I was recently asked to provide guidance on a rather unique problem. A couple owned a rental property near Lawrence and Avenue Road in Toronto, Ont. They wanted to sever the large lot and build two semi-detached homes. They would then occupy one home and provide the builder the second home — for free.
The couple's main concern: Would they be required to pay tax on the disposition of the second home — the one the builder received in lieu of payment?
Victoria, B.C.-based chartered accountant James Gustafson provided some much needed insight to this dilemma. : “They’d have to pay tax on the capital gain for the property provided to the builder.” But he was quick to add: “There are a couple of major issues to address.”
First: Since the original use of the property was as a rental, the disposition of this rental property would trigger taxable capital gains. “There are tax implications when you change the use of a property,” explains Gustafson. It’s called a deemed disposition and, according to the taxman, the property is considered sold if the use of the property has changed. “You treat the situation as if you actually sold the asset.”
To better appreciate this situation, let’s assume this couple’s marginal tax rate is 33% and they bought the property for $550,000 and it was appraised at $725,000. That means our couple would have to pay approximately $14,500 in capital gains taxes on the deemed disposition of the property.
Second: Since one of the new homes will be gifted to a third party (the builder) the transaction would trigger another taxable capital gain. “In this case they’d have to determine the fair market value of the property.”
Now, let’s assume the builder completes the two semi-detached homes and the appraised value of each is $725,000, while the building cost for each was $350,000. The couple would have to pay an additional $31,000 in taxes.
Third: To mitigate some of the taxes owed, says Gustafson, this couple could reclaim losses based on the torn down building and by subtracting the value of land. “A right-off on the building could generate an offsetting loss.”
Finally: The couple could also avoid some tax through principal residence exemptions or through deferral but counsel and guidance from a professional is strongly recommended.
“It’s a very complicated situation,” says Gustafson.