There are many tax considerations when building an asset. We must assess which construction costs can be claimed as current expenses and which costs must be capitalized as an asset on your books. We must also assess when the asset becomes available for use to determine when we can begin claiming capital cost allowance (CCA) as a deduction on your tax return.
Expenses must be incurred for the purpose of gaining or producing income to be deductible for tax purposes. During the construction of a building, the building is not being used for an income earning purpose and therefore the costs are not deductible. Most costs must be capitalized as development costs on your balance sheet and these development costs will ultimately be reclassified as the cost of the land or building upon completion. This includes hard costs of construction, such as labor and materials, as well as soft costs. Soft costs are costs of construction that do not directly relate to tangible items, including architectural and design fees, land survey fees, permits, and project management fees.
Special consideration must be given to soft costs. In addition to the soft costs listed above, soft costs also include items such as insurance, property taxes, interest, financing fees, professional fees, and other miscellaneous fees. These costs must generally be capitalized to the cost of the building during the period of construction until the time the building is substantially available for its intended use. The costs require careful analysis to determine if they directly relate to the construction activities. For example, general business insurance can continue to be deducted as a current expense, but any additional insurance taken out in respect of the construction activities must be capitalized. Financing may be obtained to fund both regular operating activities of the business as well as the construction activities. In this situation, the interest expense on the loan would need to be apportioned and capitalized on a pro-rata basis.
The timing of the construction period requires an analysis of the facts to determine when the construction period commences and ends. Generally, the construction period commences when development activities begin, such as the installation of services on the site or the date construction begins. The construction period ends when the building is substantially ready for its intended use. Receiving an occupancy or completion certificate from the municipal authorities provides sufficient evidence of this date.
Certain soft costs may be deductible as current expenses if you are receiving rental income from the property. For example, an existing building may still exist on the site, or a portion of the site is being rented for another purpose, such as parking. Soft costs can be deducted up to the amount of rental income received and any excess costs above this amount must be capitalized.
Special rules also apply to demolition costs. You may have an existing building on the site that you have been using in your business activities that needs to be demolished before commencing construction on the new building, or you may have purchased land with an existing structure that you intend to demolish. Depending on the circumstances, demolition costs can be either current or capital expenses. In the first example in which an existing building that has been used in business operations for an extended period is demolished, the demolition costs can generally be deducted as current expenses. In the second example in which a newly purchased building is demolished, the demolition costs are generally capitalized as part of the cost of land. Proper treatment of the demolition costs needs to be assessed on a case-by-case basis.
During the period of construction, the development costs are reflected on your books as a non-depreciable asset. Capital cost allowance claims are not allowed until the asset becomes available for use. At this point in time, the cost of the building can be amortized based on the rate of the applicable class to which it is capitalized.
Proper record-keeping is essential to assessing the tax implications of a construction project.
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