There are many aspects of real estate taxation; this paper addresses the following: Interest and Property Taxes on Vacant Land,

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1 COMMERCIAL PROPERTY CONFERENCE INCOME TAX CONSIDERATIONS INTRODUCTION The real estate industry has been battered by numerous income tax changes over the past few years and, as a consequence of these amendments, it is no longer proper to refer to real estate as a "tax shelter". While a real estate venture may still throw off some losses to investors, gone are the days when investors could write off large amounts of "soft costs". There are many aspects of real estate taxation; this paper addresses the following: Interest and Property Taxes on Vacant Land, Real Estate Development Projects investment vehicles, soft costs, Rental Income personal versus corporate ownership, tenant inducements, leasehold improvements, and Dispositions.

2 2 VACANT LAND From 1978 to 1987, interest and property taxes on vacant land held for future development were generally deductible when incurred by real estate developers. starting with 1988, new Tax Reform rules apply and in general, these expenses are not deductible and must be capitalized for tax purposes. However, there are exceptions: (1) If the vacant land is used in an active business other than real estate development (such as a parking lot), the capitalization rules would not normally apply. (2) There is an exclusion for a "principal business corporation" which a company whose principal business is the leasing, rental, sale or development of real estate (or any combination thereof). Such a company may deduct interest and property taxes up to its "base level deduction" which is $1 million multiplied by the prescribed rate. The base level deduction must be shared by associated companies and is prorated for a short year. Remember only principal business corporations qualify for this special treatment, not individuals or partnerships (even where all partners are principal business corporations). (3) A phase-in of the rules allows for a gradual introduction of the capitalization requirement. Basically, the nondeductible feature starts with 20% for the calender year 1988 and continues to require an ad4itional 20% capitalized in each year until 1992 when 100% must be capitalized. Proration for non-calender years is required.

3 3 As a planning point to maximize deductible amounts, consider repaying loans which result in capitalized interest before repaying loans whose interest is otherwise deductible. REAL ESTATE DEVELOPMENT As a point of clarification, a reference to real estate development generally means the activity of constructing, renovating or purchasing real estate with the intent of resale at a profit. As such, this activity would normally be considered a "business" for income tax purposes. Merely holding real estate for long term investment though rentals is not necessarily a "business" but is usually considered "income from property" and this makes a difference regarding income tax treatment. Investment Vehicles The question often arises as to the best manner of holding a real estate development project: personally, corporately, limited partnership, joint venturef,co-tenancy, etc. Regarding personal ownership, liability is unlimited and this may be a concern. On the other hand, losses (if any, and provided the project has a reasonable expectation of profit) may be used personally to offset other income but, as mentioned at the outset, the potential to enjoy large losses has been reduced by legislative changes. As with any new business proprietorship (and not merely an "income from property" rental situation), the individual has a choice of year end which affects the timing of tax reporting.

4 4 It is important to note that land inventory may not be transferred to a corporation on a tax free roll-over basis. Nonetheless, it is possible to transfer land inventory to a partnership (provided certain tests met and certain forms filed with Revenue Canada). Corporate ownership provides for limited liability and offers the small business tax rate on the first $200,000 of annual taxable income (only regarding a "business", not "income from property" rentals). Further, corporation ownership gives the shareholders potential access to the $500,000 capital gains exemption (provided the numerous tests are met). The limited partnership has been very fashionable but its use may diminish as a result of the recent tax amendments mentioned at the introduction. A limited partnership gives tax treatment similar to that of individuals since the tax results of the partnership generally flow through to the individual partners. Limited liability is possible where the partner is not actively engaged in the management of the partnership or its business. One attempt to curb the tax advantage of limited partnerships was the introduction of the "at-risk" rules (subsection 96(2.2)) in 1986 which generally 1 imi t the partner's wr i te-of f to the amount "a t-r isk" in the venture. Soft Costs There is a general rule which requires similar treatment for accounting (ie. generally accepted accounting principals) and taxation purposes unless a specific provision of the Income Tax Act provides otherwise.

