House flipping: refresher and practical advice – Part 1: income tax

According to data available on its website, the Canada Revenue Agency (the “CRA”) completed approximately 12,000 “real estate” audits in British Columbia for both income tax and goods and services tax/harmonized sales tax (“GST/HST”) between April 2015 and March 2022. These audits resulted in tax assessments topping $1.1 billion. An additional 54,000 real estate audits were completed in Ontario during the same time period, resulting in another $1.1 billion worth of assessments.

It is critical for taxpayers and their advisors to be aware of the tax rules governing real estate transactions. This article focuses on the applicable income tax rules. It outlines the rules surrounding the principal residence exemption and “house flipping”, and provides some practical advice to help taxpayers avoid or navigate a CRA audit in relation to the sale of a real estate property. A follow-up article discussing the equivalent rules in the GST/HST context will be forthcoming.

Principal residence exemption

There is a general belief that the sale of a “principal residence” is tax-free for income tax purposes. In reality, the rules are much more complex.

First, only individuals and certain types of personal trusts are entitled to claim the principal residence exemption (“PRE”). Further, a property will qualify as a principal residence only if three main conditions are met: (1) the individual or personal trust must hold the property as capital property, (2) the individual or a beneficiary of the trust must ordinarily inhabit the property, and (3) the individual or trust must file the proper forms with their tax return in respect of the year of sale in order to designate the property as a principal residence. Generally, each family unit (i.e., spouses and minor children) may only designate one property as their principal residence per year.

Capital property

The federal Income Tax Act (the “ITA”) contemplates two types of property: inventory and capital property. Dispositions of inventory give rise to business income or losses, while dispositions of capital property give rise to capital gains or losses (only one-half of which are taxable).

The PRE can only be claimed in respect of capital property. It allows taxpayers to “shelter” – either fully or partially – the capital gain that would otherwise be realized on a disposition of their principal residence.

The most important factor when determining whether a particular property constitutes inventory or capital property is the intention of the owner at the time they purchase the property. If, at the time of purchase, the owner has a primary or secondary intention to sell the property at a profit, the property will likely constitute inventory, such that its sale will give rise to business income and the PRE will be unavailable. In contrast, where an owner purchases a property with the intent of holding it long-term, the property likely constitutes a capital asset.

Other relevant factors to consider in determining whether a property constitutes capital property or inventory include the length of time the property is owned, the number of other similar transactions undertaken by the owner, and the circumstances giving rise to the sale of the property. That list is by no means exhaustive.

Ordinarily inhabited

The property must be “ordinarily inhabited” in order for its sale to qualify for the PRE. For sellers that are individuals, they, their spouse, or their child must ordinarily inhabit the property; for trust vendors, a “specified beneficiary” of the trust must do so.

An individual does not need to spend the majority of their time in the property in order to “ordinarily inhabit” it; for example, a seasonal recreation property can qualify for the PRE, depending on the circumstances. However, if none of the owner, their spouse, or their child lived in the property, even if they showed a clear intention to do so at the time of purchase, the owner will not be able to claim the PRE in relation to that property.

The “ordinarily inhabited” determination is made on a year-by-year basis. That is, taxpayers must tally the number of years in which they ordinarily inhabited the property and compare that to the total number of years during which they owned the property. The taxpayer must also be resident in Canada for income tax purposes in a given year in order for that year to count towards the PRE.

The PRE formula (in paragraph 40(2)(b) of the ITA) may add one additional year to a PRE claim, even if the taxpayer did not ordinarily inhabit the property in that year. For dispositions after October 2, 2016, this additional year is only granted if the taxpayer is a resident of Canada for income tax purposes during the year when the property is acquired.

Consider the following example: a Canadian-resident individual buys a property on capital account in 2019 and immediately begins construction of a new home. Construction is completed in 2021 and the individual moves into the new home during that year. In 2023, the individual sells the property and realizes a gain of $1,000,000. No other principal residence was owned by the individual or anyone else in their family during any of 2019-2023.

