There are a couple of goals in almost every sales transaction: sell something for more than you paid for it and maximize the money in your pocket. Maximizing your sales price is an important step towards achieving these goals, but not the only step. You must also understand whether the gain on sale will be treated as a capital gain or business income. Understanding the factors that distinguish between the two can be highly beneficial as only 50% of a capital gain is subject to tax while business income is 100% taxable.
Did you sell capital property or business inventory? This assessment can be straightforward in many situations. A grocery store selling groceries is selling business inventory to earn business income. After many years operating this business, the owner decides it is time to retire so they sell the property and realize a capital gain. Many transactions are not as clear and will require a closer look at the key factors discussed below.
Frequency and intentions are a great starting point for your analysis. Do you frequently engage in this type of transaction, such as the grocery store owner selling groceries? If so, you are likely earning business income. What were your intentions at the time of purchase? You may also be earning business income if your intentions were always to sell for a gain. This can apply regardless of frequency, such as flipping a house. Capital gains are generally incidental to the primary purpose of your purchase. In the case of the grocery store owner, they bought a building to run a business out of and proceeded to do so for many years.
Intentions are not conclusive as you may have both primary and secondary intentions at the time of purchase and your intentions are subject to change over time. You also need to consider additional factors such as your conduct and the nature of the property. The actions you take at the time of purchase, during the period of ownership and at the time of sale will be subject to scrutiny. Did you act in a manner similar to a dealer of this type of property? You may have started looking for a buyer almost immediately or spent time improving the property to improve its marketability. You may also have a professional background in a related field. All these factors suggest that you were running a business. The nature of the property is important as certain properties have no value to the taxpayer other than selling for a profit. Generally, it is presumed that you intended to sell if you can not use the property for your own enjoyment or in an income earning endeavour.
Real estate transactions are often put under the microscope in the capital vs income debate. Other key factors to consider with these transactions include the length of ownership, the use of the property during ownership and the type of financing involved. Those in the business of trading real estate tend to hold the property for a short period of time and they maximize their flexibility for a sale. They may do this by leaving the property vacant or utilizing short-term financing. You will likely receive capital gains treatment on the sale of personal-use property such as the family home or cottage and the sale may even be eligible for the principal residence exemption. The sale of a rental property that you held for a long period of time will likely be eligible for capital gains treatment as well if your primary intention was to earn rental income.
Securities transactions are also frequently subject to scrutiny. Capital gains treatment generally applies if you tend to buy and hold securities for long periods of time, particularly securities which pay out income such as dividends or interest. However, there are some factors that suggest you may be in the business of trading securities. Do you buy and sell extensively and typically hold for short periods of time? Are you very knowledgeable of the securities markets and devote significant time to studying the markets? Do you buy on margin and purchase securities that are speculative in nature? If any of these apply, you may be subject to tax at full rates.
While capital gains treatment is beneficial when we make money, income treatment is often beneficial for losses. Losses from a business can be applied against any other taxable income on your return. However, capital losses can only be applied against capital gains.
Analyzing all the facts of your situation and keeping proper documentation to support your position can potentially reduce your tax bill by half.
For more information, please contact firstname.lastname@example.org or 1 844-GYTD-CPA