5 5 overriding this general rule is a 1981 amendment to the Act which requires capitalization of all costs during the period of "construction, renovation or alteration of a building". These rules are contained in subsections 18(3.1) to 18(3.7). When these rules were first introduced, there was an exception for principal business corporations and thus such corporations could continue to deduct costs which would otherwise be deductible during the construction period (eg. interest expense deductible pursuant to paragraph 20(1) (c)). However, the 1987 Tax Reform now extends the 18(3.1) capitalization rule to principal business corporations. Once again, a gradual introduction is obtained by requiring only 20% to be capitalized for the calender year 1988, 40% for 1989 and continuing in this manner until 100% is reached in Note there is no "base level amount" mechanism as there is for interest and property taxes in relation to vacant land. Any deduction denied by the 18(3.1) capitalization rules should be added to the capital cost of the building, and not to the land. These amounts therefore become deductible as capital cost allowance in future years (and note Tax Reform has reduced the building capital cost allowance rate by 20% - from 5% to 4% for building acquired after 1987). The wording of subsection 18(3.1) is very broad in its reference to outlays or expenses that may reasonably be regarded as a cost relating to the construction, renovation or alteration of a building or the relevant land. No exhaustive definition is given. Obviously covered are interest, legal and accounting fees, property taxes, certain bridge financing fees and utility service connection costs. However, the general nature of the wording is wide enough to pick up any additional otherwise deductible expenses which can be seen to satisfy the related test.

6 6 Specifically excluded from these capitalization rules are capital cost allowance and landscaping around the building. If costs fall outside the construction period, subsection 18(3.1) would not apply. These can be split between pre and post construction costs: Pre-construction costs might include site investigation and representation costs (such as those related to zoning). These costs may be deductible if they meet the conditions set out in paragraphs 20(1) (dd) and 20(1) (cc), respectively, which include the requirement that a "business" (as opposed to "income from property") is being carried on. Post-construction costs could consist of those costs relative to the permanent mortgage financing including interest, an interestrate buy-down, lease-up costs, and guarantee fees such as those relating to cash flow and/or return on investment. Annual expense items such as post-construction interest expense should be deductible, but those items which bring into existence an enduring benefit or advantage may be considered capital expenses not fully deductible in the year incurred. If an argument may be made pursuant to generally accepted accounting principals to write off such expenses over the period to which they relate, the tax treatment should be the same. Two possible al ternati ve treatments of capital costs are: (1) adding to capital cost of building (and perhaps the land) which gives only capital cost allowance at 4% on the building costs, or (2) considering them as eligible capital expenditures whose tax treatment is to include 75% of such expenditures in an "EeE" pool giving an annual deductible amount of 7.5% on a declining balance basis.

7 Both these normally give lesser amounts of tax deduction than a write off over the period to which the costs relate. 7 Another group of historic soft costs were financing fees (20(1) (e». until 1987, the Income Tax Act allowed a deduction of expenses incurred in the course of: (1) issuing an interest in a partnership or syndicate, (2) the issue of shares of a company, and (3) borrowing money for the purpose of earning income. Such fees obviously cover a very wide range of expenses. For 1988 on subsequent years, Tax Reform generally requires a five year amortization of such fees. However, if a fee (such as standby charge, guarantee fee, registrar fee, transfer agent fee, filing fee, service fee, etc.) relates solely to one year, full deduction is permitted (20(1) (e.1».

8 8 Rental Income Personal versus corporate ownership The considerations discussed under the heading Real Estate Development - Investment Vehicles generally have similar application when considering a rental project. However, the rental of real estate has its own tax quirks. One point is the general restriction of capital cost allowance to the net rental income of the property. Put in other words, capital cost allowance can neither create nor increase a rental loss. This test is on a global basis meaning that all rental incomes and rental losses are combined before determining if any related capital cost allowance may be claimed. A principal business corporation, however, is not subject to this rule. I Note special rules cover Multiple Unit Residential Buildings (MURBs) which were subject to a tax incentive program which allowed capital cost allowance losses on qualifying buildings. For MURBs purchased after June 17, 1987, the ability to claim capital cost allowance in excess of net rental income is lost. For MURBs owned before this date, capital cost allowance may continue to generate losses until For corporations, profits from the business of earning rental income is generally taxed at the high corporate rate with a refundable portion based on dividends paid to individual shareholders. However, if a corporation is carrying on a rental business and has more than 5 full time employees working in that business, the corporation is: (1) eligible for the low "small business" corporate tax rate on its first $200,000 of annual income (but must be shared with associated companies), and (2) the individual shareholders may