This individual owned the property during five years (2019, 2020, 2021, 2022, and 2023). The individual ordinarily inhabited the property during three years (2021, 2022, and 2023). The individual’s gain on the sale would not be fully sheltered by the PRE in this case. The individual would be required to report a taxable capital gain computed as follows:

Sheltered gain = gain otherwise realized × (# of years during which property is ordinarily inhabited + 1) ÷ # of years during which property is owned

Sheltered gain = $1,000,000 × (3 + 1) ÷ 5

Sheltered gain = $800,000

————-

Capital gain = gain otherwise realized – sheltered gain

Capital gain = $1,000,000 – $800,000 = $200,000

————-

Taxable capital gain = capital gain ÷ 2

Taxable capital gain = $200,000 ÷ 2 = $100,000

Taxpayers should refer to Form T2091 (for individuals), T1079 (for personal trusts), or T1255 (for representatives of a deceased individual) to assist with this calculation when filing their income tax return in respect of the year of sale.

Taxpayers may also encounter calculation issues on a “change in use” of their residential property. A discussion of these rules exceeds the scope of this blog post, but they are partly addressed in our previous blog post on that topic.

Reporting

Since 2016, the CRA requires that the sale of a principal residence by an individual be reported using Schedule 3 of the individual’s income tax return for the year of sale and Form T2091 (personal trusts have always been required to file the applicable form). These forms are required to be filed even if the sale of the property is fully sheltered by the PRE (i.e., there would be no tax payable on the sale), though the level of detail in that circumstance is lessened. Failure to file these forms could result in the imposition of penalties or, worse, the PRE claim being denied altogether.

New deeming rules

In Budget 2022, the federal government announced new deeming rules for “flipped properties”. Where a taxpayer sells a “flipped property” at a gain, the flipped property is deemed by subsection 12(12) of the ITA to constitute inventory of the taxpayer and the gain is deemed to give rise to business income, even if the sale would otherwise give rise to a capital gain. The PRE is therefore unavailable to taxpayers who sell “flipped properties”. These deeming rules have been enacted into law and apply to dispositions occurring on or after January 1, 2023. Subsection 12(12) does not apply to “flipped properties” which are sold at a loss.

A “flipped property” is defined in subsection 12(13) of the ITA to mean a housing unit in Canada (other than property which is already part of a taxpayer’s inventory) owned by a taxpayer for less than 365 days prior to the sale. Importantly, even when a property is held for more than 365 days prior to the sale and so does not qualify as a “flipped property”, it can still be determined that this property constituted inventory based on the common law factors described above.

The ITA enumerates specific exceptions to a property being deemed to be a “flipped property”. Those exceptions are based on the taxpayer’s reasons for selling the property. For example, if the sale can reasonably be considered to be due to, or in anticipation of, the death of the taxpayer or a related person, or a lasting breakdown in the marriage or common-law partnership of the taxpayer, the property will not be deemed to be a “flipped property” and the taxpayer may be able to claim the PRE in relation to its sale (if all conditions described above are met).

In the Fall Economic Statement 2022, the federal government proposed to extend the above rules to dispositions of the right to purchase a residential property via an assignment sale within 12 months. For example, the sale of a right to purchase a condominium less than one year after that right’s acquisition (e.g., the date of entering into a pre-sale) would be deemed to give rise to business income rather than a capital gain. This extension has not yet been passed into law, but assuming it is, it will likely apply to dispositions occurring on or after January 1, 2023.

Audit risk and important documents

A taxpayer who buys and sells real estate within a relatively short period of time and claims the PRE should prepare for an audit by the CRA in respect of the sale, even if the property is not deemed to be a “flipped property”. The audit risk, and likelihood of adverse reassessment, increases if the taxpayer buys and sells two or more properties in quick succession and claims the PRE on each sale. Making significant improvements to a property prior to sale (up to and including demolishing an existing home and constructing a new one) also increases the risk of a CRA audit and reassessment.

In anticipation of such an audit, taxpayers would be wise to obtain and retain certain documents to support their PRE claim. The following is a non-exhaustive list of certain notable such documents:

Finally, taxpayers should exercise care in answering standardized audit questionnaires, as the CRA regularly relies on taxpayers’ answers to those questionnaires to form and support its reassessing positions. Taxpayers are encouraged to seek professional advice as soon as a real estate audit is commenced.