Buckwold12e Solutions Ch07

Buckwold and Kitunen, Canadian Income Taxation, 2009-2010 Ed.
CHAPTER 7 INCOME FROM PROPERTY

Review Questions 1. Although the Income Tax Act specifically refers to property income as a separate type of income, it does not provide a specific definition of the term. Identify the source from which the definition of property income is derived, briefly explain the terms meaning, and provide examples of income from property. Distinguish between income from property and the gains or losses that may occur from the sale of property. Interest income earned on loans by a financial institution may, for tax purposes, be classified in a different way from interest income earned on loans by taxpayers who are investing their savings. Explain why. Briefly explain how income from property is determined for tax purposes. Compare and contrast the taxation year of an individual with that of a corporation with respect to the determination of business income and property income. An individual can deduct for tax purposes the interest expense incurred on the mortgage loan attached to his or her personal residence. Is this statement true? Explain. A taxpayer has sold property (land) for $200,000 that was originally purchased for $70,000. The property was sold to an arms-length party (not related). The terms of sale involve a cash payment of $100,000 on closing, with the balance to be paid at $20,000 per year for five years, with no interest charged on the unpaid balance. For tax purposes, what types of income may result for the vendor from this transaction? An individual invests in a bank term deposit on July 1, 20X0. When does the individual recognize the interest income for tax purposes if the investment has a term of three years, with interest compounded annually but paid only at the end of the three-year term? Would your answer be different if the taxpayer were a corporation? Explain. Can a taxpayer deduct a reserve for unpaid interest on a loan if the interest appears not to be collectible? Explain. How does the treatment of unpaid interest compare with the treatment of the loan principal when its repayment is in doubt? Briefly explain why an individual who receives dividends from a Canadian corporation must include 125% or 145% of the dividend received in income for tax purposes, while a corporation receiving the same dividend includes only the actual 244
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Copyright 2009 McGraw-Hill Ryerson Ltd. Solutions Manual Chapter Seven
amount of the dividend. 11. If a loss occurs from the renting of real estate (that is, if annual expenses exceed rental income), the loss is not recognized in determining a taxpayers overall net income for tax purposes. Is this statement true? Explain. A building that costs $200,000 and is rental property will always create a terminal loss or a recapture of capital cost allowance when it is sold. The same result may not occur if the building is used directly in a business activity. Explain this. An investor in real estate may achieve a higher rate of return by acquiring a small portion (part ownership) of several properties, rather than a lesser number of whole properties. Explain this. Why is the purchase of rental real estate often referred to as a tax-sheltered investment? Often, an enterprise conducting an active business will separate its business operations from its appreciating assets (such as real estate) by establishing a separate corporation for each. How may this type of structure impair future expansion activities?
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Solutions to Review Questions R7-1. The definition of property income is derived from common law precedents. From this source income from property can be defined as the return on invested capital where little or no time, labour or attention is expended by the investor in producing the return. Property income includes the interest earned on bonds and loans, dividends earned on shares of corporations and rents earned from real estate [ITA 9(1)]. R7-2. Income from property refers to the regular returns derived from ownership of the property (such as dividends from shares). The gain or loss which results from the actual sale of the property is classified either as a capital gain (loss) or business income (loss) depending on the purpose for acquiring the property [ITA 38, 39(1)]. R7-3. Interest income earned by a financial institution such as a bank or trust company is normally classified as business income because substantial cost and effort is expended to earn the interest -- the loaning of money is a part of the entitys business. A taxpayer who earns interest from investing their savings earns property income because little effort is required to generate and maintain the returns. R7-4. Income from property is determined using the same rules as income from business. It is the profit determined in accordance with well accepted business principles with the aid of normal accounting principles. Similar to business income, the determination of profit is modified by several general limitations and can apply the same exceptions to those limitations [ITA 9(1)]. R7-5. The taxation year of a corporation is the fiscal period chosen to account for its affairs. Therefore both business income and property income are determined annually for the corporation's fiscal year. In contrast, property income earned by an individual cannot use a fiscal period and must be accounted for on a calendar year basis. For individuals carrying on business a calendar year end is required, however, an election to use an alternative method is available [ITA 34.1]. R7-6. Yes, the statement can be true. Interest expense on a loan is deductible in arriving at property income provided that the funds obtained from the loan are used to acquire an investment which in turn can generate taxable income [ITA 20(1)(c)]. Therefore, if an individual borrows money by mortgaging a home and uses the funds to acquire an income generating investment (and does not use the funds to buy the home) the interest is deductible. R7-7. Because the property is sold to an arms length buyer with substantial deferred payments without interest, it may be construed that the selling price of the property was increased in exchange for the elimination of interest. In such circumstance, a portion of the price may be considered to be property income from interest and taxed accordingly.
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The gain on the sale of the land (less the imputed interest) may be a capital gain if the land was originally acquired by the vendor to provide a long-term benefit and was not purchased for resale at a profit. As the capital gain is only 1/2 taxable, the reduced capital gain and enhanced interest income results in a greater taxable amount. On the other hand, the gain on sale of the land may be business income, in which case treating it as property income (interest) or business income would result in the same taxable amount. R7-8. The individual must recognize the interest earned to each anniversary day (annual accrual method) from the issue date of the investment. Therefore, no income would be recognized in 20X0. But income from July 1, 20X0 to June 30, 20X1 would be included in the 20X1 taxation year [ITA 12(4), (11)]. Income earned from July 1, 20X1 to June 30, 20X2 would be included in the 20X2 taxation year. And income earned from July 1, 20X2 to June 30, 20X3 would be included in the 20X3 taxation year. If the taxpayer is a corporation it must use the accrual method at all times. Income from July 1, 20X0 to December 31, 20X0 (assuming December 31 is the corporations year end) would be recognized in the 20X0 taxation year [ITA 12(3)]. R7-9. Using the same rules for determining income from business it can be ascertained that a deduction for a reserve for uncollectible interest on a loan can be made. Although the general limitations prohibit the deduction of reserves, a specific exception is made for uncollectible amounts which have previously been included in income. Provided that the uncollected interest has been previously recognized as income, a reserve is permitted [ITA 20(1)(l) & (p)]. However, a reserve is not permitted for the uncollectible principal of the loan because it did not create income when it was established. If, however, it was part of the taxpayer's normal course of business to lend money, a reserve for the principal is permitted. [ITA 20(1)(l) & (p)]. R7-10. Dividends received form a corporation represent corporate earnings that have already been taxed in the corporation. In order to diminish or eliminate the incidence of double taxation, a different mechanism exists for shareholders who are individuals and who are corporations. Individuals are taxable on the receipt of dividends, but that tax is reduced by a dividend tax credit which theoretically is equal to corporate taxes paid (31% or 20%). Therefore, an individual includes 145% (2009) of the eligible dividend received and 125% (2009) of the non-eligible dividend received in income, which is supposed to represent the pre-tax income of the corporation that has been distributed. For example, corporate income of $125 less corporate tax of 20% ($25) leaves $100 available for a dividend distribution. The individual, on receipt of a $100 non-eligible dividend includes $125 in income, calculates personal tax, and then reduces that tax by the dividend tax credit which is equal to $25 [ITA 82(1)(a), (b), 121]. If, however, the shareholder is a corporation, double tax is avoided by removing the dividend from taxable income altogether. As there is no dividend tax credit there is no
