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Replacement Property In A Business - Defer Tax On Gains
A business, whether incorporated or operating as a proprietorship or partnership, can elect to defer recognizing gains and the resulting tax on certain dispositions of properties. Gains that can be deferred can be capital gains, recapture on depreciable property, and recapture on eligible capital property. Properties can be disposed of either involuntarily (such as government expropriation, compensation on stolen property, or compensation on destroyed property) or voluntary dispositions.
Capital Gains
For involuntary dispositions, the election on deferral of capital gains can apply to any capital property except shares. For voluntary dispositions, the property disposed of must be "former business property" defined as real property (not including rental property) that is capital property and used primarily to earn business income.
In order to qualify for the election, a replacement property must be acquired before the end of the second taxation year following the year in which proceeds of disposition became receivable (in the case of involuntary dispositions) and before the end of the taxation year following the year in which proceeds of disposition became receivable (in the case of voluntary dispositions of former business property).
A replacement property must meet all of the following criteria:
The result of the above is that for involuntary dispositions, a taxpayer has two years after disposition proceeds are receivable to acquire and use the replacement property in order qualify for an election to defer gains. In the case of voluntary dispositions of business real property, the time period is reduced to one year.
Where an election is made, the business realizes a capital gain only to the extent that the cost of the replacement property is less than the proceeds of disposition of the former property. The cost of the replacement property is reduced by the difference between the capital gain that would have been realized had no election been made and any capital gain that was in fact realized. This mechanism transfers the capital gain potential (on subsequent dispositions ) to the replacement property.
Recapture On Depreciable Property
For involuntary dispositions, the election on the deferral of recapture can apply to any depreciable capital property. For voluntary dispositions, the property disposed of must be "former business depreciable property" that is real property which was used primarily to earn business income (essentially a building permanently attached to land).
In order to qualify for the election, a replacement property must be acquired before the end of the second taxation year following the year in which proceeds of disposition became receivable (in the case of involuntary dispositions) and before the end of the taxation year following the year in which proceeds of disposition became receivable (in the case of voluntary dispositions of former business property that is a building).
A replacement property must meet all of the following criteria:
The result of the above is that for involuntary dispositions, a taxpayer has two years after disposition proceeds are receivable to acquire and use the replacement property in order qualify for an election to defer recapture. In the case of voluntary dispositions of business property that is a building, the time period is reduced to one year.
Where an election is made, the business defers recapture to the extent proceeds of disposition of the former property giving rise to recapture are reinvested in replacement property. Where the cost of the replacement property is less than the amount of recapture, then only the amount equal to the cost of the replacement property is subject to deferral. The balance of the recapture is included in business income. This mechanism transfers the recapture potential (on subsequent dispositions ) to the replacement property.
Recapture On Eligible Capital Property
Eligible Capital Property can only have voluntary dispositions. Where a business disposes of Eligible Capital Property, it may defer the amount required to be deducted from the cumulative eligible capital property class by purchasing a replacement property before the end of the following taxation year. If the actual proceeds of disposition are equal to or less than the cost of the replacement property, the entire proceeds may be deferred. If the proceeds of disposition are greater than the cost of replacement property, the excess is recognized and the appropriate reduction to the class is made. If the reduction results in a negative balance, the amount is included in business income as recapture. This mechanism transfers the recapture potential (on subsequent dispositions) to the replacement property.
A replacement property must meet all of the following criteria:
The result of the above is that a taxpayer has one year after disposition proceeds are receivable to acquire and use the replacement property in order qualify for an election to defer possible recapture.
These issues are complex. Careful planning with a Chartered Accountant is warranted. Contact Keith Anderson CA at (780) 447-5830 if you need advice.
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