TAX COMPLIANCE SERVICES LTD.

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THE TAXPERTS GROUP

Canadian Personal & Self-employed returns

HST & Canadian Corporate Returns
U.S. Personal Returns
Voluntary Disclosure Program & CRA Audits & Appeals
email: taxperts@pathcom.com

2200 Yonge St., Suite 221, Toronto, Ont. M4S 2C6

Tel.: (416) 493-0444, Fax: (416) 493-5929
www.taxperts.on.ca

BULLETIN: CANADA REVENUE AGENCY AUDIT ATTACKS & REAL ESTATE

Housing prices in the GTA have risen steadily since 1997 and, starting in
2013, the Canada Revenue Agency Audit Divisions are being opportunistic and have adopted abusive audit practices to tax the gains on the
resale of properties - - a clear-cut tax grab. These practices are aimed
at taxing gains on the resale of personal homes including new homes,
condos and on the resale of residential rental properties. These attacks
start with CRA officers - - who do NOT identify themselves as being with
the Audit Division - - sending taxpayers a seemingly innocuous questionnaire on recent sales of residential properties. The target of the CRA is to
gather data which is prejudicial to taxpayers and to allow the CRA to
reassess for extra taxes payable including:
1 Taxing the assignment of real estate offers before a close;
2 Demanding refunds of the New Home Buyers Rebate;
3 Denying Principal Residence Exemption treatment on sales
of personal-use-properties;
4 Taxing the full gain on sales of rental properties by denying
capital disposition treatment which exempts half of any gain from
taxation;
5 Reopening tax returns beyond the 3-year limitation period for
reassessing returns and reassessing for taxes payable in these
statute-barred tax years.
6 Militant and unreasonable audits of real estate agents.

TAX WARNING

We must first discuss the most common mistake made in real

estate investment. Do NOT incorporate to buy rental properties. You
do not need the protection of limited liability provided by a corporation
and you will pay massively higher taxes than owning in your personal
name. Net rental income and capital gains in corporations are treated as
passive income and taxed at a punitive corporate rate of about 46%.
There is then a further 15% plus tax in personal tax returns on dividends
paid to shareholders with after-tax dollars. A tax disaster!!
Buy rental properties in your personal name and jointly with your
spouse, if applicable, to split net rental income and any capital gains.
Those in the 43.1% or 46.4% tax brackets should claim brick depreciation
to reduce their annual net rental income to NIL which DEFERS TAXES
until the sale PLUS it allows you to pay the taxes on recaptured depreciation with dollars devalued by inflation. If you pay with dollars valued at only
80% of current dollar values, you are saving 20% on taxes in real dollar
terms .With personal ownership, you protect your equity in rental properties by getting sufficient wrongful death and slip-and-fall insurance. With
sufficient insurance protection, the insurance company will be responsible
for the huge legal fees and damages awarded in a lawsuit. The insurance
coverage completely protects your equity. Any accountant or lawyer
recommending corporate ownership of rental properties is incompetent.

BACKGROUND

The new militancy on the part of the Audit Divisions of the CRA has its
origin in Harper and Flaherty making the huge mistake of reducing the
GST rate from 7% to 5%. This has lead to the Tory government running
up huge annual deficits with tax revenues down by about $12 billion a
year. As a result of this critical error, there is little room left for any significant personal or corporate tax breaks and federal spending is being cut by
billions of dollars. The most offensive consequence of this chain of events
was to convert the Audit Divisions to profit-makers by implementing
abusive and unfair audit practices.
To understand tax planning and decision-making in business, you must
always keep your eye on the combined Federal/Ontario tax brackets. Joint
ownership of rental properties affords the flexibility of splitting net rents
and capital gains over to a co-owner in a lower tax bracket. Conversely,
the tax brackets determine the amount of extra taxes payable if sales of
real estate are taxed higher or a substantial amount of business expenses
are disallowed when auditing real estate agents.

