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Replacement Property Rules

17/07/2012


Disposing of a business asset for proceeds in excess of its cost base will have a tax consequence, whether it is recapture of depreciation, or capital gains. Replacement property rules, however, may assist you with deferring capital gains and recapture in certain circumstances.

Qualifying Former Property

Whether or not property qualifies for the replacement property rules depends on both the nature of the property disposed of and how the disposition occurred.

Voluntary disposition – assets disposed of voluntarily (by sale, for example) do not qualify for replacement property unless they are real property (land and fixtures) and the property is not a “rental property”. Real property that is a “rental property” will not qualify under the replacement property rules unless the property has been rented a related party (as defined in the Act), and the related property did not use the property for the purpose of earning rental income. Involuntary disposition – compensation for assets disposed of non-voluntarily (theft, fire, or expropriation for example) qualify for the replacement property rules. These assets include all forms of real property, including rental property, and it may also include depreciable properties such as equipment.

Qualifying Period

When a taxpayer disposes of a qualifying property described above, either voluntarily or involuntarily, the replacement asset must be acquired within a specified time period to be eligible for the tax deferral. For voluntary dispositions, the asset must be replaced before the later of:

a) 12 months after the end of the taxation period in which the property was disposed of, and
b) before the end of taxation year following the taxation period in which the property was disposed of.

For involuntary dispositions, the qualifying period is the later of:

a) 24 months after the end of the taxation period in which the property was disposed of, and
b) the end of the second taxation year following the taxation period in which the property was disposed of.

Qualifying Replacement Property

The property acquired as a replacement must meet the following criteria to qualify for the tax deferral:

1. The replacement property acquired must have been acquired to replace the former business property
2. The replacement property must be used for the “same or similar” or similar use as the former property.
3. Where the former property was used for the purpose of earning income, the replacement property must also be used for producing income from that business or a similar business.

Illustration:

Let’s say for example that a Farmer has their land and barn expropriated by the local municipality. The expropriation is an involuntary disposition. The farmer replaces the property within two fiscal periods following the period in which the property is expropriated.

 

Land Building Proceeds of disposition A $225,000 $90,000

Capital cost

B $125,000 $80,000 Depreciated capital cost C N/A $40,000        

Capital gain otherwise recognized (A-B)

  $100,000 $10,000 Recapture otherwise recognized (A-C)     $40,000         Replacement property deferral               Proceeds of disposition   $225,000 $90,000 Cost of replacement properties    $250,000 $100,000 Proceeds not reinvested:   N/A N/A         Gain / recapture deferred   $100,000 $50,000        

Effect on cost base of replacement properties

      Replacement cost   $250,000 $100,000

Less deferred gain

  - $100,000 -$10,000         Capital Cost   $150,000 $90,000

Less deferred recapture

  N/A - $40,000

Depreciated Capital Cost

  N/A $50,000        

 

In the case above, no immediate tax will be incurred from the disposition if taxpayer makes the replacement property election. When the replacement properties are eventually disposed, the capital gains and recapture that was deferred will be recognized and may be subject to taxation.

The replacement property rules may help the taxpayer to preserve the capital needed for reinvestment in a business in a situation where the assets sold have been replaced. The analysis, and calculations require a significant amount of professional understanding. It is strongly recommended that an MNP tax specialist be involved in the planning stages of the disposition to ensure all requirements for the replacement property election are met.