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need for the gross-up. A corporation simply includes the actual dividend in net income and removes the full amount when calculating taxable income [ITA 112(1)]. R7-11. The statement is not true. A loss from real estate rentals can be used to offset other types of income. However, a rental loss cannot be created or increased by a capital cost allowance (CCA) deduction [Reg. 1100(11)]. Therefore, where expenses before CCA exceed the revenues an actual loss is recognized but the loss cannot be increased further by CCA. R7-12. Each building that is classified as a rental property to its owners and costs more than $50,000 must be included in a separate capital cost allowance class to which no additions can be made [Reg. 1101(1ac)]. Therefore, the sale of one building combined with the purchase of another is not pooled, and the sale will result in a recapture or terminal loss unless the selling price is equal to the property's undepreciated capital cost. All buildings owned and used directly by the owner in a business are pooled together in a single class. Therefore, the sale of one building in a pool of several buildings, or the sale of a building combined with the replacement of another, may not result in a recapture or terminal loss. [Note that it is possible to place buildings meeting certain requirements into a separate Class 1.] R7-13. If an investor purchases a fewer number of larger real estate properties (each costing over $50,000), the opportunity to dispose of a lower quality property in order to acquire a better quality property is diminished, because the cash available on the sale of the first property may be reduced by tax on the recapture of capital cost allowance. However, if a larger number of lower cost properties (each costing less than $50,000) are acquired, the sale of one to acquire a better quality property may defer the tax on recapture due to the fact that the properties are pooled in a single capital cost allowance class. Therefore more cash is available for replacement. Of course, one must also consider the marketability of properties that are partly owned compared to properties that are wholly owned. R7-14. Real estate is often referred to as a tax-sheltered investment because it permits the deduction of capital cost allowance even when it is not an actual expense and bears no relationship to economic reality. Capital cost allowance is an arbitrary allocation of a building cost which does not take into account the estimated salvage value of the property. In many cases, the sale of a building results in substantial recapture of capital cost allowance indicating that the previous deductions of capital cost allowance were too high. Therefore, annual rental income is subject to annual reduced tax in exchange for the payment of tax at a later time (recapture). In effect, a portion of the annual rental income is sheltered from tax until the property is sold and this enhances annual cash flows. R7-15. By separating the appreciating property from the business corporation the property becomes classified as rental property. Therefore, the normal transaction of selling a smaller building to replace it with a larger building as part of an expansion program
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will result in diminished cash flows from recapture of capital cost allowance, impairing the expansion capability (each rental property over $50,000 falls into a separate class). On the other hand, this diminished cash flow could be avoided if the building were held directly in the business corporation as a business asset because the sale and replacement activities are pooled in the same class. The replacement property rules allow a taxpayer who incurs a capital gains and/or recapture on the disposition of a former business property to elect to defer the capital gain and/or recapture to the extent that the taxpayer reinvests the proceeds in a replacement property within 12 months of the end of the taxation year in which the disposal takes place [ITA 13(4); 44(1)]. The taxpayer can take advantage of these rules even if the property is held separate from the business as long as the person who owns the property is related to the entity which uses the property to carry on business. Former business property is defined in S.248(1) as a capital property used by the taxpayer or a related person for the purposes of earning income from a business. These rules are discussed in Chapters 6 and 8.
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Key Concept Questions QUESTION ONE Determine the amount of interest to be included in income in Years 1, 2, and 3 for each of the following situations. Income tax reference: ITA 12(1)(c), 12(3), (4), (11). Percel Ltd. has a December 31 year end. In Year 1, Percel purchased a $10,000 bond on its issue date of November 1.The bond pays interest at 6% compounded annually. Percel will receive interest when the bond matures on October 31,Year 3. Debra purchased a $10,000 bond on its issue date, November 1, Year 1.The bond pays interest at 6%, compounded annually. Debra will receive the interest when the bond matures on October 31,Year 3. QUESTION TWO Anne received the following dividend income during the current year: $1,000 of eligible dividends from taxable Canadian corporations. $1,000 of non-eligible dividends from taxable Canadian corporations. $1,000 of foreign dividends. The foreign country withheld $150 in foreign tax and Anne received the net amount of $850. Determine the amount of dividend income to be included in Annes property income for the current year. Income tax reference: ITA 12(1)(j), (k), 82(1). QUESTION THREE A Ltd. received the following dividend income during the current year: $1,000 of eligible dividends from a taxable Canadian corporation. $1,000 of non-eligible dividends from a taxable Canadian corporation. Determine the amount of dividend income to be included in As property income for the current year. Income tax reference: ITA 12(1)(j),112(1).
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QUESTION FOUR At the end of the current year, Fred owned two rental properties. Rental property #1 cost $125,000 (land $50,000; building $75,000) and at the close of last year had a UCC of $64,000. Rental property #2 was acquired in the current year for $210,000 (land $80,000; building $130,000). Revenue and expenses for the rental properties during the year were as follows: Property #1 Property #2 Revenue Expenses: Mortgage interest Repairs & maintenance Property tax Insurance Income $13,200 (0) (5,000) (3,100) (500) (8,600) $ 4,600 $4,500 (3,000) (0) (1,000) (200) (4,200) $ 300 Total $17,700 (3,000) (5,000) (4,100) (700) (12,800) $ 4,900
Determine the maximum CCA deduction for the rental properties for the current year. Income tax reference: Reg. 1100(11), 1101(1ac).
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Solutions to Key Concept Questions KC 7-1 [ITA: 12(1)(c), 12(3), (4), (11) - Interest income] In both cases $1,236 of interest will be earned and received on the maturity of the bond on October 31, Year 3. Nov 1, Year 1 to Oct 31, Year 2 Nov 1, Year 2 to Oct 31, Year 3 $10,000 x 6% = $10,600 x 6% = $ 600 636 $1,236
Timing of income recognition for tax purposes: Percel Ltd. Corporations must include interest income as it is earned on a daily basis [ITA 12(3)]. Year 1: Year 2: Year 3: Debra Individuals must include interest income on an annual accrual basis referred to as an anniversary day accrual [ITA 12(4)]. Interest earned to the anniversary day must be included. The first anniversary day in this case is October 31, Year 2 [ITA 12(11)]. The second anniversary day is October 31, Year 3, the maturity date in this case. Year 1: No interest income is included as there is no anniversary day Year 2: Interest earned Nov 1, Year 1 to Oct 31, Year 2 is included Year 3: Interest earned Nov 1, Year 2 to Oct 31, Year 3 is included $ 0 600 636 $1,236 Nov 1 to Dec 31 - $10,000 x 6% x 61/365 = Jan 1 to Oct 31 - $10,000 x 6% x 304/365 = Nov 1 to Dec 31 - $10,600 x 6% x 61/365 = Jan 1 to Oct 31 - $10,600 x 6% x 304/365 = $1236 $500 106 $ 100 606 530