9 have the opportunity to access the $500,000 capital gains exemption on a disposition of their shares. 9 Tenant inducements These became immensely popular following a court case which allowed the recipient of such an inducement non-taxable capital treatment. Naturally, the government was not pleased at this turn of events and in 1985 amendments to the Income Tax Act brought an end to this favourable tax treatment. Paragraph 12 (1) (x) now requires all inducements to be included into income unless the inducement is received to acquire property (such as leaseholds) and the recipient elects to reduce the cost base of such property by the amount of the inducement. From the lessor's viewpoint, the payment of a tenant inducement is, in Revenue Canada's view (IT-359R2, paragraph 14), considered an eligible capital expenditure (which means reduced tax benefit as only 75% of such expenses can be written off at 7.5% per year). Nonetheless, if an argument can be made pursuant to generally accepted accounting principles to write off the inducement over the lease term, similar tax treatment should be possible. Leasehold Improvements with the surplus of rental space in the Metro area, it has become fashionable for landlords here to offer financial assistance for tenant leasehold improvements in exchange for lease commitment from the tenant.

10 10 If the landlord merely constructs the leaseholds for the tenant, then the cost of construction would normally become part of the building cost (permitting only capital cost allowance and subject to the rental loss rules discussed immediately above). A better tax posi tion may possibly be obtained by offering a lump sum tenant inducement which the tenant then uses to construct the leaseholds. The tenant could elect to reduce the cost base of the leasehold improvements by the amount of the inducement. The landlord would then have arguments to deduct the inducement over the lease term. Where a tenant incurs leasehold improvement costs, these generally are pooled (into class 13) and are permitted capital cost allowance on a straight line basis over the term of the lease plus one renewal period. The minimum write off term is stated as five years although this means a minimum of six years is necessary when the half-rate rule is taken into account. For example, a five year lease with no renewal term provides capital cost allowance to the lessee on leaseholds as: year I, 10%i year 2 to 5, 20%; and year 6, 10%. As a tax planning point, it may be beneficial to the tenant to keep the lease term plus one renewal period to a five year maximum which allows the quickest leasehold tax write off to the tenant. Where the parties want comfort for more than five years, a "put/ call" arrangement might be considered. For example, if the parties wanted commitment for, say, a 10 year period, it may be possible to arrange an initial three year term, with a first renewal period of two years and a subsequent renewal period of five years. At each renewal date, the landlord has the right to require the tenant to take the space and the tenant has the right to lease the space. In such a situation, the initial lease term plus one renewal period is five years to accommodate the maximum leasehold write off period to the tenant, ~ut either party can stretch the lease term to 10 years if desired.

11 11 DISPOSITIONS When a property is disposed of, there are basically two types of tax treatment, income or capital gain. Before 1972, capital gains were not taxed in Canada so the difference between the two treatments was very significant. After 1971, capital gains were taxed at 50% and the latest round of Tax Reform increases the inclusion rate to 75% in 1990 (with a transitional 66 2/3% for 1988 and 1989). Thus the difference between capital gain and income treatment is narrowing except for the fact that the $100,000 capital gains exemption is available to individuals making some capital gains tax free. Note that the $500,000 exemption limit is only permitted on certain active business corporations and farms provided a host of other conditions are met. The Income Tax Act is of no help in determining whether a disposition is capital in nature. In fact, the Act defines capital property to be property the disposition of which would be a capital gain or loss (54 (b)) while a capital gain is a gain from the disposition of capital property (39(1) (a)). Needless to say, the courts have had numerous opportunities to judge on this matter and one of the most important points in determining the nature of gains is the intention of the taxpayer at the time of acquisition. A resale intention means income gains, an intention to hold the property to produce income means capital treatment. Other factors to consider include extent to which intent carried out, evidence of subsequent changed intention, nature of taxpayer's business, length of holding period, reasons for sale, solicited versus unsolicited offer, zone and location of the property.

