What’s Your Tax Issue? 69 Problems

The Tax Issue:

As we speak, I’m studying for my corporate tax midterm and my teacher has told me something that doesn’t make much sense.

According to section 69, if a transaction with a non arms length person occurs at below fair market value (FMV), the adjusted cost base (ACB) to the purchaser will be the actual amount paid.

OK, fine.

Then, under subparagraph 13 (7)(e)(iii), the undepreciated capital cost (UCC) to the purchaser will be the FMV and the cost base will be the same ACB of the vendor, the difference between the two being deemed capital cost allowance (CCA)…

Say what?

Here’s an example of a building:

Capital cost to vendor: $325
FMV: $200
Actual sale price: $180.

Under section 69, the ACB of the purchaser will be $180; OK fine.

Now, under section 13 (7)(e)(iii), the UCC will be $200 with a capital cost of $325, the $125 being deemed CCA…

Don’t these provisions contradict themselves?

The Answer:

Since you are studying for your midterm, I’ll try to answer quickly.

Section 69 has been discussed in a previous post. It makes only a one-way adjustment to the proceeds to the seller in a non-arm’s length sale below FMV. It remains silent on the consequences to the purchaser. In a normal case of non-depreciable property, therefore, the cost to the purchaser remains the price paid as you have stated.

However, special rules for the purchaser kick in when he has purchased depreciable property. Subparagraph 13(7)(e)(iii) is there to ensure that a non-arm’s length purchaser does not turn a future recapture of depreciation (fully taxable) into a capital gain (half taxable).

First of all, if you read the preamble in paragraph 13(7)(e) it applies “notwithstanding any other provision of the Act”, so it overrides section 69.

Next, it doesn’t change the cost of the property to the purchaser, it simply designates it as UCC, and tacks the seller’s original capital cost on top so that a future sale triggers a recapture of depreciation to the extent that the original vendor would have a recapture, thus preserving the original tax treatment of capital cost.

In your example, the UCC will be the actual cost to the purchaser, being $180. This is true under both section 69 or under 13(7(e)(iii). The effect of 13(7)(e)(iii) is to deem the capital cost to be $325, so if the property is eventually sold for, say $400, there will be a recapture of $145 (325-180), which is fully taxable and a capital gain of only $75 (400-325), which is 50% taxable.

Good luck on your mid-term!!

What’s Your Tax Issue? Related Party Sale of Home

The Tax Issue:

Hi David,

My girlfriend (soon to be fiance) and I are seriously considering purchasing her parents home since they will be moving in six months time.  Her father has offered to sell the house to us at a price that is $40,000 below the fair market value.  It is my understanding that as long as I purchase the house from him before we are married (therefore not related for tax purposes), then there will be no tax consequences for him or myself on the transaction.  However, I’m also of the understanding that if I purchased the house from him after we were married than there would also be no tax consequences for him or myself since he would have use of his principal residence exemption which would eliminate any tax on the deemed capital gain resulting from selling the house to me at less than FMV.  Is this correct?  Also, does the fact that my girlfriend will be contributing up to half of the down payment for the house impact the transaction in any way?
I really enjoy your website, keep up the great work! Cheers!

The Answer:

You are correct when you say that the consequences to your future father-in-law are the same no matter when you make the deal. No matter what his proceeds or “deemed” proceeds are, any gain on the sale of his house will be exempt from tax (see my previous post on the principal residence exemption).

So what was your friend alluding to? Section 69 of the Income Tax Act. Let’s say the property you were purchasing was not an exempt principal residence. Section 69 contains special provisions dealing with transactions between persons who are not dealing at arm’s length. The rules are somewhat punitive in nature because they make one-sided adjustments to the price.

If the price is less than fair market value, as in your case, then the deemed proceeds to the vendor are adjusted upwards to equal that value. However, the cost to the purchaser is not adjusted and remains whatever was paid. If the price is more than fair value, the proceeds are not adjusted downward, but the purchaser’s cost is reduced for tax purposes.

So, would these rules apply to you if the sale was made before you were married? Probably, yes. The rules apply to non-arm’s length transactions. People who are related are, by definition, not at arm’s length, so if you made the purchase after getting hitched, there would be an automatic non-arm’s length situation. However, there is also a rule that states that any two people may be deemed to be not dealing at arm’s length if the facts warrant it. In your case, the facts would seem to warrant it.

Finally, the fact that your future bride is putting in part of the money won’t make any difference, because there is only one principal residence allowed between spouses, so it really doesn’t matter who makes the claim in the end, when you finally pass the property on to your kids at a generous discount, right?

Congratulations!