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KC 7-2 [ITA: 12(1)(j), (k), 82(1) - Dividend income (Individual)] Anne will include $3,700 of dividend income in her property income for the current year. Eligible dividends from Canadian corporations grossed up ($1,000 x 145%) = $1,450 Other dividends from Canadian corporations grossed up ($1,000 x 125%) = 1,250 Dividends from foreign corporation 1,000 $3,700 KC 7-3 [ITA: 12(1)(j), 112(1) - Dividend income (Corporation)] A Ltd. will include $2,000 of dividend income in property income for the current year. The corporation includes the amount received [ITA 12(1)(j)]. In computing its taxable income the corporation will deduct the $2,000 of dividends received from taxable Canadian corporations [ITA 112(1)]. KC 7-4 [Reg. 1100(11), 1101(1ac) - Rental income] Two special rules apply to rental properties with respect to CCA: Each rental building costing $50,000 or more must be held in a separate CCA class. They cannot be pooled [Reg. 1101(1ac)]. CCA can be deducted only to the extent that it does not create or increase a net loss from all rental properties combined [Reg. 1100(11)]. Class 1 #1 $64,000 $(2,560) $ (2,600) $5,160 Class 1 #2 $ 0 130,000 Total
UCC, beginning of year Purchases Maximum CCA available: $64,000 x 4% $130,000 x 4% x
Since these are residential buildings the CCA rate is 4%. Although a maximum of $5,160 CCA is available, the maximum CCA that can be claimed is limited to $4,900, being the net rental income before CCA for the two properties, combined. The $4,900 of CCA can be claimed partly from property #1 and partly from property #2, in any proportion up to the maximum available for each class. Net rental income before CCA CCA Net rental income for tax purposes
$4,900 (4,900) $ 0 253
Problems PROBLEM ONE [ITA: 12(1)(c); 12(3), (4), (11)] On April 1, 20X0, a corporation with a December 31 taxation year purchased a three-year investment certificate for $20,000.The certificate pays interest only at the end of the threeyear term but is compounded annually at the rate of 10%. Currently, the corporations marginal tax rate is 33%. However, in 20X1, the marginal tax rate will increase to 36%. An individual makes the identical investment on April 1, 20X0.The individuals marginal tax rate in 20X0 is also 33% and is expected to rise to 36% in 20X1. Required: Calculate and compare the tax on the interest income for the three-year period for the individual and the corporation.
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Solution to P 7-1 The actual interest income earned on the investment certificate is: Year 1 Year 2 Year 3 10% x $20,000 10% x $22,000 10% x $24,200 $2,000 2,200 2,420 $6,620 The Individual: The individual can use the cash method or the receivable method, subject to the overriding anniversary day accrual rules. The receivable method would normally recognize the interest when it is due and payable at the end of the three year term. Similarly the cash method (if paid on time) would require a recognition at the end of three years. However, both the receivable and cash method are constrained by the anniversary day accrual method which requires that interest on an investment must be recognized at least every year from the date of issue [ITA 12(4), 12(1)(c), 12(11)]. The actual payment of interest occurs at the same time under each alternative however, the amount and timing of tax payments are different. Tax payments under the anniversary day accrual method: Income 20X0 20X1 20X2 20X3 0 2,000 2,200 2,420 TOTAL TAX Tax Rate 33% 36% 36% 36% Tax 0 720 792 871 $2,383
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The Corporation: The corporation must use the standard accrual method to recognize interest income [ITA 12(3)]. Tax payments under the accrual method: Income 20X0 20X1 275/365 x $2,000 = 90/365 x $2,000 = 275/365 x $2,200 = 90/365 x $2,200 = 275/365 x $2,420 = 90/365 x $2,420 = $1,507 $ 493 1,658 $2,151 $ 542 1,823 $2,365 $597 TOTAL TAX The timing and amounts of tax payments are compared below: Corporation 20X0 20X1 20X2 20X3 $ 497 774 851 215 $2,337 Individual $ 0 720 792 871 Tax Rate 33% Tax $ 497
36%
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36% 36%
851 215 $2,337
20X3
$2,383
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PROBLEM TWO [ITA: 5(1); 8(1)(m); 12(1)(c), (j), (k), (l); 12(4), (11); 13(1), (21); 20(1)(a), (c), (e), (e.1), (bb);74.1(2); 82(1)(a), (b); Reg 1101(1ac)] Ken Potman is the sole shareholder in Brickbase Enterprises Ltd., a Regina-based construction company. In addition, Potman is a 25% partner in a retail kitchenware store, although he does not actively participate in its management. The following information relates to Potmans financial affairs for the year 20X1: 1. Brickbase was organized three years ago. For its year ending May 31, 20X1, the company earned a profit of $88,000. Potman originally contributed $200,000 to the corporation, using $50,000 of his own savings and funding the balance with a bank loan. In return, the corporation issued Potman $1,000 worth of common shares and $199,000 of preferred shares. In 20X1, the company declared a dividend of $12,000 on the preferred shares. All of Brickbases income is subject to the small business deduction. During the year, Potman sold a warehouse property for $180,000 (land $15,000, building $165,000). The building was used by Brickbase to store construction equipment, and the company paid Potman a fair rental for use of the property. The property was originally purchased at a cost of $140,000 (land $10,000, building $130,000). At the end of 20X0 the building had an undepreciated capital cost of $110,000. Simultaneously with the sale, Potman purchased a larger warehouse property (constructed after March 18, 2007), which was also rented to Brickbase. The new property cost $400,000 (land $50,000, building $350,000). During the year, the company paid Potman net rents of $30,000 for both properties. The new property was financed with the proceeds from the sale of the old building as well as mortgage financing. 3. The retail store partnership earned $40,000 for its year ending December 31, 20X1. The profit consisted of a $32,000 profit from operations and $8,000 of interest income earned on excess undistributed cash deposits. Potmans other cash receipts and disbursements for 20X1 are shown in the table below. On July 1 of the previous year, Potman purchased a four-year guaranteed investment certificate for $30,000 that bears interest at 10%.The interest compounds annually but is not payable until the end of the four-year term. Potman did not include any amount of interest in his previous years income. During the year, one of the Canadian public corporations of which Potman is a shareholder issued him 100 additional shares as a stock dividend. The shares had a stated value of $40 per share. Potman placed the shares in his safety deposit box along with his other securities. 257
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Receipts: Salary from Brickbase Dividends from Canadian public corporations Dividends from foreign public corporations (net of 10% foreign withholding tax) Winnings from provincial lottery Interest on a loan to his daughter Disbursements: Contribution to Brickbase employee pension plan Investment counsel fees Legal fees for registering mortgage on new warehouse Life insurance premium on policy required as collateral for the bank loan used to purchase Brickbase shares Interest on warehouse building mortgage Interest paid on house mortgage (The house mortgage is $100,000, of which $70,000 was used to acquire the house. The balance was used to purchase public corporation shares.) Interest on bank loan (re: Brickbase shares) Donations to local charity Safety deposit box fees Required:
$62,000 6,000 9,000 2,000 1,000 3,000 1,000 5,000 1,000 21,000 10,000 15,000 4,000 100
Determine separately, for the year 20X1, Potmans income for tax purposes from employment, business, and property.
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Solution to P 7-2 Property income: Interest Share of interest earned by partnership (25% of $8,000) [ITA 12(1)(l)] Interest from daughter [ITA 12(1)(c), 74.1(2)] Investment certificate (note 1) Dividends [ITA 12(1)(j), (k), 82(1)] Stock dividend ($40 x 100 = $4,000 x 145%) Brickbase Enterprises ($12,000 x 125%) Canadian public corporations ($6,000 x 145%) Foreign dividends ($9,000 + tax of $1,000) Less: Interest on bank loan [ITA 20(1)(c)] Interest on house mortgage [ITA 20(1)(c)] $100,000 x $30,000/$100,000 Life insurance collateral on Brickbase shares fully deductible [ITA 20(1)(e.2)] Rental Rental Income Recapture on sale of warehouse ($130,000 - $110,000) Note 2 Deduct: Interest on mortgage CCA ($350,000 x .06 x 1/2) * Legal fees to register mortgage (cost of arranging financing 1/5 of $5,000) [ITA 20(1)(e)] Deduct Safety deposit box Investment counsel fees [ITA 20(1)(bb)] NET INCOME FROM PROPERTY $5,800 15,000 8,700 10,000 39,500 (15,000) (3,000) (1,000) 20,500
