Real estate developers often face delays before they can deduct expenses. Most costs are capitalized during construction, but some can be deducted when incidental income is earned.
Soft costs
Under subsections 18(3.1) and (3.2), many construction, renovation, or land ownership expenses are denied as current deductions. However, certain “soft costs” may be deductible, provided they don’t relate directly to construction. CRA Views 2009- 0329971C6 supports this treatment. These include:
- Office expenses (general and admin)
- Accounting (year-end bookkeeping and tax)
- Marketing costs (ads, brochures, sales office ops, provided they offer no enduring benefit).
- Site Repair (small repairs and minor renovations)
- Financing costs (some expenses could be deductible over five years under 20(1)(e), including construction loan fees)
- Interest and property taxes (on sites with buildings – to the extent of incidental income).
Revaluation of inventory
Another current issue faced by developers is the revaluation of inventory in a depressed market. Subsection 10(1) allows inventory to be valued at the end of the year at the lower of the taxpayer’s acquisition cost or its fair market value (FMV) or in a manner prescribed by the Income Tax Act (ITA). In a weak market, like the current market with falling new home sales, writing down inventory may offset other income.
The key driver in this scenario is to ensure the taxpayer is doing is holding real estate inventor as a business (including through a partnership or joint venture) rather than involved in the adventure in nature of trade.
This has been challenged before the Supreme Court of Canada by the Friesen [1995]. As a result, subsection 10(1.01) was added to the ITA and applies to cases where the property is held as an adventure in the nature of trade. If a taxpayer is found to be pursuing an adventure in the nature of trade, the ITA states the inventory must be valued at cost, denying any fair value adjustments until revenue is recognized.
Adventures in the nature of trade
Adventure or concern in the nature of trade is not explicitly defined in the ITA under subsection 248(1) except as part of the definition of business. However, it is discussed in Interpretation Bulletin IT-459. An adventure in the nature of trade is generally where property has been purchased with the intention of selling.
The general principle looks at the frequency of activities the taxpayer is involved in, even if these activities are separate from their ordinary occupation. The courts have emphasized that all the facts surrounding the transaction must be considered, and no single criterion can be applied. The courts have looked to the principal tests as follows:
a) whether the taxpayer dealt with the property acquired by him/her in the same way as a dealer in such property ordinarily would deal with it;
b) whether the nature and quantity of the property excludes the possibility that its sale was the realization of an investment or was otherwise of a capital nature, or that it could have been disposed of other than in a transaction of a trading nature; and
c) whether the taxpayer’s intention, as established or deduced, is consistent with other evidence pointing to a trading motivation.
The principal tests are designed to evaluate whether the steps taken by a taxpayer would be trading in a similar property regularly and frequently, and would take active steps to sell the property.
Future increases in FMV
If inventory is written down due to a drop in FMV and later rises in value, the increase up to original cost is treated as income. Once the value returns to its original cost, inventory is reported at cost again.
Article written by: Jonas Charyk CPA, CA, MMPA, Senior Tax Manager