TAXABLE INCOME INCREASES BY THE AMOUNT OF INCOME ADDED OR

THE AMOUNT OF EXPENSES DISALLOWED ON AN AUDIT.

COMBINED 2013 FEDERAL/ONTARIO TAX BRACKETS

46.4% FEDERAL/ONT. RATE ON TAXABLE INCOME

OVER $135,054;
43.1% FEDERAL/ONT. RATE ON TAXABLE INCOME
FROM $87,123 TO $135,054
33.3% FEDERAL/ONT. RATE ON TAXABLE INCOME
FROM $ 43,561 TO $87.123
20.05% FEDERAL/ONT. RATE ON TAXABLE INCOME
FROM $ 0 to $43,561

TAX TREATMENTS ON THE SALE OF REAL ESTATE

When residential properties are sold, there are only FOUR tax
treatments possible. While you can never claim a loss on the sale of a
personal-use-property - - home, cottage, boats etc. - - you can use the
Principal Residence Exemption (PRE) to exempt most or all of a gain
from taxation. The exemption is a year-by-year designation but there is a
1-year bonus year allowed in using the PRE. If you both live in a home for
years and rent out the property for years during the ownership period then
the property is treated as a mixed-usage property. You can designate it
for each full or part year of personal usage. So, if you live in a home for 7
full- or part-years and rent it for 5 full years, the exempt portion would be:

7 + 1 over 12 or 8/12ths of the calculated gain on sale.

In this example, with a calculated gain of $300,000, you would exempt

two-thirds of the gain or $200,000. Of the remaining $100,000, you would
have a $50,000 taxable capital gain which is split in the case of joint ownership. The T2091 Designation of Principal Residence form needs to be
completed to calculate the taxable gain on a mixed-usage property.
When you use a home primarily for personal purposes - - at least 51%
of the home - - then any gain is entirely exempt. If you rent a basement
apartment making up 34% of your home and claim a 10% home/office
expense in a self-employed business statement, then 44% of the home is
used for business but the gain is still fully exempt. The 44% business usage
is defined as incidental business usage to the primary purpose of
personal usage and the full gain is exempt under the PRE.
If your use your home primarily - - at least 51% - - for personal
purposes you are only required to attach a note to your tax return claiming
PRE status giving the property address and indicating for which years you
are designating the property for PRE purposes. ALWAYS SAVE the PRE for
your personal use property with the greatest increase in value.
The third tax treatment is to process the sale as a Capital Disposition.
This usually involves the sale of a rental property or of a second personal
home on which you are NOT claiming PRE status and, in this situation, you
will pay taxes on only half of the capital gain.
The fourth situation is where you pay full tax on a gain since the gain
is treated as regular income. The most common examples are where you
sell an offer before the closing date and where you buy a property and flip
it for a fast profit. Gains will be fully taxed if you have an expertise in real
estate, sell a rental property shortly after acquisition and have a high
number of purchases and sales.

CRA AUDITS ON REAL ESTATE

1 ASSIGNMENT OF OFFERS. The CRA knows that new homes or

condos have seen a huge increase in market value between having an

offer accepted and obtaining ownership for from a 3 - 5 year period or
longer after the original offer is finalized. CRA is catching purchasers who
sell their offer before the official close for an amount including their deposit
plus an extra amount to reflect the substantial increase in market value
Gains on these transactions are fully taxable.
To catch these transaction, the CRA requires developers to keep a
registry of all persons who sign an Agreement of Purchase and Sale for a
new condo or home and to note the amount of the deposit and of the
purchase price. The CRA will use the Teranet service to check the deed