12 A VACANT LAND REVISED RULES WITH TAX REFORM INTEREST AND PROPERTY TAXES GENERALLY MUST BE INVENTORIED OR CAPITALIZED UNLESS: USED IN A BUSINESS (BUT NOT SIMPLY AN "ADVENTURE"), OR INCOME GENERATED FROM LAND. CORPORATIONS ONLY: HISTORICALLY, PRINCIPAL BUSINESS COMPANIES "PBC" (IE > 50% LEASING RENTAL OR SALE OF REAL ESTATE) ALLOWED TO DEDUCT INTEREST AND PROPERTY TAXES ON VACANT LAND. NOW, PHASE-IN PERIOD: % MUST BE CAPITALIZED % " % " % " % " BUT RELIEF FOR SMALL PBC DEVELOPER WHO GETS TO DEDUCT INTEREST AND PROPERTY TAXES ON VACANT LAND UP TO $1 MILLION MULTIPLIED BY "PRESCRIBED RATE" (NOW 11%) PLANNING POINT - REPAYMENT OF NON-DEDUCTIBLE LOANS BEFORE DEDUCTIBLE ONES.

13 B REAL ESTATE DEVELOPMENT INVESTMENT VEHICLES PERSONALLY HELD: UNLIMITED LIABILITY, WATCH INSURANCE COVERAGE LOSSES, IF ANY, AVAILABLE PERSONALLY PROVIDED REASONABLE EXPECTATION OF PROFIT CHOICE OF YEAR END CANNOT TRANSFER LAND INVENTORY TO COMPANY ON TAX FREE BASIS LIMITED PARTNERSHIP: LIMITED LIABILITY IF LIMITED PARTNER NOT ACTIVELY INVOLVED IN MANAGEMENT AT-RISK RULES WHICH LIMIT AMOUNT OF TAX LOSS A LIMITED PARTNER CAN CLAIM TO THE AMOUNT THE PARTNER HAS "AT RISK" TAX RESULTS OF PARTNERSHIP GENERALLY FLOW THROUGH TO PARTNERS IN THEIR YEAR IN WHICH THE PARTNERSHIP YEAR END FALLS CORPORATELY HELD: LIMITED LIABILITY LOW TAX RATE ON FIRST $200,000 OF ANNUAL PROFITS $500,000 CAPITAL GAINS EXEMPTION

14 C REAL ESTATE DEVELOPMENT "SOFT COSTS" THROUGH 1980' S, SEVERE GOVERNMENT ATTACK ON "SOFT COSTS" WHICH CONTINUED IN TAX REFORM PROCESS GENERAL RULE: COSTS WHICH MUST BE CAPITALIZED FOR ACCOUNTING PURPOSES (PURSUANT TO GENERALLY ACCEPTED ACCOUNTING PRINCIPLES) MUST ALSO BE CAPITALIZED FOR TAX PURPOSES UNLESS THERE IS A SPECIFIC PROVISION IN THE INCOME TAX ACT TO PERMIT OTHERWISE. IN 1981 (AND OVERRIDING THE GENERAL RULE, ABOVE) INCOME TAX ACT AMENDED TO REQUIRE CAPITALIZATION OF ALL COSTS DURING THE PERIOD OF "CONSTRUCTION, RENOVATION OR ALTERATION OF A BUILDING" (18(3.1» BUT EXEMPTION PROVIDED TO PBC'S AT THE TIME NOW, TAX REFORM EXTENDS RULES TO PBC'S SUBJECT TO PHASE IN SIMILAR TO VACANT LAND RULES BUT WITHOUT BASE LEVEL DEDUCTION: % MUST BE CAPITALIZED % " % II % II ALL "

