Real estate inventory – Capital gains vs. income

Our July 9, 2008 blog entry on Capital Gains vs. Income highlighted the challenges that taxpayers face when dealing with dispositions of property and the tax treatment thereof. One of the more difficult issues in this area is whether or not a disposition of real estate property could be considered to be on account of income.

To the extent that real estate is considered to be inventory and not capital property, then such properties may not be transferred on a tax deferred basis to a Canadian corporation under the provisions of section 85 of the Income Tax Act (that is otherwise available for capital property). Real estate inventory is specifically excluded as “eligible property” for the purposes of eligibility for a tax deferred transfer under section 85 pursuant to the provisions of subsection 85(1.1). Accordingly, tax practitioners are usually very attuned to this area when advising their clients as to whether or not real estate can be transferred on a tax deferred basis to a corporation.

The determination of whether real estate is a capital property vs. inventory is ultimately a question of fact. The courts have heard many cases on whether property is inventory or capital property. The CRA also has their views on the determination of the factors that should be looked at when determining whether a property is capital property or inventory that is documented in many of their technical interpretations and Interpretation Bulletins.

A recent case, Dalron Construction Limited v. Her Majesty the Queen 2008 TCC 476 released August 26, 2008 highlights the importance of looking at this area closely. The facts of the case appear relatively straight forward. Dalron Construction Limited appeared to be in the business of real estate development. It transferred one of its properties to an 80% owned susidiary and attempted to defer part of the ultimate gain by utilizing the provisions of section 85. In other words, Dalron took the position that its transferred real estate property was a capital property and eligible for a tax deferral on the transfer. However, the CRA disqualified the tax deferral on the basis that the transferred property was inventory and not capital property. As mentioned, the determination of whether the property is a capital property or inventory is a question of fact and, after the court reviewed the facts, had no difficulty in determining that the real estate property owned by Dalron was inventory especially given its history of land development. Accordingly, the court found that the transfer of property to its subsidiary was not eligible for tax deferral utilizing the provisions of section 85.

Taxpayers need to take great caution when utilizing the many tax deferral opportunties that are available under the Act. With respect to real estate inventory, one of the common planning techniques that is utilized in order to overcome the problems with section 85 and the inability to transfer real estate inventory is to look at whether or not the tax deferred provisions of subsection 97(2) could be utilized in order to transfer the real estate inventory to a Canadian partnership. While exhaustive planning techniques of this method are beyond the scope of this blog, let it be said that many real estate transactions and the related planning thereto utilize subsection 97(2) given that such provisions do not carry a prohibition on the transfer of real estate inventory.