Replacement Property Rules 

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Replacement Property Rules

Tax on certain property sales can be deferred – if you know the rules.

FROM: MAY-JUN 2007 ISSUE | BY MANU KAKKAR

A basic principle of income tax is that if you sell property for a gain there will be immediate tax consequences. But there is an exception when it comes to replacement property rules governing land and buildings. These rules allow the capital gain and/or recapture on the sale of either former business property or former property to be deferred until the sale of the replacement property – provided certain conditions are met.

Former business property (FBP) is real property, held as capital property, and used by the taxpayer primarily for the purpose of gaining or producing income from a business. However, it does not generally include rental properties, so taxpayers who replace rental properties with newer properties would not be eligible for the replacement property rules. Former property is defined as any capital property belonging to the taxpayer, but doesn’t include a share of the capital stock of a corporation.

Qualifying Dispositions

Two categories qualify for the replacement property rules: involuntary disposition and voluntary disposition of property. An involuntary disposition commonly arises when property is stolen, destroyed by fire or a natural disaster, or expropriated by government. In these kinds of situations, a taxpayer must acquire a replacement property by the later of two taxation years or 24 months following the year of disposition.

When dispositions are voluntary, the property must be a FBP and the taxpayer must acquire a replacement property by the end of the first taxation year or 12 months following the year of disposition in order to be eligible for a deferral.

Eligibility Criteria

The replacement property rules stipulate criteria a property must meet in order to qualify as a replacement property for both involuntary and voluntary dispositions. The three most important rules are:

1. The property was acquired by the taxpayer to replace the FBP or former property.
2. The property was acquired and used by the taxpayer or a person related to the taxpayer for a similar purpose as the use to which the taxpayer or related person used the FBP or former property (“Same or similar use” test). For example, a manufacturing plant will not be considered a replacement property for a hotel because the respective uses of the two real properties are quite different.
3. Where the FBP or former property was used by the taxpayer or a person related to the taxpayer for the purpose of gaining or producing income from a business, the replacement property was acquired for the purpose of gaining or producing income from that or a similar business (“Same or similar business” test).

The first criterion is a fact-based test and is generally fairly obvious to determine. However, the “same or similar use” and “same or similar business” tests may yield some traps for the unwary. The Canada Revenue Agency (CRA), in paragraph 16 of Interpretation Bulletin IT-259R4 Exchanges of Property, states:

Although the property generally will bear the same physical description as the former property [or FBP, as the case may be], for example, land replaced by land or a building by a building… there may be cases where a different type of property provides the same function as the former property [or FBP]. For example, where shares of a cooperative corporation which carry rights to accommodation in an office building are acquired to replace an expropriated office building, the shares could constitute a replacement property.

The CRA accepts that the appearance of the replacement property may be different than that of the FBP of former property, provided the use of both is the same or similar. But the CRA appears to apply the “same or similar business” test for the purpose of the replacement property rules in a broader manner than the “same or similar use” test. In paragraph 18 of Interpretive Bulletin IT-259R4, the CRA gives examples of similar businesses for the purpose of the replacement property rules (abridged list):

1. Merchandising-retailing and wholesaling
2. Farming
3. Financial services
4. Communications
5. Transportation
6. Construction, including subcontracting
7. Manufacturing and processing

According to this list, it would seem that the “same or similar business” test could be satisfied by having, for example, a plastics manufacturing plant be the replacement property for a garage door manufacturing plant. However, more detailed quantitative and qualitative rules need to be considered when deciding whether or not to use the replacement property rules in a client situation. A tax advisor should definitely be consulted to navigate through the complexity of these rules.

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Manu Kakkar , MTAX, CA, CGA, is an independent tax consultant specializing in personal, corporate, estate and trust tax planning, corporate reorganizations, divestitures and acquisitions, scientific research and experimental development tax credits. E-mail manu@kakkar.com.

“Tax Strategy” is co-ordinated by J. Thomas McCallum, CBV, FCGA, a business valuation and income tax consultant based in Whitby, Ontario, and author of several CGA-Canada professional development courses. E-mail jtmc@jthomasmccallum.com.

The information appearing in “Tax Strategy” is provided for the interest of the readers. Neither CGA Magazine nor the column authors and co-ordinator assumes any responsibility or liability to any persons relying on the information in the article to perform tax planning and/or compliance of any kind.