots were disposed of.
We trust that our comments will be of assistance. If you wish to discuss any of the above, please contact the writer.
Yours truly,
Sandy Parnanzone
For Director
Business and Partnerships Division
Income Tax Rulings Directorate
Legislative Policy and Regulatory Affairs Branch
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