The Income Tax Act contains many rules which allow you to defer recognizing income in specific situations. One set of these rules relates to recognizing capital gains and recapture on certain properties if a replacement property has been purchased within the prescribed timeframe. The replacement property rules allow you to defer paying tax which leaves more cash available to reinvest in an income-producing property.
The replacement property rules may apply to both voluntary and involuntary dispositions. For the rules to apply to voluntary dispositions, the property must have been a former business property. A former business property is a capital property that was used primarily (greater than 90%) to earn income from a business at the time of disposal. The property must be real or immovable property (land or buildings), or a right in certain intangible properties such as a limited period franchise, concession or license. Rental properties are specifically excluded from the definition of former business property, unless the property is leased to a related person who is not using the property principally to earn rental income.
Involuntary dispositions include the receipt of compensation in respect of stolen property, compensation in respect of property that has been destroyed such as by a fire or natural disaster, or compensation for property that has been taken under statutory authority. The replacement property rules for involuntary dispositions apply to all capital property, such as land, buildings or equipment.
The replacement property must be purchased by the taxpayer to replace the old property, and the use must be the for the same or similar purpose of the old property. This must be analyzed on a case-by-case basis depending on the facts and circumstances. These rules are designed to assist in the replacement of property to be used in the same or similar income earning endeavour. They do not apply to business expansions or starting a new business.
The timing of the purchase and use of the new property is critical as well. For voluntary dispositions of a former business property, the replacement property must be purchased before the later of the end of the first tax year following the initial year, and 12 months after the end of the initial year. For involuntary dispositions, these timeframes are extended to the second tax year following the initial year, and 24 months after the end of the initial year. The initial year is the year in which proceeds of disposition become receivable. This is often the year of disposition but may be later for involuntary dispositions depending on the timing of compensation.
When the entire amount of the proceeds of disposition is reinvested in the replacement property, the entire amount of the capital gain and recapture, if applicable, will be deferred. This is achieved by reducing the cost base of the replacement property by the amount of the proceeds. By doing so, the amount eligible for capital cost allowance will be reduced by the amount of the deferrals and a lower capital cost will be used to calculate capital gains on future dispositions of the replacement property. If the proceeds are not fully reinvested, the reinvested portion will reduce the capital cost of the replacement property and the retained portion will be used to calculate the current period capital gain and recapture.
A letter must be submitted with the tax return in the year the replacement property was purchased to elect for these rules to apply. If the replacement property was purchased in a subsequent year after the disposition, an adjustment can be requested to the capital gain and recapture previously recognized.
The tax deferrals available under the replacement property rules can be very beneficial to you and your business by allowing you to reinvest a greater amount of the proceeds received. It is critical that you understand the criteria and assess whether these rules apply to you.
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