Subdivision and Development of Former Principal Residence: 6 Considerations You Should Make
There are many tax implications that can apply to you when planning to move out of your current principal residence and then developing it. The income tax rules can be very detailed and certain procedures or steps can alter when and how a transaction is taxed.
Before committing to a plan to rezone and develop a property, a tax plan should be discussed to ensure that you are not causing the loss of certain benefits or complicating certain transfers. If done properly, you should be able to transfer a property to a corporation utilizing the principal residence exemption on the portion of the property that qualifies and a tax deferred rollover on any portion that does not. This is while setting up the structure to allow future projects and allow for potential income splitting with a spouse or other family members, with consideration to attribution and tax on split income rules.
The comments below are general and based on current rules. Any planning should be discussed with a Smythe advisor prior to implementation.
1. CHANGE OF USE
There is a deemed disposition at the fair market value at the time that you change the use of a property that was originally acquired for a purpose other than earning income to now becoming the purpose of earning income. You may elect to not have the change of use rule apply which would potentially defer the timing of the income inclusion if you were to develop the property personally. In general, where the change of use is due to development of the property for resale, the Canada Revenue Agency will consider any increase in value from the time of the change of use to be on the account of income rather than the tax preferred capital gain. The portion up to the change of use would be capital and could be eligible for the principal residence exemption.
A transfer to a corporation would not be subject to the change of use rules and would result in any deferral on prior elections being rescinded.
It is important to consider if a change of use to inventory (property held for development) occurred prior to a transfer to a corporation as the change to inventory would cause the tax deferred rollover under Section 85 of the Income Tax Act (Canada) for the transfer of assets to a corporation to be unavailable to the transferor. In the case where the property is converted to inventory prior to a transfer, it may be necessary to sell the property at fair market value and pay income tax on the transfer (unless it qualifies for the principal residence exemption) to the corporation or where cash is needed for the development, consider a more complicated series of transfers.
2. PRINCIPAL RESIDENCE EXEMPTION
If you owned the property personally and you, your spouse or common-law partner, a former spouse or common-law partner or one of your children ordinarily inhabited the property during a particular year, you may be able to designate the property at the time of the disposition as your principal residence for qualifying years to fully or partially exempt the property from income taxes. Before designating the property, consideration should be given to the impact on other properties you own that may be eligible for the exemption as you may only designate one property for year.
Even where the principal residence exemption applies if the property is larger than one-half hectare (1.235 acres), it may only be partially exempt. The principal residence exemption is only available if the land in excess of one-half hectare is essential for its use and enjoyment as principal residence or there is a minimum lot size, unavoidable severance restrictions or other factors.
3. USE OF A CORPORATION
The use of a corporation could provide several benefits. For example, a corporation may limit liability to the assets within the developing corporation. The benefit of limited liability should be discussed with a lawyer.
For income tax purposes, the main benefit is that the corporate tax rate would apply on the profit earned from the development of the property. The corporate income tax rate on the first $500,000 of active business income earned by an associated corporate group is 11%. When compared to the higher personal marginal rate in BC of 53.5%, there is a significant deferral of income taxes on the profit if left in the corporation. When profit is transferred out after the development, the income tax deferral would be eliminated due to personal taxes on dividends.
The share structure of the corporation should consider who is contributing to the property and allow for all contributors to benefit from the profits by providing appropriate share structure.
4. OTHER TAXES
In addition to income taxes, the transfer of a property may result in other taxes.
Depending on the province and its specific rules, a property transfer tax may apply. For example, in British Columbia, property transfer tax is charged on the fair market value of the property transferred at 1% on the first $200,000, 2% on the value between $200,000 up to $2,000,000 and 3% on the amount in excess of $2,000,000 plus an additional 2% on residential property in excess of $3,000,000 when title is registered unless an exemption applies. In general, the exemptions that would apply to the transfer of a principal residence will not apply to the transfer to a corporation. A title may be retained by the transferor on the initial transfer using a bare trust arrangement allowing the property transfer tax to not apply while transferring the beneficial interest. A bare trust may not be feasible is situations where there are investors other than the transferor or where property is to be retained as a future registration is based on the fair market value at the time of registration.
GST may apply in certain situations where land has been partitioned multiple times prior to the transfer or the property was used in a commercial activity. If GST applies on the initial transfer, it should be fully recoverable. If residential property is retained for rental purposes, the self-supply rules will apply on the fair market value at the time of completion. A rebate for long-term residential rent may apply to the GST charged on the self-supply.
5. OTHER INVESTORS
Arrangements with other parties add complexity, therefore profit share on the development must be considered. A corporation may still be an appropriate structure with each investor owning a percentage of the shares entitling them to that portion of the profits. However, other structures such as partnerships and joint ventures can have built-in flexibility to allow for the following:
- contributions over time by one of the parties (for example, one party transfers land and the other contributes development cost);
- each party retain a portion of the developed properties;
- profit sharing based on different allocations.
Legal ramifications should be discussed with your lawyer regarding where third parties are involved as their actions could impact you depending on the structure set-up.
6. OTHER CONSIDERATIONS
There are some remaining considerations not discussed above. Foreign ownership, profit sharing with family members, developing multiple units in a property with the intention to retain one as a principle residence, situations with multiple passive investors and the ability to use RRSP funds, to name a few.
Each of these scenarios is complex and should be discussed with your Smythe Advisor. If you have any questions regarding the development of your principal residence, please visit our Real Estate & Construction page on our website or contact us directly and we can put you in touch with the right advisor to help you and your organization succeed.