$ 2,000 1,000 3,000 6,000
$30,000 20,000 50,000 (21,000) (10,500) (1,000) 17,500 44,000 (100) (1,000) (1,100) $42,900
* Non-residential buildings built after March 18, 2007 qualify for an additional allowance of 2% increasing the CCA rate to 6%. To receive the additional allowance the taxpayer must elect to place the building in a separate Class 1.
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Note 1 Investment certificate - No interest is paid until the end of four years. The annual accrual method requires that interest be recognized on each one year anniversary date. In this case one year of interest must be recognized by June 30, 20X1 -10% of $30,000 = $3,000 [ITA 12(4)]. Note 2 Sale of Building and CCA - The warehouse building although used by Brickbase Enterprises to conduct its business is, nevertheless, a rental property to Potman who rents it to the corporation. The building falls into a separate CCA class [Reg. 1101(1ac)] and therefore results in a recapture on sale even though another building was acquired in the same year. Old building: UCC Sale ($165,000 - credit pool With original cost of $130,000) Recapture [ITA 13(1)] New building: Addition [ITA 13(21)] CCA 20X1 ($350,000 x .06 x ) UCC $350,000 (10,500) $339,500 $110,000 (130,000) $ (20,000)
In addition, the sale of the property will result in capital gains on the land and building to the extent the selling price exceeds the cost. These gains are not part of property income. The replacement property rules allow a taxpayer who incurs a capital gains and/or recapture on the disposition of a former business property to elect to defer the capital gain and/or recapture to the extent that the taxpayer reinvests the proceeds in a replacement property within 12 months of the end of the taxation year in which the disposal takes place [ITA 13(4); 44(1)]. The taxpayer can take advantage of these rules even if the property is held separate from the business as long as the person who owns the property is related to the entity which uses the property to carry on business. Former business property is defined in S.248(1) as a capital property used by the taxpayer or a related person for the purposes of earning income from a business. In this case, the credit to the UCC for the disposal of the old building would be reduced by the lesser of the recapture ($20,000) and the cost of the new building ($350,000). Thus, $110,000 - $110,000 = Nil recapture. The capital cost of the new building is reduced the by the $20,000 of deferred recapture. These rules are discussed in Chapters 6 and 8.
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Employment income: Salary [ITA 5(1)] Less: Contribution to pension plan [ITA 8(1)(m)] Net employment income Business income: Share of partnership profits [ITA 12(1)(l)] Total profits $40,000 Business income 32,000 Potman's share -- 25% of $32,000
$62,000 (3,000) $59,000
$8,000
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PROBLEM THREE [ITA: 13(1); 20(1)(a); 45(1); Reg. 1100(11); 1101(1ac)] Anne Osinski acquired a townhouse unit in 20X0 for $120,000 (land $10,000, building $110,000). She bought the unit in order to rent it. By the end of 20X2, the undepreciated capital cost of the building was $103,500. In August 20X3, Osinski decided to live in the unit herself. At that time, similar townhouses were selling for $136,000 (land $12,000, building $124,000). Prior to August, her 20X3 net rental income before capital cost allowance was $1,000. In September 20X3, Osinski purchased, for rental purposes, a residential condominium unit for $145,000 (land $15,000, building $130,000). Between September and the end of the taxation year, the condo earned net rentals of $900 before capital cost allowance. Required: Determine the change to Osinskis 20X3 net income for tax purposes as a result of the above activity.
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Solution to P 7-3 The change in use of the townhouse from investment to personal use results in a deemed disposition at fair market value [ITA 45(1)]. Her net income for tax purposes is: Rental income: Rents townhouse Rents condo Recapture of CCA on deemed disposition of the townhouse ($110,000 - $103,500) [ITA 13(1)] Rental income before CCA Less CCA on condo (Class 1) $130,000 x 4% x 1/2 Net rental income Capital gains: Building ($124,000 - $110,000) Land ($12,000 - $10,000) Net Income $7,000 1,000 $ 1,000 900 6,500 8,400 (2,600) 5,800
8,000 $13,800
Note: The new condo falls into a separate CCA class because its cost is greater than $50,000 [Reg. 1101(1ac)]. It does not qualify for the additional 2% CCA since it is a residential building. Also, note that the recapture is considered to be rental income and its inclusion increases the rental income to a level that permits the CCA to be claimed [Reg. 1100(11)].
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PROBLEM FOUR [ITA: 13(1); 20(1)(a); Reg. 1100(11); 1101(1ac)] After receiving an inheritance, Sandra Yaworski decided to invest her newly acquired funds in real estate. In 20X1, she purchased the following properties: Property 1 2 3 4 Land Building Total $10,000 $ 40,000 $ 50,000 12,000 45,000 57,000 20,000 80,000 100,000 30,000 100,000 130,000
Each of the properties is a residential condominium unit, and each unit is part of a separate condominium high-rise project. Not all of the units were fully rented during the year of acquisition, and Yaworski determined that her net rental position (before capital cost allowance) for each of the properties was as follows for 20X1: Property Rent revenue Expenses* Income (loss) 1 $4,000 (6,000) ($2,000) 2 $5,000 (3,000) $2,000 3 $7,000 (6,000) $1,000 4 $12,000 (9,000) $ 3,000 Total $28,000 (24,000) $ 4,000
* Property taxes, insurance, interest, maintenance. In 20X2, one of Yaworskis close relatives ran into financial difficulty, and she was forced to sell two of the properties in order to provide financial assistance. She sold property 1 for $52,000 (land $12,000, building $40,000) and property 3 for $110,000 (land $24,000, building $86,000). In 20X2, the four properties (including the two sold properties to the date of sale) earned net rental income of $7,000. Required: Determine Yaworskis net income from property from the rental properties for 20X1 and 20X2.
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Solution to P 7-4 For capital cost allowance purposes buildings 1 and 2 are pooled together because their cost is less than $50,000. Buildings #3 and #4 fall into separate pools [Reg. 1101(1ac)]. The maximum available capital cost allowance in 20X1 is as follows: Class 1 Building Pool 1 2 3 4 A $40,000 45,000 . $85,000 CCA available - 4% x TOTAL $1,700 $80,000 . $80,000 $ 1,600 $ 5,300 $100,000 $100,000 $2,000 B C
The 20X1 rental income for tax purposes is as follows: Net rentals before CCA from all four properties ($28,000 - $24,000) Less capital cost allowance Available -- $5,300 Maximum permitted [Reg. 1100(11)] Net rental income $4,000 (4,000) $ 0
Note that these buildings do not qualify for the additional 2% allowance for buildings acquired after March 18, 2007 since they are residential buildings. The limited capital cost allowance of $4,000 must be allocated among the pools, subject to the maximum available to each pool. The taxpayer must choose the allocation. Without the benefit of hindsight (i.e., knowing when and which properties may be sold) it is difficult to plan the best strategy. One possible option is to claim the maximum CCA from a pool which holds several assets (e.g., Pool A) because a sale of one property would not likely create a recapture whereas single asset pools always create recapture. Using this principle, CCA is applied first to Pool A, then to Pool B and finally to Pool C until the limit of $4,000 is reached.
265
This results in the following effect on the CCA pools in 20X1 and 20X2: A 20X1 Opening UCC 20X1 CCA UCC 20X2 Sales Recapture CCA 4% $85,000 (1,700) 83,300 (40,000) $43,300 (1,732) $41,568 20X2 net rental: Net rentals before CCA Recapture of capital cost allowance INCOME BEFORE CCA 20X2 CCA NET RENTAL INCOME $7,000 1,600 $8,600 (5,704) $2,896 $ 0 B $80,000 (1,600) 78,400 (80,000) (1,600) 1,600 C $100,000 (700) 99,300 99,300 (3,972) $ 95,328 $1,600 $(5,704) Total $(4,000)
