Replacement Property Rules
Did you know you may be able to defer a capital gain by using Replacement Property Rules?
The Income Tax Act has a provision for business transactions where a property is disposed of but replaced by a new property that will be used in the same or similar fashion as the previously owned property in order to generate revenue. The replacement property provision allows the taxpayer to defer the tax consequences of the disposition due to the replacement nature of the transaction.
We generally see this in instances of voluntary disposition where land and/or a building is disposed of or sold as part of a business plan and replaced by a new structure used for the same or similar purposes to generate revenue for business purposes. The ability to defer the capital gains on the property keeps cash in the business as it is not needed to pay the taxes right away thereby allowing the business to run more smoothly without a tax hit in cash flow. This also keeps taxation within the spirit of the act and rather than taxes being paid on the disposition of the property, the new property is considered replacement property, and the gain is deferred. To do this, the capital cost of the replacement property is reduced by the amount of the capital gain and/or recapture being deferred on the disposed of the property. This of course means that the new cost of your asset for tax purposes is lower than the replacement value and you will pay the taxes on the gain upon the eventual disposal of the replacement property. When the disposition and subsequent replacement is voluntary in nature the replacement property must be acquired within 12 months of the disposition of the original property. This typically means it must be replaced during the following tax year.
Although this is not always the best option as it can create higher taxable disposition down the road, its implementation can give you and your accountant time to plan for proper disposal upon wind up of the business or disposal when the business is in a more favorable cash position and has the cash flow to pay taxes. This is especially true in instances of involuntary disposition due to circumstances beyond your control.
Frequently, the involuntary replacement of such property happens when a business is hit with an unexpected circumstance. This can be the expropriation of land due to development by governments, something often outside of the control of landowners, or property loss due to fire or other disasters. When the disposition is considered involuntary, the taxpayer has 24 months from the disposition of the property in which to replace it and implement the Replacement Property Rules.
It is becoming common to see more development of farmland for other purposes, loss of land through expropriation to towns and cities as well as to transmission and pipelines. For farmers, this frequently means renting or buying additional farmland to maintain growing acres, or subsequently downsizing their operations leading to lost revenue. Thus the replacement rules can impact a decision on how to replace “lost” land for some farmers.
If you think you may qualify to use Replacement Property Rules talk to us today, let us help you navigate your decision.