Issues arising on the conversion of real property from capital to inventory (or vice versa)

When a real property held by a taxpayer as a rental property becomes the taxpayer’s residence (or vice versa), the “change-in-use” rules in section 45 and subsection 13(7) of the Income Tax Act (the “ITA”) are triggered. Subsection 45(1) provides that when a taxpayer, having acquired property for the purpose of earning income, has commenced at a later time to use it for some other purpose (or vice versa), the taxpayer is deemed to have disposed of the property for fair market value at the time of the “change-in-use” and to have reacquired the property for that same amount. The deemed disposition can be deferred through the filing of certain elections. Subsection 13(7) ensures that certain consequences resulting from the disposition or acquisition of depreciable property, such as recapture, terminal loss and computation of undepreciated capital cost, also apply in respect of the deemed disposition due to a change in use of the property.

But what happens when a taxpayer decides to rebuild or substantially renovate a property, formerly held as rental property, in order to sell it for profit? Or where a taxpayer purchases a property for resale and decides thereafter to hold it as a rental property? In those cases, the property never ceases to be income-producing, despite its change in character between capital property and inventory.

As these circumstances do not fall squarely into the language of section 45 of the ITA, the Canada Revenue Agency (“CRA”) issued an Interpretation Bulletin (“IT218R”) which sets out its administrative views on the application of the law. In IT218R, the CRA expresses the view that when real property is converted from capital to inventory (or vice versa) (a “Conversion”), section 45 and subsection 13(7) of the ITA do not apply. Instead, the CRA requires taxpayers to calculate the business income/loss or capital gain/loss, if any, on the basis that a notional disposition of the property occurred on the date of Conversion and to report the respective income, gain or loss in the taxation year in which the actual disposition of the property occurs.

Notwithstanding the Federal Court of Appeal’s decision in CAE Inc v R (2013 FCA 92), which stated that the “change-in-use” rules in section 45 and subsection 13(7) of the ITA apply to a Conversion, the CRA has continued to apply its position set out in IT218R. The CRA’s justification for not following the decision in CAE is that the CRA views the Court’s analysis regarding the change-in-use rules as “obiter dicta”, which is a legal term for portions of a decision that are not binding because they are not necessary to the Court’s decision in the case.

The issue thus becomes determining if and when a Conversion occurs. The timing of the Conversion affects the tax payable on the gain on the sale of property, due to the shift in allocation between capital gain (50% taxable) and business income (100% taxable). This timing can also become important in determining whether certain tax advantages are available in respect of the property, such as the “cost-bump” under s. 88(1)(d) of the ITA in the course of a corporation’s wind-up or amalgamation, which is only available in respect of capital property.

The jurisprudence has established that “a clear and unequivocal positive act implementing a change of intention” is necessary to change the character of a real property (Edmund Peachey Ltd. v. R., 79 D.T.C. 5064 (F.C.C. – Appeal Division). What kinds of “positive acts” will suffice has been the subject of numerous decisions, all of which turned on very specific sets of facts.

Rezoning applications and requests for subdivision approval may suffice to trigger a Conversion provided they are accompanied by other positive acts, such as the preparation of a solid development plan or efforts to make the property more attractive to potential purchasers (Radiant Properties Inc. v. MNR, 91 D.T.C. 1005 (T.C.C), Karam v. R., 2013 TCC 354 and Jones v MNR, 90 D.T.C. 1849 (T.C.C)). However, when an application to rezone a property held as inventory from industrial to residential is denied by the municipality, the mere fact that the development of the land into residential lots for resale is no longer viable may not be sufficient to convert the property from inventory to capital, even when the property has been held for many years and is sold as a result of an unsolicited offer (Edmund Peachey).

Similarly, when the development of a property becomes financially unfeasible because of stringent requirements imposed by the municipality, the sale of the undeveloped land (even if made as a result of an unsolicited offer) may still be considered to be on income account. For example, in Peluso v R., 2012 TCC 153, the Tax Court of Canada (the “TCC”) found that the decision not to develop the land was a change of “plan” and not a change of “intention” that would have given rise to a Conversion of the property from inventory to capital. However, the TCC did note that there would have been a Conversion had the developer entered into a joint venture to erect a rental building on the property when faced with the new municipal regulations.

Interestingly, in another case, the TCC found that when development of a property could not be carried out because of a First Nations blockade (rendering the land useless for development), a Conversion did occur. The TCC reasoned that, although the property did not change its character to capital – as it simply went from being used as a trading asset to no use at all – the land did cease to be inventory and thus its disposition was on capital account by default (Henco Industries v. R, 2014 TCC 192)

Property sold immediately after being inherited may retain its character as capital property as long as it had been held as such by the deceased individual. In Fiducie Charbonneau c. Québec (Sous-ministre du Revenu), 2010 QCCA 400, a testamentary trust held what was originally farmland that the deceased individual, Mr. Charbonneau, had used in the past. Before his death, Mr. Charbonneau had stopped farming the land and sold two lots. After his death, the trust sold some further lots. The Court of Appeal of Quebec found that there had been no Conversion and that the sales by the trust were realized on capital account, since the trust simply continued doing what Mr. Charbonneau had begun doing while he was alive.

As illustrated by these examples, it is the particular circumstances of each case that will dictate whether there was a Conversion and the date it occurred. As such, taxpayers who intend to use their real property for different purposes should seek advice from tax professionals to ensure that they do not become subject to unexpected or adverse consequences resulting from the “Conversion rules”.