The allocation of capital cost allowance to the three pools was not totally satisfactory. No recapture occurred in Pool A. However, Pool B which holds property #3 resulted in full recapture. Notice that Pool B claimed full CCA in 20X1 whereas Pool C was reduced to $700 (from the maximum available of $2,000). Much of the recapture could have been avoided if Pool C claimed full CCA in 20X1 and Pool B was reduced. Unfortunately, information was not available to make that decision. The decision-maker could have considered reducing both pools by a similar amount rather than forcing the limitation on only one pool. This would have spread the risk from not knowing which property might be sold first.
266
PROBLEM FIVE [ITA: 20(1)(c)] Toshiaki Minamiyama is a successful business executive. Over the years, he has allocated a portion of his large salary to the building of an investment portfolio. He currently has a net worth of $800,000 (exclusive of retirement plans), as follows: Personal assets: Automobiles Sailboat House Investment assets: Corporate and government bonds (average interest return10%) Common shares of public corporations Rental real estate Liabilities: First mortgage on house (interest at 9%) Term financing on sailboat (12%) First mortgage on rental real estate (10%) Net worth $ 30,000 29,000 220,000 200,000 306,000 360,000 1,145,000 (150,000) (15,000) (180,000) $ 800,000
Minamiyama seldom trades his investments, as his strategy is to hold various types of investments for a long time in order to delay any tax that may occur on their disposition. (He is in the 45% tax bracket.) In fact, he chose not to dispose of any investments when he needed money to purchase his house and sailboat. Required: From a tax planning perspective, what would you recommend he do in order to enhance his wealth accumulation? If possible, quantify how he would benefit from your recommendations, assuming a five-year time period.
267
Solution to P 7-5 Minamiyama has a substantial amount of investment income and is subject to high marginal tax rates. In addition, he has outstanding debt, from which a large portion of the interest is not deductible because the loans were made to acquire personal property and are not for the purpose of earning income. If, for example, the bond investment which earns taxable interest income is compared to the personal debt which incurs non-deductible interest the following analysis can be made: Investment in Bonds Less interest bearing debt House mortgage Sailboat debt Net equity The net equity results in the following annual cash flow: Interest income ($200,000 @ 10%) Less tax @ 45% Net cash inflow Interest expense (not deductible) House $150,000 @ 9% Boat $15,000 @ 12% NET CASH COST $(13,500) ( 1,800) $ 20,000 (9,000) 11,000 $200,000 $(150,000) ( 15,000) 165,000 $ 35,000
(15,300) $ (4,300)
Therefore equity of $35,000 actually results in an annual after-tax cash loss of $4,300. If $165,000 of bonds were liquidated (leaving bonds of 35,000) and used to pay off the personal debt, the annual after-tax cash flow would be a positive amount of $1,925 as follows: Interest income $35,000 @ 10% less tax @ 45% Interest expense NET CASH INFLOW $3,500 (1,575) 1,925 0 $1,925
268
Annual cash flow, after-tax, would increase by $6,225 (i.e., from a loss of $4,300 to a gain of $1,925 = $6,225). If this annual income is reinvested in corporate bonds yielding 10% (5.5% after-tax; 10% - 45% tax = 5.5%) the series of annual payments would compound to $36,653 after five years ($6,225 for 5y @ 5.5%). In addition, a further wealth enhancement could be achieved if, shortly after the house mortgage was paid off, a new mortgage of $165,000 was taken out at the same rate of 9% but used to purchase new bonds yielding 10%. Because the mortgage funds are now used to generate income, the interest would be deductible and a further annual cash gain of $908 could be achieved as follows: New bond interest income: 10% of $165,000 Less deductible interest expense 9% of $165,000 Less tax @ 45% NET CASH GAIN $16,500 (14,850) 1,650 (742) $ 908
After five years the $908 annual cash flow would accumulate to an additional $5,436, resulting in a total wealth enhancement of $42,089 ($36,653 + $5,436).
269
PROBLEM SIX [ITA: 13(1); 20(1)(a); Reg. 1101(1ac)] Quantro Enterprises Ltd. and Baizley Holdings Ltd. (BHL) are both 100% owned by Harold Baizley. Both companies are Canadian-controlled private corporations. Quantro operates a wholesale business and pays rent to BHL for the use of a warehouse property. BHL owns only one assetthe warehouse building and related land that is rented by Quantro for $36,000 per year. The property was originally owned by Quantro but was sold to BHL several years ago as a means to reduce the risk exposure of this appreciating asset. On December 31, 20X1 (the year end of both companies), BHL sold the warehouse property to a third party for $370,000 (land $40,000, building $330,000). The property originally cost $320,000 (land $25,000, building $295,000).The undepreciated capital cost of the building at December 31, 20X0, was $254,000. One month before selling the warehouse property, BHL purchased a newly constructed warehouse property for $480,000 (land $50,000, building $430,000). Required: Determine BHLs net income for tax purposes for 20X1.
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Solution to P 7-6 The warehouse is considered to be a rental property. Therefore, the new property acquired must be placed in a separate Class 1, since it cost more than $50,000 [ITA 1101(lac)]. Income: Rent Recapture of CCA ($295,000 - $254,000) Less CCA on new warehouse $430,000 x 6% x * Taxable capital gains: Building ($330,000 - $295,000) Land ($40,000 - $25,000) $36,000 41,000 77,000 (12,900) 64,100 $17,500 7,500 25,000 $89,100 * Non-residential buildings acquired after March 18, 2007 and placed in a separate class have a CCA rate of 6% (other than buildings that were used by any person or partnership prior to March 19, 2007). Former business property is defined in ITA 248(1) as a capital property used by the taxpayer or a related person for the purposes of earning income from a business. Since the warehouse owned by BHL is used by Quantro (a related person) in its wholesale business, it qualifies as a former business property. Thus, BHL can elect under ITA 44(1) and ITA 13(4) to defer recognition of the capital gain and recapture on the sale of the old warehouse.
271
PROBLEM SEVEN [ITA: 9(1); 12(1)(c), (j), (k), (l), ;18(1)(a), (b); 20(1)(a), (e), (n), (aa); Reg. 1100(11)] Sally Corbet is the sole shareholder of Corbet Holdings Ltd. (CHL), a Canadian-controlled private corporation. The corporation holds investments in shares, bonds, and real estate. You have been retained to complete CHLs tax return for the year ended December 31, 20X2, and provide certain other tax advice. It is now February 15, 20X3, and you have gathered the information outlined below. 1. The draft income statement for the year ended December 31, 20X2, is as follows: Income Interest on bonds and certificates Dividends from Canadian corporations Net loss from real estate rentals Gain on sale of land (Pelican Lake) Share of profits of Pantry Products Ltd. Expenses Legal fees for general corporate affairs Directors fees Donationscharitable Income before income tax 2. $ 1,000 21,000 8,000 $ 78,000 32,000 (19,000) 170,000 120,000 381,000
(30,000) $351,000
CHL owns a 40% interest in Delroy (a partnership), which has a June 30, 20X2, year end. The partnerships profit for the year was $200,000, which consisted of dividends from taxable Canadian corporations of $80,000 and royalties from mineral rights of $120,000. On December 31, 20X2, CHL received $100,000 as its share of a partnership cash distribution. The partnerships results are not reflected in the above income statement. On September 30, 20X2, CHL purchased a $100,000 guaranteed investment certificate bearing 9% interest. The company intends to record the interest of $9,000 on September 30, 20X3, its one-year anniversary date. The dividend income of $34,000 consists of the following: Public corporations Turner Inc.an American corporationnet of a 10% U.S. withholding tax $16,000 18,000
3.
4.
Not included in the above is a dividend received from Pantry Products Ltd. of $25,000. CHL owns 50% of its voting shares and records the investment using the equity method of accounting. Pantry earned business income of $240,000 in the current year.
272
5.
During the year, CHL received 100 shares of Mustang Ltd. (a public corporation) as a stock dividend. Mustang increased its paid-up capital by $30 for each stock dividend share issued. CHL did not record the receipt of the stock dividend. In January 20X2, CHL purchased three hectares of land at Pelican Lake for $130,000.The land was then rezoned and subdivided into six building lots. The entire subdivision was immediately sold to a building contractor for $300,000.The payment terms called for no cash down, but payments of $50,000 are required as the contractor completes construction on each lot. By December 31, 20X2, one payment of $50,000 had been received. In 20X1, CHL had purchased two rental properties as follows: Fourplex Townhouse 1 Land $50,000 20,000 $70,000 Building $150,000 40,000 $190,000 Total $200,000 60,000 $260,000
