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.Miscellaneous questions on availability of principal residence exemption, qfp; reserves etc.

Position:

Question of fact- Will provide general comments

Reasons: n/a

XXXXXXXXXX 2002-012830
Lena Holloway, CA
613-957-2104
July 2, 2002

Dear XXXXXXXXXX:

Re: Technical Interpretation Request - Principal Residence

This is in reply to your letter dated March 6, 2002, requesting assistance in calculating the capital gain from the sale of a principal residence and adjacent land.

The situation described in your letter is an actual fact situation. While it is the responsibility of your local Taxation Services Office ("TSO") to provide assistance in determining the current tax status of past transactions, your letter states that the XXXXXXXXXX TSO referred you to our Directorate for guidance. In the future, where you require confirmation of the tax consequences of proposed transactions, we bring to your attention Information Circular 70-6R5 dated May 17, 2002 issued by the Canada Customs and Revenue Agency ("CCRA"). Proposed transactions involving specific taxpayers should be the subject of a request for an advance income tax ruling. Nevertheless, the following general comments may be of assistance to you. If you require additional information regarding your specific tax situation, we invite you to contact your local TSO.

All references herein are to the Income Tax Act (Canada) (the "Act") unless otherwise indicated.

Background

The following situation was described in your letter:

In XXXXXXXXXX you purchased a property from your mother consisting of land with a house situated on it. You described the property as including "acreage" which had been rented out for many years prior to your acquiring the property. While you lived in the house you continued to rent out the land after your purchase. In XXXXXXXXXX the property was flooded which required major repairs. XXXXXXXXXX. In XXXXXXXXXX you moved out of the house and your daughter moved in and paid you rent. You have not claimed any capital cost allowance on the property. XXXXXXXXXX. In the year XXXXXXXXXX, the sewer system was upgraded (you did not state in your letter whether this was at your expense or at the expense of the municipality). In XXXXXXXXXX the land was severed from the house and sold to the adjacent neighbour who consolidated this land with his own. Your daughter then purchased the house XXXXXXXXXX from you and still owes you a portion of the sale price which will be paid to you in XXXXXXXXXX. Your letter asked:

i) for assistance in computing the capital gain;

ii) if you were allowed to use a reserve; and

iii) whether or not the farmland would qualify for a capital gains deduction.

Our Comments

CCRA's general interpretation of the provisions of the Act which apply to a property which is an individual's principal residence is contained in Interpretation Bulletin IT-120R5, Principal Residence. We have enclosed a copy of this bulletin for your reference.

Principal Residence Exemption

If the land on which your housing unit was situated is one-half hectare or less, it will usually qualify as part of your principal residence. Land in excess of one-half hectare may also qualify, but only to the extent that it is established by the taxpayer to be necessary for the use and enjoyment of the housing unit as a residence. Paragraphs 14 to 17 of IT-120R5 provide additional information on this issue. However, (as in your case) where a portion of that land is used to earn income from business or property, such portion will not usually be considered to contribute to such use and enjoyment, hence any gain on the sale of this land will in fact be taxable (unless the property qualifies as qualified farm property as discussed below). Where a taxpayer has claimed a portion of the expenses related to the land (such as property taxes or mortgage interest) in computing income, the allocation of such expenses for this purpose is normally an indication of the extent to which he or she considered the land was used to earn income.

Change in Use of Principal Residence and Sale of House to Daughter

Your daughter started renting the house in XXXXXXXXXX when you moved out. Where a taxpayer has converted a property which partially qualified as a principal residence to increase its 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 same amount. However any gain arising from this deemed disposition may be eliminated to the extent that the principal residence designation is available in respect of the years the property was so owned. In fact, the principal residence designation may also be available to you after your daughter commenced renting the property up to and including 2001, the year of the actual sale. The definition of principal residence allows for anyone of a number of people including the child of the taxpayer/owner to inhabit the house (other than the taxpayer) and still have the property qualify for designation of the property as principal residence. Therefore any deemed gain arising on the change in use of the property in 1999 from personal use to rental can be eliminated by designating the house as your principal residence for those years and any gain on this same part of the property arising thereafter to the year of the actual sale can also be eliminated in the same manner since it is your daughter who is living in the house. This of course assumes that the property otherwise meets all the requirements to qualify as a principal residence, as outlined in IT-120R5 (for example, only one property may be designated as a principal residence per family unit as noted in paragraph 6 of IT-120R5).