against the developers registry of those making the original offer. If the
names are different there will be an audit and severe consequences.
Taxpayers usually treat the gain as a capital disposition and others might
not declare the gain at all.
If you do not declare the gain or treated it as a capital disposition, you
should consider retaining a lawyer and doing a Voluntary Disclosure
Application. The application must be: (a) voluntary meaning the CRA
has not commenced action; (b) provide full disclosure; (c) it must involve
the potential of a CRA penalty; and (d) the information must be at least 1
year overdue. Our firms experience is that the CRA is happy to get the
taxes plus interest and penalties are invariably waived. Those caught not
declaring the gain face 50% penalties under s. 163 (2) of the Income Tax
Act (ITA) and ALSO face prosecution in the criminal courts under s.239 (1)
of the ITA with further penalties of from 50% to 200% of taxes payable and
up to 2 years in jail. One or more of these taxpayers will be prosecuted to
send a message of deterrence to the public.
2 NEW HOME BUYERS REBATE. This HST rebate is available to
anyone who buys for personal usage a new or substantially renovated
home. Under the Excise Tax Act which governs HST, the maximum HST
rebate is $32,100 on the first $58,500 of HST on a home bought for up to
$450,000. The Courts have identified personal homes as those with a
period of personal occupancy and also a home where there is a
bona fide period of personal usage. The period of occupancy required
is unclear so the CRA is attacking purchasers who sell quickly. The CRA
deems the purchaser to have had a primary motive of profit and will
demand repayment of the HST rebate and will tax the full gain by arguing
that the taxpayer did not have the primary intent of personal usage. An
ambush!!
Some investors are ticking off personal when buying an investment
property then renting out the property. They too are being forced to refund
the New Home Buyers Rebate and when they do, the CRA does not
inform them that there is an almost equivalent Tenant Home Buyer
Rebate if you can prove 12 months of tenant occupancy. Contact your
investors. If investors were forced to refund the original rebate, advise
them to reapply for the tenant rebate. They must do so within 2 years of
purchase.
3 PRINCIPAL RESIDENCE EXEMPTION. The CRA is using
Teranet to identify fast sales of personal homes and rental properties. The
questionnaire which they send to taxpayers requires that ALL homes
bought and/or sold in the last 5 years be listed. For personal homes, the
CRA will demand proof of occupancy including all bills paid while living in
the home and such things as proof of changing ones driving license to
that address. This started 6 months ago and the CRA seems to be
focusing, so far, on condos but they will likely broaden their search.
Where there is a resale within a year, the trend is for CRA auditors to
insist on repayment of the HST rebate , deny PRE status and tax the full
gain and intimidate the vendors by threatening to levy a 50% penalty
under s. 163 (2) of the ITA which is overkill since this requires that a
taxpayer knowingly filed a false return. The CRA is deeming the
taxpayer to have had the primary intention of, so to speak, cashing in
their profit and will tax the full gain as an Adventure in the Nature of
Trade which concept has normally been invoked when a purchaser flips
a property . Our firm is having success in defending these attacks by citing
the provision that these consequences will not apply where the sale was
the result of a material change in personal circumstances which can
include serious health problems, a change in financial circumstances or
the end of an engagement or marriage between signing the offer, taking
possession and selling the home.

4 TAXING THE FULL GAINS AS REGULAR INCOME.

The 3 main factors which will lead the CRA to deny capital disposition
treatment is where there is an expertise in real estate, secondly, the
property was sold quickly and, lastly, where there is a high number and
frequency of transactions. If you assign an offer or flip a property, the
gain will be fully taxed. If you are a real estate agent or sophisticated
investor and you sell a rental rent property less than 18 months after
acquisition, the CRA will reassess and tax the full gain as regular income.
If agents or investors rent their investment property for at least 18
months and preferably 2 years or more, our firm is successfully arguing
that the sale should be treated as a capital disposition with half the gain
exempt on the basis that agents and investors should be allowed capital
disposition treatment as does the average taxpayer. CRA auditors are
routinely demanding that the HST be repaid, taxing the full gain and
levying 50% penalties with the expectation that most taxpayers will not
appeal or get incompetent representation.