6.
7.
Maximum capital cost allowance was claimed in 20X1. In 20X2, townhouse 1 was sold for $75,000 (land $25,000, building $50,000). On December 1, 20X2, CHL purchased townhouse 2 for $50,000 (land $11,000, building $39,000). Also, in 20X2, CHL constructed a sixplex rental unit for $437,000, as follows: Land Permanent landscaping Labour and materials Air-conditioning and heating equipment $ 80,000 8,000 300,000 49,000 $437,000
All of the properties resulted in a net rental loss of $19,000 (as shown on the financial statement).The following items are included in the net loss calculation: Cost of surveying land (new sixplex) Amortization/depreciation Legal fees for mortgage (new sixplex) Advertising for new tenants Required: Determine CHLs net income for tax purposes for the 20X2 taxation year. Also, prepare a breakdown of the net income for tax purposes showing the net income from property and any other sources of income. Assume all rental properties are residential properties. $ 2,400 28,000 2,000 4,000
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Solution to P 7-7 Net income for tax purposes (20X2): Net income per financial statements [ITA 9(1)] Donations [ITA 18(1)(a)] Gain on sale of land (Pelican Lake) [ITA 18(1)(b)] Sale of subdivided land is business income: Gain (300,000 - 130,000) Reserve 250,000/300,000 x 170,000 [ITA 20(1)(n)] Share of profits of Pantry Products Ltd. - separate corporation Dividend from Pantry [ITA 12(1)(j)] Share of partnership profit [ITA 12(1)(l)] (200,000 x 40%) -property income Interest on GIC (9,000 x 3/12) [ITA 12(1)(c)] Additional dividend on US shares [ITA 12(1)(k)] - foreign tax withheld Stock dividend (100 @ $30) [ITA 248(1)] Rental loss (see note below) Taxable capital gain on Townhouse #1: land and building (75,000 60,000) Net income for tax purposes Note (rental properties): Rental loss reported Landscaping included in capital costs [ITA 20(1)(aa)] Cost of surveying land (add to land cost) [ITA 18(1)(b)] Amortization [ITA 18(1)(b)] Cost of financing mortgage (legal) [ITA 20(1)(e)] (1/5 deductible annually) 4/5 x 2,000 Income before CCA CCA limited to net rental income [Reg.1100(11)] Rental income CCA Schedule: Class 20X1 20X1 CCA 4% (2) Purchase Townhouse #2 Constructed sixplex Sale: townhouse #1 1 $150,000 (3,000) 147,000 1 $40,000 (800) 39,200 39,000 1 $351,000 8,000 (170,000) $170,000 (141,667) 28,333 (120,000) 25,000 80,000 2,250 2,000 3,000 19,000 7,500 $236,083 $(19,000) (8,000) 2,400 28,000 1,600 5,000 (5,000) $0
*349,000 . (40,000) . 147,000 38,200 *349,000 Maximum CCA (4%)* (5,880) (1,528) (6,980) * Cost includes labour and materials of $300,000 plus the cost of air conditioning and heating equipment. CCA is - $349,000 x 4% x 1/2 = $6,980. Residential properties are not eligible for the 6% CCA rate. Copyright 2009 McGraw-Hill Ryerson Ltd. 274
Solutions Manual Chapter Seven
Breakdown of net income for tax purposes: The net income for tax purposes includes property income, business income and taxable capital gains. General administrative expenses of $1,000 for legal and $21,000 for directors fees should be apportioned between the business income and the property income proportionately. The property income before the administrative expenses is as follows: Net income for tax purposes Add - administrative expenses ($1,000 + $21,000) Deduct: Business income - land sale Taxable capital gain Property income The breakdown of net income for tax purposes is: Business income: Land sale less administrative expense (22,000 x 28,333 /(28,333 + 222,250) $236,083 22,000 (28,333) (7,500) $222,250
$ 28,333 (2,488) 25,845
Property income: Above Less administrative expense: (22,000 x 222,250/ (28,333 + 222,250)
$222,250 (19,512) 202,738 7,500 $236,083
Taxable capital gain
275
PROBLEM EIGHT [ITA: 3; 5(1); 6(1)(b), (f); 8(1)(h.1), (j); 12(1)(c), (l), 12(4); 13(7)(g); 20(1)(a), (bb); 60(i); 82(1); Reg. 1100(2.5); 1100(11); 1101(1af); 7307] Carol Wong is the president and major shareholder of CW Ltd., a Canadian-controlled private corporation that operates a construction business in Regina, Saskatchewan. CW earns only business income which is all subject to the small business deduction. In 20X7, she had a number of financial transactions. She has asked you to help her prepare her 20X7 tax return and provide advice on other tax matters. The following additional financial information is provided: 1. Wongs 20X7 gross salary was $90,000, from which CW Ltd. deducted the following amounts: Income tax CPP and EI premiums Private health insurance premiums Group sickness and accident insurance premiums $30,000 2,851 600 400
In addition to her salary, CW Ltd. paid $2,000 to a deferred profit-sharing plan, $600 of private health insurance premiums, and $400 of group sickness and accident insurance premiums on Wongs behalf. 2. Wong is required to use her own automobile for company business. For this, CW Ltd. pays her an annual allowance of $3,600. In 20X7, Wong incurred automobile operating costs of $5,200. Also, in 20X7, she purchased a new automobile for $34,000 plus PST at 8% and GST, and received $18,000 as a trade on her old car. At the end of the previous year, the old car had an undepreciated capital cost allowance balance of $15,000 (class 10.1).Of the 20,000 kilometres driven in 20X7, 12,000 were for employment purposes. For three months in 20X7, Wong was sick and could not attend work. She received $9,000 from the companys group sickness and accident insurance plan. Since the plans inception, Wong had paid premiums totalling $2,000. During 20X7, Wong purchased a warehouse property and leased it to CW Ltd. to store construction equipment. The property cost $250,000 (land 30,000, building 220,000). The building was constructed after March 18, 2007. The price for the land includes $2,000 of permanent landscaping completed just after acquisition. The 20X7 rental income is summarized below.
3.
4.
276
Rent received Expenses: Insurance Property taxes Interest Repairs: General maintenance Storage shed addition Income 5.
$20,000 1,200 4,000 10,000 800 3,000 (19,000) $1,000
Wong is a 30% partner in a computer software business but is not active in its management. The partnership financial statement shows a profit of $40,000 for the year ended December 31, 20X7. The profit consists of $32,000 from software sales and $8,000 from interest earned. On July 1, 20X6, Wong purchased a three-year guaranteed investment certificate for $20,000 with interest at 10%.The interest compounds annually but is not payable until July 1, 20X9. Wong received (made) the following additional receipts (disbursements) in 20X7: Receipts: Dividends (Eligible) from Canadian public corporations Dividends (Non-eligible) from CW Ltd. Dividends from foreign corporations (net of 10% foreign tax) Winnings from a provincial lottery Disbursements: Contribution to RRSP (within allowable limits) Dental expenses for children Donation to a charity Safety deposit box Life insurance premium used as collateral for personal bank loan Investment counsel fees $2,000 3,000 900 12,000 10,000 3,500 2,000 100 800 1,000
6.
7.
Required: Determine Wongs minimum net income for tax purposes in accordance with the aggregating formula of section 3 of the Income Tax Act.
277
Solution to P 7-8 Net income for tax purposes: Employment income: Salary [ITA 5(1)] Group sickness benefit ($9,000 - $2,000) [ITA 6(1)(f)] Automobile allowance (unreasonably low) [ITA 6(1)(b)] Operating costs CCA Class 10.1 old car ($15,000 x 30% x 1/2) [ITA 8(1)(j), Reg 1100(2.5)] CCA Class 10.1 new car ($30,000 x 1.13 x 30% x ) [ITA 8(1)(j), 13(7)(g), Reg. 1101(1af)]] 12,000/20,000 km x $12,535 Business income: Partnership (30% x $32,000) [ITA 2(1)(l)] Property income: Partnership (30% x $8,000) [ITA 12(1)(l)] Rental property: Income reported Storage shed (to building CCA) Landscaping (from land cost) CCA class 1 - ($220,000 + $3,000) x 6% x = 6,690 - limit to rental income Interest GIC (10% x 20,000) [ITA 12(4)] Dividends: [ITA 12(1)(j), (k), 82(1)] Public (2,000 x 145%) CW Ltd. (3,000 x 125%) Foreign ($900 + $100) Property deductions: Safety deposit box (assumed used to hold investments) Investment counsel fees [ITA 20(1)(bb)] Other deductions: RRSP [ITA 60(i)] Net income for tax purposes $ 5,200 2,250 5,085 $12,535 (7,521) 93,079 9,600 2,400 $1,000 3,000 (2,000) 2,000 (2,000) 2,900 3,750 1,000 0 2,000 $ 90,000 7,000 3,600 100,600
7,650 12,050 (100) (1,000) 10,950 113,629 (10,000) $103,629
278
