Selling your home can be an exciting milestone, but it can also attract the attention of the Canada Revenue Agency (CRA). Homeowners often rely on the principal residence exemption to shelter capital gains from the sale of their principal residence from taxes. However, when CRA audits a property sale, it will challenge the claim of this exemption, especially if they suspect that the property sale could be considered business income rather than a capital gain.
The Capital Gain vs. Business Income Debate
To understand why this is significant, it’s essential to recognize the difference between capital gains and business income. A capital gain arises when you sell an investment, such as your home, for more than you paid for it. Business income, on the other hand, is earned from the sale of property considered to be inventory—essentially a transaction conducted for the purpose of making a profit.
CRA will argue that the sale of your home was conducted as part of a business or an adventure in the nature of trade, which results in business income rather than a capital gain. This matters because only capital gains can benefit from the principal residence exemption.
Test: Capital Gain vs. Business Income
In determining whether a property sale should be treated as business income or a capital gain, CRA and the courts use a variety of factors. These criteria have been discussed in several cases, most notably in Happy Valley Farms Ltd. v. The Queen, and include the following:
- Subject Matter of the Sale
- What kind of property was sold? A property that does not generate rental income or personal enjoyment, and must be sold to produce any profit, is more likely to be treated as business income
2. Frequency of Similar Transactions
- If you have sold multiple properties in a short period, CRA may argue that you are engaging in a business rather than holding property for long-term investment.
3. Length of Ownership
- A shorter period of ownership may indicate that the property was acquired for the purpose of resale. In contrast, holding a property for an extended period may support the position that it was intended as a long-term investment.
4. Supplementary Work on the Property
- If substantial renovations or improvements were made to the property to enhance its resale value, CRA may view this as evidence of a business activity.
5. Circumstances Surrounding the Sale
- Sometimes, the sale of a property is triggered by unforeseen circumstances, such as financial hardship, job relocation, or health issues. If the sale was prompted by such reasons, the courts may be less likely to conclude that the property was purchased with the intention of resale for profit.
6. Intention or Motivation
- This is one of the most crucial factors. CRA will scrutinize your intention at the time of purchasing the property and throughout the entire ownership period. Was the purchase made with the goal of making a profit from its eventual sale, or was it intended as a long-term home or investment? Was your original intention realistic and did you follow through?
7. Borrowed Money and Quick Sales
- If you financed the purchase of your property with borrowed money and sold it quickly, this might raise red flags. Quick flips with significant financing are more likely to be classified as adventures in the nature of trade, resulting in business income rather than a capital gain.
8. Nature of the Taxpayer’s Business or Profession
- If your business or profession involves real estate, such as being a real estate agent or developer, CRA may argue that the property sale was part of your regular income-generating activities, further supporting a business income classification.
What You Should Do if You’re Being Audited?
If CRA audits your sale of a principal residence, they will look closely at these factors to argue that the profit should be taxed as business income. Here are some steps you can take to protect your principal residence exemption:
- Gather Documentation: Maintain records that support your claim that the property was your primary residence.
2. Explain Your Circumstances: Be prepared to explain any unusual circumstances surrounding the sale, such as a sudden need to relocate.
3. Seek Professional Help: Given the complexity of the issue and the potential tax consequences, consulting with a Toronto Tax Lawyer is key. We can help you prepare for the audit and defend your position.
Conclusion
The sale of a principal residence can offer significant tax advantages, but an audit by CRA could result in the loss of the principal residence exemption. Understanding the criteria used by CRA and courts to distinguish between capital gains and business income is crucial in defending your claim. For homeowners facing this issue, seeking professional advice early on can help protect your exemption and minimize the risk of a costly reclassification.
If you need assistance, contact us for free consultation. We will review your facts and outline the steps necessary to resolve your tax problem.
SpenceDrake Tax Law
Disclaimer
Each article/blog post is only meant to provide general information. It is posted on a specific date. Laws and rules change. Please know that it may be out of date. It is not meant to provide legal advice, and it does not provide legal advice. It cannot be relied on. Every tax situation is unique, and that may mean situations differ from this article/blog. If you have legal questions, please consult a lawyer.