3 May 2002 External T.I. 2002-0127425 - surface lease & principal residence

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.

Please note that the following document, although believed to be correct at the time of issue, may not represent the current position of the CCRA.

Prenez note que ce document, bien qu'exact au moment émis, peut ne pas représenter la position actuelle de l'ADRC.

Principal Issues: 1. treatment of first year payments of surface lease on land containing taxpayer's principal residence.

Position: 1. question of fact whether adjacent land can be considered part of principal residence- but- partial disposition may be recognized

Reasons: 1. as per paragraphs 1 & 2 of IT-200 - capital portion is treated as partial disposition;
See also IT-120R5 paragraphs 15 &16 (land >1/2 hectare may qualify if zoning restrictions don't allow smaller lots) & paragraph 18 ( re -partial disposition)

Lena Holloway, CA
XXXXXXXXXX 613-957-2104
2002-012742
May 3, 2002

Dear XXXXXXXXXX:

Re: Surface Leases

This is in reply to your letter dated March 7, 2002 regarding the receipt of payments pertaining to the first year of a surface lease granted on land. Your concern arises from the fact that the surface lease was placed on land owned by one of your clients and you believe that this land could in fact be part of the taxpayer's principal residence. Your letter also stated that the Regional Municipality whose jurisdiction includes the land under consideration will not allow further subdivisions on that particular acreage. While you have read IT- 200, you had questioned how these payments should be reported on your clients' tax return as your situation involves a principal residence, and not farmland. Your local taxation services office referred you to us.

Our Comments

Written confirmation of the tax implications inherent in particular transactions is given by this Directorate only where the transactions are proposed and are the subject matter of an advance ruling request submitted in the manner set out in Information Circular 70-6R4, Advance Income Tax Rulings, dated January 29, 2001. Also, it would be necessary to review all relevant documentation before an actual determination of the income tax implications could be made. However, we can provide you with the following general comments.

All section references hereunder are to the Income Tax Act (Canada) unless otherwise indicated.

As indicated in Interpretation Bulletin IT-120R5, "Principal Residence" (copy enclosed), the capital gain from the disposition of a principal residence is generally exempt from income taxation. To the extent that a portion of a property does not qualify as being part of the principal residence, the related capital gain would be taxable. Under the definition of principal residence in the Income Tax Act, if the total area of the land upon which a housing unit is situated and any immediately contiguous land, exceeds one-half hectare, the excess land is considered not to be part of the principal residence unless the taxpayer establishes that such excess land is necessary for the use and enjoyment of the housing unit as a residence.

A minimum lot size and a severance restriction imposed by local municipal by-laws with respect to residential lots may be factors indicating that land in excess of one-half hectare may be required for the use and enjoyment of the housing unit as a residence. To the extent that a taxpayer, in order to acquire a property as a residence, is required because of a by-law or regulation to acquire land that exceeds one-half hectare, the land that must be so acquired is generally considered to be necessary for the use and enjoyment of the housing unit as a residence throughout the period that the property is continuously owned by the taxpayer after the acquisition date. Consider however the impact of the following comment made in paragraph 16 of IT-120R5 to the current situation:

"...For this purpose, it should be noted that the mere existence of such a law or regulation on the date the taxpayer acquired the property does not necessarily mean that he or she was required to acquire the excess land. For example, if the taxpayer could have made an application for severance of the excess land and it is likely that such a request would have been approved, the taxpayer would generally not be considered to have been required to acquire the excess land."

Paragraphs 1 and 2 of Interpretation Bulletin IT-200, "Surface Rentals and Farming Operations" are also relevant to your situation and are reproduced as follows:

1. Persons exploring or drilling for petroleum or natural gas often obtain a lease from the owner of land covering certain surface rights. For example, the lease may cover several years in respect of a small acreage of land, possibly set in from the boundaries of the owner's land. The first year's payment may be in a lump sum for such things as damage to land, land improvements, inconvenience, severance and the first year's rent, without a specific amount being ascribed to any of these items. For the second and subsequent years, the lease may require a periodic payment or payments for rental, severance, or inconvenience. In these circumstances, the portion of the lump sum paid in the first year that is equal to the periodic payments to be made in subsequent years is considered to be income within the meaning of subsection 9(1). The remainder of the lump sum payment is generally considered to be capital.

Capital

2. The capital portion of the first year's payment, as compensation for property injuriously affected, damaged or destroyed, constitutes "proceeds of disposition" within the meaning of paragraph 54(h) and may result in a capital gain or loss. Under section 43, the adjusted cost base of the part of the property disposed of is that part of the adjusted cost base of the whole property that is reasonably attributable to the part. The adjusted cost base of the whole property is then decreased by that amount pursuant to paragraph 53(2)(d). Where the part disposed of is relatively small in relation to the property, the Department accepts any reasonable portion of the adjusted cost base that the taxpayer wishes to attribute to the proceeds.

We have also enclosed a copy of IT-264R "Part Dispositions" which provides similar comments in its paragraph 3, regarding compensation received in respect of damage to a property.

Whether or not any portion of the payments made to a landowner in respect of a surface lease is on account of income or capital is a question of fact that can only be determined after reviewing all of the facts in a particular situation. Where such a payment is on account of capital, it should be treated as a partial disposition of the property.

As discussed in paragraph 18 of IT-120R5, where only a portion of a property qualifying as a taxpayer's principal residence is disposed of, the property may be designated as the taxpayer's principal residence in order to use the principal residence exemption for the portion of the property disposed of. It is important to note that such a designation is made on the entire property (including the housing unit) that qualifies as the principal residence, and not just on the portion of the property disposed of. Accordingly, when the remainder of the property is subsequently disposed of, it too will be recognized as the taxpayer's principal residence for the taxation years for which the above-mentioned designation was made. No other property may be designated as a principal residence for any of those years by the taxpayer (or, for any of those years that are after the 1981 taxation year, by the taxpayer or any of the other members of his or her family unit).

Where a landowner receives the first year's payment from a surface lease granted on his or her land, the portion of the payment that is compensation for damage to the land represents proceeds of disposition as explained above. To the extent that this portion of the land is considered to be part of the owner's principal residence, in light of the comments made above, any capital gain arising on the disposition of such portion of the property may be sheltered by the principal residence exemption. Such determination, as previously stated is a question of fact.

As a final consideration, in granting the surface lease, it is likely that the taxpayer has had a partial change in use of the property from personal use to income-producing (see paragraph 30 of IT-120R5). Where a taxpayer has partially converted a personal use property such as a principal residence to an income-producing use, paragraph 45(1)(c) provides for a deemed disposition of the portion of the property so converted for proceeds equal to its proportionate share of the property's fair market value. Paragraph 45(1)(c) also provides for a deemed reacquisition immediately thereafter of the same portion of the property at a cost equal to the very same amount. The portion of the property which qualified as part of the taxpayers' principal residence before the change in use would no longer qualify for the principal residence exemption after the change in use.

We trust that the forgoing comments are of assistance to you.

Yours truly,

Milled Azzi, CA
for Director
Business and Partnerships Division
Income Tax Rulings Directorate

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