PROBLEM NINE [ITA: 9(1); 12(1)(d); 13(1); 20(1)(a), (l), (m); 39(1)(b); Reg. 1100(11), 1101(1ac)] CB Ltd. is a Canadian-controlled private corporation owning a portfolio of investments including stocks, bonds, and rental properties. The financial statements for the year ended June 30, 20X1, show a profit of $104,300, summarized as follows: Bond interest Taxable dividends from Canadian corporations Gain on sale of assets Rental loss Income before income taxes Additional financial information is outlined below. 1. The previous years corporation tax return includes the following tax account balances: Undepreciated capital cost: Class 1building A Class 1building B Class 1building C 2. $125,000 35,000 46,000 $ 50,000 20,000 40,000 (5,700) $104,300
Taxable Canadian dividends totalling $20,000 include $8,000 from public corporations and $12,000 from X Ltd., a Canadian-controlled private corporation. CB Ltd. Owns 30% of X Ltd.s common shares. The rental properties were purchased prior to March 18, 2007. The details are as follows: A B C Land cost $ 20,000 $35,000 $21,000 40,000 49,000 Building cost 130,000 $150,000 $75,000 $70,000
3.
On February 28, 20Xl, property A was sold for $170,000 (land 30,000, building 40,000) and property B was sold for $77,000 (land 40,000, building 37,000). The combined rentals resulted in a loss of $5,700 after deducting amortization/depreciation of $3,000 for the year ended June 30, 20X1.The rental revenue includes a $1,000 rental deposit applying to the last two months rent on a lease expiring December 31, 20X2. For the year ended June 30, 20X0, CB Ltd. deducted a reserve for unpaid rents of $2,000. In January 20X1, $1,000 of the unpaid rents was received and credited to the reserve account. No reserve has been claimed at June 30, 20X1; however, $1,200 of the current years rent remains unpaid. Required: Determine CBs minimum net income for tax purposes for the 20X1 taxation year.
279
Solution to P 7-9 Net income per financial statement (20X1) [ITA 9(1)] Gain on sale of assets [ITA 18(1)(b)] Taxable capital gains: [ITA 38] Property A - (170,000 150,000) land and building Property B - (40,000 - 35,000) land only Capital loss on depreciable property (building) is denied [ITA 39(1)(b)] Rental loss (included in financial statement income) Rental income (loss) (see note 1) Net income for tax purposes Note 1: First determine maximum CCA that is available. Then determine rental income before CCA to establish CCA limit. Rental Property A is in a separate Class 1 pool since the capital cost is $50,000 or more [Reg. 1100(11)]. UCC beginning of year Sale of property (credit to pool limited to capital cost) Recapture [ITA 13(1)] Rental Property B & C are pooled - Class 1 UCC beginning of year (35,000 + 46,000) Sale of property B Available CCA - 4% x 44,000 $125,000 (130,000) $ (5,000) $ 81,000 (37,000) $ 44,000 $ 1,760 $104,300 (40,000) 10,000 2,500 0 5,700 (1,100) $ 82,500
Maximum CCA cannot exceed rental income [Reg. 1100(11)] calculated as follows: Rental Income: Loss for the year $ (5,700) Recapture of CCA 5,000 Amortization [ITA 18(1)(b)] 3,000 20X0 bad debt reserve ($2,000 - $1,000) [ITA 12(1)(d)] 1,000 20X1 bad debt reserve [ITA 20(1)(l)] (1,200) Rental deposit [ITA 20(1)(m)] (1,000) Rental income before CCA 1,100 CCA - limit (1,100) Net rental income $ 0
280
CASE Helen Chapman [ITA: 13(1); 20(1)(a), (c), (e), (aa); 38; 39; 40(1); Reg. 1100(11)] Helen Chapman is 56 years old and intends to retire in four years. Most of her investment funds are tied up in her employers pension plan and in her personal registered retirement savings plan. In addition, she has managed to accumulate a personal investment fund of $100,000, which currently is invested in government treasury bills earning interest at 9%. Immediately before retirement, Chapman intends to use her personal investments and her pension plans to acquire a life annuity that will provide her with a guaranteed monthly income. She is looking for an investment for the $100,000 currently invested in treasury bills that will maximize the value of the annuity. Her investment counsellor has proposed two secure investment options, as follows: Option 1 is a corporate bond yielding annual interest of 13%.The counsellor has advised that Chapman could fund a purchase of $200,000 of the bonds with $100,000 of cash (from the treasury bills) and $100,000 of borrowed funds. Because her house is debt-free, her bank has offered to provide her with a term loan secured by a mortgage on the house. The loan interest rate would be 10%, and no principal payments would be required until the end of the term of the loan. Option 2 is a real estate investment. A small, single-tenant commercial building is currently under construction and will be completed in six weeks. A prospective tenant has already agreed to a 12-year lease. The lease calls for rent payments of $40,000 annually for four years, at which time the annual rent will increase by 12% and then remain fixed for the remaining eight years of the lease. The tenant will be responsible for all costs associated with the property, including property taxes and insurance.
281
Solution to Case - Helen Chapman In comparing the two investments, it is assumed that Helen can reinvest the after-tax annual returns in treasury bills similar to her current investment, and earn 9% annually (or 5% after tax; 9% - 45% tax = 5% rounded). Option 1 - Corporate Bond Annual cash flow: Interest income ($200,000 x 13%) Interest expense on loan ($100,000 x 10%) [ITA 20(1)(c)] Less tax @ 45% Value of investment after four years: Sale of bonds Less bond loan Net interest return for four years ($8,800) Reinvested and compounded at 5% Total available for annuity Option 2 - Real Estate Before determining the cumulative position of this option, a number of separate items must be examined: A. Resale Value of Property: The value of the property to the owner is based upon the net rentals which can be achieved. Assuming that the property will be sold to an investor after four years who will also hold the property to earn rental income, the value of the property should increase in proportion to the increase in net rentals. After four years the net rentals increase by 12%. Therefore, it is assumed that the property value will increase from $398,000 to $445,760 (land cost $40,000 + landscaping $8,000 = $48,000 x 1.12 = $53,760; building cost $350,000 x 1.12 = $392,000). $26,000 (10,000) $16,000 (7,200) $ 8,800 $200,000 (100,000) $100,000 37,929 $137,929
282
B.
Deductions for Tax Purposes: In addition to the annual interest expense the following amounts are deductible in particular years: Landscaping of $8,000 is fully deductible in year 1 [ITA 20(1)(aa)]. Legal fees of $2,000 to register the mortgage is a cost of borrowing money and can be deducted at 1/5 per year [ITA 20(1)(e)]. However, because the term is for four years the remaining balance is deductible in year 4. Year 1 Year 2 Year 3 Year 4 1/5 ($2,000) 1/5 ($2,000) 1/5 ($2,000) Balance $ 400 400 400 800 $2,000
Capital cost allowance is limited to the net rental income in any year as follows [ITA 20(1)(a), Reg. 1100(11)]: Year Rent income Interest expense Landscaping Legal cost 1 $40,000 (27,000) (8,000) (400) $ 4,600 2 $40,000 (27,000) (400) $12,600 3 $40,000 (27,000) (400) $12,600 4 $40,000 (27,000) (800) $12,200 $350,000 (4,600) 345,400 (12,600) 332,800 (12,600) $320,200
CCA Cost Year 1 Year 2 Year 3 Sold in year C. 6% (1/2) to maximum of $4,600 6% to maximum of $12,600 6% to maximum of $12,600 4
Gain on sale of property Recapture of CCA [ITA 13(1)] UCC Proceeds limited to cost Capital Gain [ITA 39, 40(1)] Proceeds Cost Taxable 1/2 of $55,760 [ITA 38] = Land $53,760 (40,000) $13,760 Building $392,000 (350,000) $ 42,000 Total $445,760 390,000 $ 55,760 $ 27,880 283 $320,200 (350,000) $ 29,800
D.
Taxable Incomes and taxes payable in cash year Net rents Recapture Taxable capital gains CCA Taxable Income Tax @ 45% 1 $4,600 (4,600) $ 0 $ 0 2 $12,600 (12,600) $ 0 $ 0 3 $12,600 (12,600) $ 0 $ 0 4 $12,200 29,800 27,880 -$69,880 $31,446
E.
Cash flows excluding sale of property Year 1 2 3 4 Net rents ($40,000 - $27,000) Net rents Net rents Net rents $13,000 13,000 13,000 13,000 $52,000
F.
Value after four years Sale of property Less mortgage Net annual rents of $13,000 reinvested at 5% after-tax Less tax in year four Total available for annuity $445,760 (300,000) $145,760 56,031 $201,791 (31,446) $170,345
The real estate investment provides a total of $170,435 after four years compared to $137,929 from the bond investment. Students may also include points in the discussion such as: the inclusion of a real estate commission on the sale. a different assumption about the value of real estate after four years. the fact that real estate may not be easy to liquidate when desired.
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Buckwold and Kitunen, Canadian Income Taxation, 2009-2010 Ed.