Calculation of Gain

In a telephone discussion (XXXXXXXXXX/Holloway) you expressed the need for guidance in determining the cost of the properties sold. While your letter outlined the major expenditures made in respect of your property, for income tax purposes, expenses are generally deductible only to the extent the property is used to earn property or business income with a reasonable expectation of profit (for example, where a property is rented). Current expenditures (i.e. repairs and maintenance) on personal property such as a principal residence are not deductible under the Act as they are personal in nature. Capital expenditures, on the other hand are added to the cost of the property. Generally, an expenditure is considered to be of a capital nature when an enduring benefit ensues.

Based on relevant case law, the CCRA has outlined its position in paragraph 4 of Interpretation Bulletin IT-128R, Capital Cost Allowance - Depreciable Property (enclosed) on the factors that should generally be considered when determining whether an expenditure is capital in nature (where property was acquired or improved) or currently deductible (because it is in respect of the maintenance or repair of a property). Paragraph 4 of IT-128R provides the following guidance on whether an expenditure is current or capital in nature:

Capital Expenditures on Depreciable Property versus Current Expenditures on Repairs and Maintenance

4. The following guidelines may be used in determining whether an expenditure is capital in nature because depreciable property was acquired or improved, or whether it is currently deductible because it is in respect of the maintenance or repair of a property:

(a) Enduring Benefit - Decisions of the courts indicate that when an expenditure on a tangible depreciable property is made "with a view to bringing into existence an asset or advantage for the enduring benefit of a trade", then that expenditure normally is looked upon as being of a capital nature. Where, however, it is likely that there will be recurring expenditures for replacement or renewal of a specific item because its useful life will not exceed a relatively short time, this fact is one indication that the expenditures are of a current nature.

(b) Maintenance or Betterment - Where an expenditure made in respect of a property serves only to restore it to its original condition, that fact is one indication that the expenditure is of a current nature. This is often the case where a floor or a roof is replaced. Where, however, the result of the expenditure is to materially improve the property beyond its original condition, such as when a new floor or a new roof clearly is of better quality and greater durability than the replaced one, then the expenditure is regarded as capital in nature. Whether or not the market value of the property is increased as a result of the expenditure is not a major factor in reaching a decision. In the event that the expenditure includes both current and capital elements and these can be identified, an appropriate allocation of the expenditure is necessary. Where only a minor part of the expenditure is of a capital nature, the Department is prepared to treat the whole as being of a current nature.

(c) Integral Part or Separate Asset - Another point that may have to be considered is whether the expenditure is to repair a part of a property or whether it is to acquire a property that is itself a separate asset. In the former case the expenditure is likely to be a current expense and in the latter case it is likely to be a capital outlay. For example, the cost of replacing the rudder or propellor of a ship is regarded as a current expense because it is an integral part of the ship and there is no betterment; but the cost of replacing a lathe in a factory is regarded as a capital expenditure because the lathe is not an integral part of the factory but is a separate marketable asset. Between such clear-cut cases there are others where a replaced item may be an essential part of a whole property yet not an integral part of it. Where this is so, other factors such as relative values must be taken into account.

(d) Relative Value - The amount of the expenditure in relation to the value of the whole property or in relation to previous average maintenance and repair costs often may have to be weighed. This is particularly so when the replacement itself could be regarded as a separate, marketable asset. While a spark plug in an engine may be such an asset, one would never regard the cost of replacing it as anything but an expense; but where the engine itself is replaced, the expenditure not only is for a separate marketable asset but also is apt to be very substantial in relation to the total value of the property of which the engine forms a part, and, if so, the expenditure likely would be regarded as capital in nature. On the other hand, the relationship of the amount of the expenditure to the value of the whole property is not, in itself, necessarily decisive in other circumstances, particularly where a major repair job is done which is an accumulation of lesser jobs that would have been classified as current expense if each had been done at the time the need for it first arose; the fact that they were not done earlier does not change the nature of the work when it is done, regardless of its total cost.

(e) Acquisition of Used Property - Where used property is acquired by a taxpayer and at the time of acquisition it requires repairs or replacements to put it in suitable condition for use, the cost of such work is regarded as capital in nature even though, in other circumstances, it would be treated as current expense.