5 DISREGARDING THE 3-YEAR LIMITATION ON REASSESSING TAX RETURNS. The limitation on reassessing tax

returns more than 3 years after the date of the original assessment is a
safeguard provided to taxpayers and the CRA will need to prove gross
misconduct to get around this limitation. The CRA is citing s. 152(4) of the
ITA which sets out that the limitation does not apply if a taxpayer has
made a misrepresentation in a tax return and auditors are relying on the
most trifling of errors to get at statute-barred returns.
The law is that any word must be construed in the context of the
surrounding language. Section 154 (2) reads: attributable to neglect,
carelessness or willful default or has committed any fraud in filing the
return. The 3 types of misrepresentation are fraudulent, negligent
or innocent misrepresentation with the last involving mere inadvertence. The incorrect position of CRA auditors is that ANY act of misrepresentation is sufficient. Our firm is convinced that the CRA will have to
prove fraud, gross negligence or willful blindness amounting to knowingly
filing a false return to get around the limitation. A low threshold would open
the floodgates for CRA audits and make the limitation period meaningless.
The courts will support our position on this issue.

6 MIILITANT & UNFAIR AUDITS OF REAL ESTATE AGENTS.

CRA auditors will review the two most recent tax returns on the basis of
the sufficiency of receipts and vouchers. Receipts must be categorized
by type and totaled on tapes or spreadsheets. Auditors routinely disallow
between 20% to 40% of expenses and reduce the business driving to 75%
or lower where no logbook is provided.
Reasons for disallowance
include: no proof of payment, insufficiently documented; not clearly
connected to business and personal in nature. You can get a lot of
disallowed expenses restored by appealing the disallowances to the CRA
Appeals Division.
The law is that all expenses must be: incurred for the purpose of
earing income. This explains the need to provide names for business
dinners, events and gifts. Self-employed taxpayers can pay a spouse for
administrative support but the spouse MUST be put on payroll with taxes
and CPP premiums withheld. Any payment to a spouse for Casual Labor
will be disallowed. Keep all of your credit card chits. Credit card
statements will not be treated as sufficient proof of an expense.
You may claim a home/office expense based on a square footage or
room-by-room basis whichever is most favorable. Since agents installed
the MLS service in their home, and since most tasks are performed at
home including record-keeping, drafting documents, banking, using MLS,
booking appointments etc. then under the usage test as it relates to s.
18 (12)(a) (i) of the ITA your home is your principal place of business.
You do not need to meet clients at your home and you are doing business
driving once you leave the driveway.
The CRA has set up new vehicle logbook rules and provides a
prescribed manual logbook. In the first year, a taxpayer must log 12
months of driving to get a full logbook which will give a base proportion of, say, 89% of business use. The logging of each trip must include
a) the date; b) the departure and destination addresses; c) the purpose of
the trip; and d) the exact distance driven. In any subsequent year, you
need to log ONLY any consecutive 3-month period to get a simplified
logbook. The agent can select their busiest 3-month period and will likely
get a figure of 90% business driving or higher on the 3-month basis. You
need not log the other 9 months but should do so if related to business
dinners, events and gifts.
The CRA set up the manual system knowing that agents would not
want to spend 150 hours a year to track their driving. The good news is
that there are a number of computerized programs which are
CRA-approved which record all of the data required by the CRA and cut
the time for logging down to about 15-20 hours per year which is manageable. Without intending to promote a product, our research shows that the
best product available is Odotrack which uses a GPS system and is the
only system which stores all of the data required by the CRA on a main
server which server is accessed by a password. The system also records
business dinners, events and gift expenses which are the most commonly
audited expenses. Once you hit the business button on their dashboard
unit, it automatically enters the data. Check out the product at
www.odotrack.ca. It will print out the 12 months of data or 3-consecutive
months on request. Keep all of your vehicle receipts and your business
proportion of driving will be bullet-proof from a CRA attack.

William Howse B.A., LL.B. (Barrister & Solicitor.)

Mr. Howse gives a 3-credit CEU RECO classroom seminar on Taxation and Residential Real Estate and has the same course on-line at taxperts.on.ca for 2 CEU
credits. There is also a 1-CEU Credit classroom course on CRA Audits and Appeals. We believe that our firm does the best self-employed tax returns in Toronto.