Businesses have many assets for various reasons. They may use an asset to provide a good or service to clients. They may sell or lease an asset. How the asset is used is one of the biggest factors in determining whether the asset is capital or inventory for tax purposes. What happens when the asset could be used in more than one way or is used in more than one way? The conversion of real property from capital to inventory, or from inventory to capital, depends on several factors, not just the way the asset is used. If you are struggling with whether you have converted real property from capital to inventory or vice versa, consider contacting an experienced tax lawyer at Jeremy Scott Law by calling (902) 403-7201 to schedule a time to go over the specifics of your tax situation and discuss your legal options.
What Is the Difference Between Capital and Inventory?
Understanding converting property from capital to inventory or vice versa starts with understanding the difference between capital and inventory. Inventory is property held for resale that, when sold, produces a business income. This business income is then taxable.
Capital is property that is used for other purposes like leasing that, when sold, can create either a capital gain or loss. A capital gain is not income but can be taxed. A capital loss can offset a taxpayer’s capital gains and lower income. If there are no gains, the Canada Revenue Agency (CRA) allows the taxpayer to carry the losses forward or backward to apply them to different years’ returns.
What Is Real Property?
The Government of Canada defines real property as land, minerals, and mines. Canada also includes the buildings and fixtures that are on, above, or below the surface of the land as real property. The land may be located in Canada or abroad, and Canada includes any interest, including both legal interests (e.g., estates) and physical interests (e.g., mines and minerals). If you are not sure whether your interest qualifies, a skilled lawyer from Jeremy Scott Law may be able to help you determine how to proceed.
What Happens When You Convert From Capital to Inventory (or Vice Versa)?
There are no immediate repercussions for converting from capital to inventory or vice versa. Making this change, by itself, has no effect. The differences between capital and inventory come from selling the real estate after conversion from capital to inventory. On the date that the taxpayer converts the property from capital to inventory or vice versa, the CRA requires the taxpayer to calculate the business income or loss or capital gain or loss, assuming there is any, based on the notional disposition that a sale took place on the conversion date. Then the taxpayer reports that calculated income, gain, or loss when selling the property to someone else.
The Income Tax Act does not specify the circumstances under which gains or losses from real estate sales are determined as either income or capital. This means that each sale may be determined differently, even if they seem to be the same, based on the specifics of that sale.
What Are Some Examples of Conversion of Real Property From Capital to Inventory (or Vice Versa)?
Canadian law has established that there must be an unequivocal, clear positive act that implements a change of intention for there to be a conversion from capital to inventory. What those positive acts are, however, is not as clear.
The conversion of real property from capital to inventory or vice versa can be confusing because of this lack of clarity. Examples of converting property from capital to inventory or inventory to capital include the following:
- The taxpayer owns an apartment building. This is capital property. The taxpayer converts the apartment building to condo units to be resold. At this point, it becomes an income property, which makes it inventory. Changing from apartments to rent to condos to be sold converts the property from capital to inventory.
- The taxpayer purchases undeveloped land to develop condos for sale. This would be inventory. If the taxpayer later enters a joint venture to erect apartments for rent instead, then this joint venture would convert the property from inventory to capital. Changing from an intention to build condos for sale to building apartments for rent converts the property from inventory to capital.
- Rezoning or subdivision may also, in some cases, involuntarily convert property from capital to inventory or vice versa if it prevents the taxpayer from following through with the original intention for the property.
- The property is useless for development. When a property cannot be developed, this may trigger a conversion because the property may cease to be inventory and become capital by default.
What Factors Can Be Used To Help Determine Whether Property Has Been Converted?
The Income Tax Act does not give specific details about determining whether gains from real estate sales are income or capital. Without guidance from the Income Tax Act, other factors must be used to determine whether a taxpayer has converted property from capital to inventory or vice versa. Some of the factors that may be used to decide if property has been converted include:
- Taxpayer’s intention when buying the property
- Whether that intention is feasible
- The extent to which the intention is carried out
- Evidence that the intention changed after purchase
- Property’s zoned use and geographical location
- Nature of the taxpayer and taxpayer’s associates’ business, profession, calling, or trade
- How much money was borrowed to finance the purchase and the terms of the financing
- How long the taxpayer held the property
- Any other people who share interests in the property
- Motivation behind the sale
Contact a Tax Lawyer for Assistance in Converting Capital to Inventory
If you are confused about the conversion of real property from capital to inventory, or vice versa, you may want to make sure you are handling the conversion properly. If you have questions about real property and whether it is inventory or capital, you may want to go over your specific situation with an experienced tax lawyer. Consider contacting Jeremy Scott Law at (902) 403-7201 to go over the details and discuss your legal options.