Love Flipping Condos? CRA Loves You Too!
With the April 30 deadline of filing your taxes quickly approaching, the CRA has taken it upon themselves to crack down on the real estate sector. The age-old adage of investing in real estate: go to the front office of the pre-construction, put down your down payment, and purchase 5 units. Before the construction ends, you assign your right to purchase before the building is registered and profit. However, that way of investing has now attracted the attention of the Canada Revenue Agency and they are excited to have a chat with you. Like many investors, this was the way to do things. Now, with what is being described as the “Condo Project,” many investors are finding themselves having to pay large tax bills in what the government considers “tax dodging.” The question lies within whether the profit is capital gains or income?
What is the difference between capital gains and income? And why is it such a big difference? As we all know, taxes are inevitable. The distinction between capital gains and regular income determines how much tax a person pays. The difference between the two is like the difference between a tree and the fruit that it bears.
“The tree is capital and it produces a fruit and the income is the profit that is derived when that fruit is sold.” With that in mind, you have a tree and it produces fruit. When the fruit is sold, profit made from the sale is considered income and will be fully taxed. However, when you sell the tree for a profit, which is considered capital gains, it is taxed at the 50% rate. Keeping that in mind and applying it to real estate, making profit from rental income of the property is considered income, taxed at 100%. Later on when the condo is sold for a profit, it is considered capital gains. If the entire business is selling condos, without any rental income, it is considered regular income, being taxed at 100%. So if you make $100,000 of profit, under capital gains, only $50,000 of that would be taxable, whereas under regular income all $100,000 of it would be taxable.
The CRA has been asking one simple question: “What was your intention when you bought that condo?” Auditors look at the intention, type of property that was sold, frequency of purchase and sales, why did the seller sell, and how does the purchase and sale fit with the person’s ordinary business. Like most investors on the same boat, in order to avoid paying hefty taxes, any profit gained from flipping the condos were being reported as capital gains, instead of regular income, which essentially reduces tax paid by half. This is a form of tax dodging and is heavily frowned upon by the government. Because of this, the CRA is clamping down and auditing the real estate sector, specifically condos. Not only does this come with a higher tax bill, but possibly a hefty fine for falsely reporting income, intentional or not. Unfortunately, the auditors don’t care what your situation is or was when the sale happens. They only look at the time period in which the property was actually owned. If to them, the time period is too short, then they have themselves a case.
An architect, single at the time, bought a condo in downtown Toronto in 2006. By 2010, he was married and wanted his wife to be closer to her work in Burlington. As such, he sold the condo, shortly after it was registered. When audited, it was decided by the auditor that the sale occurred too soon after the registration. Because of this, he was assessed with over $120,000 of income, which led to a tax bill of roughly $60,000 as well as facing a penalty of more roughly $30,000
So as an investor, what could you do to get off the boat that’s headed for stormy seas? One solution to this situation is to be more conservative when you are filing your taxes. When in doubt, count the gain as income. It is better to be a little more conservative than to incur a hefty tax bill along with a fine while fighting Revenue Canada for 50 years.
Another option is to investor in rent-to-own deals. But what’s the difference between flipping condos versus rent-to-own? Exploring the possibility of both, let’s take a look at flipping condos. When you’re flipping a condo, you essentially buy the pre-construction condo 3-5 years in advance. There are many factors that make an investment such as this very risky. For starters, what are you exit strategies, if any? Will you be able to flip it before the property closes? If not, now you are faced with having to close it yourself, and then come the question of financing. Would you be able to finance it if it got to that point? Also, finding a tenant to occupy the unit, and ensuring that they are good tenants is a tough task. Finally, let’s say that you do flip the condo, but you declare the profit as capital gains instead of income; now you have the CRA chasing you around.
Looking at rent-to-own, you have essentially the same concept, with significantly less risk than flipping condos. There are many factors that make rent-to-own a much safer investment. First off, there are exit strategies in place before the deal is done and so if the deal is not 100% comfortable with you, you are not forced into it. Another factor is that you don’t just collect first and last month rent, but rather a 10% down payment as collateral. You also collect rent that is 30% above market rent values. One of the biggest factors is that the tenants that are occupying the property are usually the future homeowners of that property, so you can expect a certain level of care that is given to the property.
With the brief outline of the differences between flipping condos versus doing a rent-to-own program, you can see that they are similar, yet very different. At the end of the day, taxes will have to be paid for both. Does it not make more sense to pay taxes while making profit with a certainty that flipping property can’t provide? So I ask you, which boat are you on? Are you on the boat known as flipping property that is headed for stormy seas, or are you on the boat known as rent-to-own that has smooth sailing ahead?