CHAPTER 7 INCOME FROM PROPERTY

Copyright 2009 McGraw-Hill Ryerson Ltd. Solutions Manual Chapter Seven

Buckwold and Kitunen, Canadian Income Taxation, 2009-2010 Ed.

Copyright 2009 McGraw-Hill Ryerson Ltd. Solutions Manual Chapter Seven

Buckwold and Kitunen, Canadian Income Taxation, 2009-2010 Ed.

Copyright 2009 McGraw-Hill Ryerson Ltd. Solutions Manual Chapter Seven

Buckwold and Kitunen, Canadian Income Taxation, 2009-2010 Ed.

Buckwold and Kitunen, Canadian Income Taxation, 2009-2010 Ed.

Buckwold and Kitunen, Canadian Income Taxation, 2009-2010 Ed.

Copyright 2009 McGraw-Hill Ryerson Ltd. Solutions Manual Chapter Seven

Buckwold and Kitunen, Canadian Income Taxation, 2009-2010 Ed.

Copyright 2009 McGraw-Hill Ryerson Ltd. Solutions Manual Chapter Seven

Buckwold and Kitunen, Canadian Income Taxation, 2009-2010 Ed.

Copyright 2009 McGraw-Hill Ryerson Ltd. Solutions Manual Chapter Seven

Buckwold and Kitunen, Canadian Income Taxation, 2009-2010 Ed.

Copyright 2009 McGraw-Hill Ryerson Ltd. Solutions Manual Chapter Seven

Buckwold and Kitunen, Canadian Income Taxation, 2009-2010 Ed.

UCC, beginning of year Purchases Maximum CCA available: $64,000 x 4% $130,000 x 4% x

$4,900 (4,900) $ 0 253

Buckwold and Kitunen, Canadian Income Taxation, 2009-2010 Ed.

Copyright 2009 McGraw-Hill Ryerson Ltd. Solutions Manual Chapter Seven

Buckwold and Kitunen, Canadian Income Taxation, 2009-2010 Ed.

Copyright 2009 McGraw-Hill Ryerson Ltd. Solutions Manual Chapter Seven

Buckwold and Kitunen, Canadian Income Taxation, 2009-2010 Ed.

851 215 $2,337

Copyright 2009 McGraw-Hill Ryerson Ltd. Solutions Manual Chapter Seven

Buckwold and Kitunen, Canadian Income Taxation, 2009-2010 Ed.

Copyright 2009 McGraw-Hill Ryerson Ltd. Solutions Manual Chapter Seven

Buckwold and Kitunen, Canadian Income Taxation, 2009-2010 Ed.

Copyright 2009 McGraw-Hill Ryerson Ltd. Solutions Manual Chapter Seven

Buckwold and Kitunen, Canadian Income Taxation, 2009-2010 Ed.

$ 2,000 1,000 3,000 6,000

Copyright 2009 McGraw-Hill Ryerson Ltd. Solutions Manual Chapter Seven

Buckwold and Kitunen, Canadian Income Taxation, 2009-2010 Ed.

Buckwold and Kitunen, Canadian Income Taxation, 2009-2010 Ed.

$62,000 (3,000) $59,000

Copyright 2009 McGraw-Hill Ryerson Ltd. Solutions Manual Chapter Seven

Buckwold and Kitunen, Canadian Income Taxation, 2009-2010 Ed.

Copyright 2009 McGraw-Hill Ryerson Ltd. Solutions Manual Chapter Seven

Buckwold and Kitunen, Canadian Income Taxation, 2009-2010 Ed.

Copyright 2009 McGraw-Hill Ryerson Ltd. Solutions Manual Chapter Seven

Buckwold and Kitunen, Canadian Income Taxation, 2009-2010 Ed.

Copyright 2009 McGraw-Hill Ryerson Ltd. Solutions Manual Chapter Seven

Buckwold and Kitunen, Canadian Income Taxation, 2009-2010 Ed.

Copyright 2009 McGraw-Hill Ryerson Ltd. Solutions Manual Chapter Seven

Buckwold and Kitunen, Canadian Income Taxation, 2009-2010 Ed.

Copyright 2009 McGraw-Hill Ryerson Ltd. Solutions Manual Chapter Seven

Buckwold and Kitunen, Canadian Income Taxation, 2009-2010 Ed.

Copyright 2009 McGraw-Hill Ryerson Ltd. Solutions Manual Chapter Seven

Buckwold and Kitunen, Canadian Income Taxation, 2009-2010 Ed.

Copyright 2009 McGraw-Hill Ryerson Ltd. Solutions Manual Chapter Seven

Buckwold and Kitunen, Canadian Income Taxation, 2009-2010 Ed.

Copyright 2009 McGraw-Hill Ryerson Ltd. Solutions Manual Chapter Seven

Buckwold and Kitunen, Canadian Income Taxation, 2009-2010 Ed.

Copyright 2009 McGraw-Hill Ryerson Ltd. Solutions Manual Chapter Seven

Buckwold and Kitunen, Canadian Income Taxation, 2009-2010 Ed.

Copyright 2009 McGraw-Hill Ryerson Ltd. Solutions Manual Chapter Seven

Buckwold and Kitunen, Canadian Income Taxation, 2009-2010 Ed.

Buckwold and Kitunen, Canadian Income Taxation, 2009-2010 Ed.

Copyright 2009 McGraw-Hill Ryerson Ltd. Solutions Manual Chapter Seven

Buckwold and Kitunen, Canadian Income Taxation, 2009-2010 Ed.

Buckwold and Kitunen, Canadian Income Taxation, 2009-2010 Ed.