15 D REAL ESTATE DEVELOPMENT SOFT COST EXAMPLES FINANCING COSTS (EG. FEES RE BORROWING FUNDS & MORTGAGE COMMITMENT FEES OR FEES INCURRED IN THE COURSE OF ISSUING SHARES OR PARTNERSHIP UNITS) GENERALLY MUST AMORTIZE OVER MINIMUM OF 5 YEARS LANDSCAPING DEDUCTIBLE IF "AROUND BUILDING", NOT SUBJECT TO 18(3.1) COSTS OF REPRESENTATION USUALLY TO GOVERNMENT DEDUCTIBLE IF A BUSINESS (NOT MERELY INCOME FROM PROPERTY), SUBJECT TO 18(3.1) INVESTIGATION OF SITE UTILITIES CONNECTION DEDUCTIBLE IF A BUSINESS, SUBJECT TO 18(3.1) i..

16 E RENTAL INCOME PERSONALLY HELD: UNLIMITED LIABILITY, WATCH INSURANCE COVERAGE PERSONAL USE OF LOSSES EXPECTATION OF PROFIT BUT MUST HAVE REASONABLE $100,000 GENERAL CAPITAL GAINS EXEMPTION IF BUSINESS, CHOICE OF YEAR END CCA RESTRICTION (UNLESS PRE-JUNE 17, 1987 "MURB" WHICH CONTINUES TO PERMIT CCA GENERATED LOSSES UNTIL 1994) CORPORATELY HELD: LIMITED LIABILITY NO CCA RESTRICTION IF A PRINCIPAL BUSINESS CORPORATION IF: (1) A BUSINESS AND (2) MORE THAN 5 FULL TIME EMPLOYEES: SMALL BUSINESS DEDUCTION $500,000 CAPITAL GAINS EXEMPTION

17 F RENTAL INCOME TENANT INDUCEMENTS LEASEHOLD IMPROVEMENTS TENANT INDUCEMENTS BECAME IMMENSELY POPULAR FOLLOWING A COURT CASE WHICH ALLOWED THE RECIPIENT OF SUCH AN INDUCEMENT NON TAXABLE, CAPITAL TREATMENT INCOME TAX ACT CHANGES (12(1) (X» EFFECTIVELY PUT AN END TO THIS BENEFICIAL TREATMENT. CURRENT SITUATION: LESSEE VIEWPOINT PAYMENTS AS INDUCEMENTS MUST BE INCLUDED IN INCOME UNLESS THE RECIPIENT RECEIVED THE INDUCEMENT TO ACQUIRE PROPERTY AND ELECTS TO REDUCE THE COST BASE OF SUCH PROPERTY BY THE AMOUNT OF THE INDUCEMENT. LESSOR VIEWPOINT IF INDUCEMENT MADE TO ACQUIRE TENANT FOR TERM OF LEASE, SHOULD BE ABLE TO JUSTIFY THE WRITE OFF OF THE INDUCEMENT OVER THE LEASE TERM. PLANNING POINTS RE LEASEHOLD IMPROVEMENTS: (1) INSTEAD OF THE LANDLORD CONSTRUCTING IMPROVEMENTS FOR A TENANT, CONSIDER THE ALTERNATIVE OF OFFERING A LUMP-SUM UNRESTRICTED INDUCEMENT FOR WRITE OFF OVER THE LEASE TERM WITH LESSEE CONSTRUCTING HIS OWN LEASEHOLD IMPROVEMENTS. WHERE THE LANDLORD FINANCES AND CONSTRUCTS THE IMPROVEMENTS DIRECTLY, HE WOULD NORMALLY ACQUIRE BUILDING CAPITAL COST, GENERALLY DEDUCTIBLE AS CCA (ONLY 4% PER YEAR) (2) TENANT OWN IMPROVEMENTS NORMALLY WRITTEN OFF OVER LEASE TERM PLUS ONE RENEWAL PERIOD, MINIMUM FIVE YEARS (BUT ONLY ONE HALF THE AMOUNT OTHERWISE AVAILABLE IN ACQUISITION YEAR). THUS CONSIDER LEASE TERMS OF 3/2/5 YEARS VERSUS 5/5 TO GIVE TENANT 5 YEAR WRITE OFF INSTEAD OF 10 YEARS.