(f) Anticipation of Sale - Repairs made in anticipation of the sale of a property or as a condition of the sale are regarded as capital in nature. On the other hand, where the repairs would have been made in any event and the sale was negotiated during the course of the repairs, or after their completion, the cost should be classified as though no sale was contemplated.

As such determinations generally require a review of all the relevant facts of each particular situation we cannot comment further as to which of your expenditures would be capital or current in nature. We have also not been provided with any information to comment on the tax implications of any insurance proceeds or assistance you may have received with respect to damaged or destroyed property and the acquisition or repair of property. If you need assistance in this regard you may submit all relevant information to your local TSO.

Qualified Farm Property

Whether any capital gain arising on the sale of the land to your neighbour would be eligible for a capital gains deduction depends on whether this property would in fact meet the definition of qualified farm property. Subsection 110.6(2) provides for the capital gains deduction in respect of "qualified farm property" (which is defined in subsection 110.6(1)). In order for real property (i.e. land and buildings) of an individual to be considered a qualified farm property within the meaning of subsection 110.6(1), the property has to have been used in the course of carrying on the business of farming in Canada. Whether a property is considered to have been used in the course of carrying on the business of farming is in turn dependent on when the property was last acquired by the individual.

Where the property was last acquired after XXXXXXXXXX, pursuant to subparagraph (a)(vi) of the definition of qualified farm property in subsection 110.6(1), real property may be considered to be used in the course of carrying on the business of farming in Canada if it has been owned by, inter alia, the individual, or a spouse, child or parent of the individual, throughout the 24 months preceding the disposition. In addition, the real property must meet the conditions described in clause (a)(vi)(A) or (a)(vi)(B) of the definition of qualified farm property in subsection 110.6(1). Clause (a)(vi)(A) provides, in part, that in at least 2 years while the property was owned by one of the previously noted persons, the gross revenue of such a person from the farming business, in which the property was "principally" used, and in which such a person was actively engaged on a regular and continuous basis, must have exceeded the person's income from all other sources for the year. The person meeting this gross revenue test need not be the person who owns the property, such that, for instance, it may be the spouse or parent of the individual. For example, if a parent has met the gross revenue test in at least two years while he or she owned the property, and the parent later transfers the property to a child, the requirements of clause (a)(vi)(A) of the definition of qualified farm property in subsection 110.6(1) may be met even though the child has not farmed the property. Clause (a)(vi)(B) of the definition of qualified farm property in subsection 110.6(1) only applies when the farmland was used by a corporation or a partnership as described therein.

The determination of whether real property was used "principally" in carrying on a farming business is a question of fact. Where reference is made to an asset being used "principally" in the business of farming, the asset will meet this requirement if more than 50% of the asset's use is in the business of farming. Furthermore, it is also a question of fact whether a particular farming operation constitutes a farming business at any particular time. Some of the criteria which should be considered in making this determination are set out in Interpretation Bulletin IT-322R. In addition, the CCRA's general position with respect to the meaning of a farming business is outlined in paragraph 8 of Interpretation Bulletin IT-433R and paragraph 7 of Interpretation Bulletin IT-145R (Consolidated). We have enclosed copies of these interpretations bulletins for your information. As indicated in paragraph 9 of IT-433R, the crop share received by a landlord in a sharecropping arrangement is considered to be rental income and not income from farming. In our view, rental income is not income from farming.

Availability of a Reserve

Subsection 40(1) contains rules for determining a taxpayer's gain from the disposition of capital property and the general rules for deducting a reserve related to the proceeds of disposition that are not payable to the taxpayer until after the end of the taxation year. A reserve claimed in one year becomes the capital gain on the particular disposition for the next year under subparagraph 40(1)(a)(ii) and a new reserve on that capital gain may be available in that later year. For more information see Interpretation Bulletin IT-236R4 Reserves - Disposition of Capital Property, dated July 30, 1999 (enclosed).

The foregoing comments represent our general views with respect to the subject matter and are not an exhaustive explanation of the many details of the subject of your enquiries. As indicated in paragraph 22 of Information Circular 70-6R5, the above comments do not constitute an income tax ruling and accordingly are not binding on the CCRA. In light of the complexity of the tax issues involved in the above situation, you may wish to consider consulting with a tax advisor.

We trust the above comments are of assistance to you.

Yours truly,

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

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