18 G DISPOSITION OF REAL ESTATE CAPITAL VERSUS INCOME GAI~ CAPITAL GAINS - ONLY 75% INCLUDED IN TAXABLE INCOME (66 2/3% FOR 1989) - CAPITAL GAINS EXEMPTION POSSIBLY AVAILABLE INCOME TAX ACT NO HELP IN DETERMINING CHARACTER OF GAINS GENERAL CONSIDERATIONS IN DETERMINING NATURE: PRIMARY OR SECONDARY INTENT AT PURCHASE EXTENT TO WHICH INTENT CARRIED OUT EVIDENCE OF SUBSEQUENT CHANGED INTENTION NATURE OF TAXPAYER'S BUSINESS HOLDING PERIOD REASONS FOR SALE SOLICITED VERSUS UNSOLICITED OFFER LOCATION AND ZONE USED

19 H PLANNING IF DEVELOPMENT BUSINESS: GENERALLY INCORPORATE TO ENJOY LOW TAX RATE ON FIRST $200,000 OF PROFITS PROVIDED THESE PROFITS CAN BE LEFT IN THE COMPANY (IE. NOT WITHDRAWN BY SALARY OR DIVIDENDS) INCORPORATE TO ENJOY ACCESS TO $500,000 CAPITAL GAINS EXEMPTION (BUT WATCH ALTERNATIVE MINIMUM TAX AND CUMULATIVE NET INVESTMENT LOSS RULES) IF OWN DEVELOPMENT PROPERTY PERSONALLY WITH ACCRUED GAIN, SET UP PARTNERSHIP WITH CORPORATION TO FINISH DEVELOPMENT SO THAT SOME PROFITS CAN ENJOY THE LOW TAX RATE (NOTE LAND INVENTORY UNABLE TO TRANSFER TAX FREE TO CORPORATION BUT CAN TRANSFER TAX FREE TO PARTNERSHIP) IF PERSONALLY OWNED, NORMALLY: CHOICE OF YEAR END FOR BUSINESS, LATE IN YEAR IF LOSSES EXPECTED WHICH CAN BE USED, EARLY IN YEAR IF PROFITS EXPECTED WHICH DEVELOPER WOULD PREFER TO DEFER

20 I PLANNING IF RENTAL PROPERTY: HOLD PERSONALLY UNTIL DEGREE OF ACTIVITY AMONG BUSINESS PROPERTIES GIVES BUSINESS STATUS (NEED 5 FULL TIME EMPLOYEES), THEN INCORPORATE USING ROLLOVER PROVISIONS OF THE INCOME TAX ACT. POOL PROPERTIES WITH OTHERS TO RAISE STATUS OF ACTIVITY TO BUSINESS - CAN INCORPORATE ON ROLLOVER BASIS INTO JOINT OWNED COMPANY. IF INCORPORATED AND USING FULL $200,000 SMALL BUSINESS DEDUCTION ON OTHER VENTURES, DO NOT WANT BUSINESS STATUS AS THIS CAUSES HIGH RATE OF TAX. THUS REDUCE ACTIVITY TO PROPERTY INCOME STATUS WHICH GIVES COMPANY A REFUNDABLE PORTION OF THE HIGH RATE TAX PAID. IF CONTEMPLATING SALE IN 1990, CONSIDER 1989 SALE TO GET 66 2/3% INCLUSION RATE (VERSUS 75% IN 1990) ON CAPITAL GAIN NOT COVERED BY CAPITAL GAINS EXEMPTION. CONSIDER JOINT OWNERSHIP (EG. WITH FAMILY MEMBERS) TO SPLIT FUTURE GROWTH.