18 What are the ‘replacement property’ rules? Why do they exist? What are the tax implications?

What are they?

Replacement property rules allow taxpayers, when applicable, to defer capital gains and/or capital cost allowance when replacing property that was disposed of either voluntarily or involuntarily.  Qualifying for replacement property rules lets taxpayers replace disposed assets without having to face immediate tax implications.

Qualifying for replacement property rules:

Voluntary Disposition: Assets that have been voluntarily disposed of can only qualify if it is land and fixtures, and was not a rental property.

Involuntary Disposition: Assets that were not disposed of voluntarily such as being stolen, damaged beyond repair, or expropriated.

Timeframes for replacing property (per “IT Folio S3-F3-C1”)

“For involuntary dispositions, the replacement property must be acquired before the later of:

• the end of the second tax year following the initial year; and
• 24 months after the end of the initial year. 

For voluntary dispositions, the replacement property must be acquired before the later of:

• the end of the first tax year following the initial year; and
• 12 months after the end of the initial year.

For purposes of the replacement property rules, the initial year is the tax year in which an amount has become receivable as POD (proceeds of disposition) for the former property.”

Qualifying replacement property:

• The new replacement property must be used to replace the disposed business property.
• The new replacement property must be used in a similar or identical manner as the property it is replacing.
• If the property being replaced was used to earn business income, the new replacement property must also be used to earn business income.

The purpose of the replacement property rule is to allow the taxpayer to defer the capital gains or recapture of CCA when a business property has been disposed of and it is to be replaced with a similar property so that the proceeds can be used to purchase a replacement property.

Example

Brewed Awakening Coffeehouse had been operating in Lower Lonsdale for 3 years until the owners decided to sell the property and relocate. Brewed Awakening has a December 31^st year-end. Brewed Awakening was sold on November 26, 2018, for $320,000 and had an adjusted cost base of $105,000. On January 3, 2019, the owners bought a new property for Brewed Awakening in White Rock for $289,000. How much capital gains, if any, would the owners of Brewed Awakening have to report for the 2018 taxation year?

Capital Gains to be reported, lesser of:

Actual capital gain (Proceeds from Sale – Adjusted Cost Base)

$320,000 – $105,000 = $215,000

Proceeds not reinvested (Proceeds from Sale – Cost of Replacement Property)

$320,000 – $289,000 = $31,000

The owners of Brewed Awakening would have to report capital gains of $31,000.

Impact on Taxable Income

The purpose of the replacement property rule is to allow the taxpayer to defer the capital gains or recapture of CCA when a business property has been disposed of and it is to be replaced with a similar property so that the proceeds can be used to purchase a replacement property. In the example above, the taxpayer is able to defer $184,000 of capital gains as they reinvested that amount when purchasing the replacement property. This results in a lower taxable income for the taxpayer in the year of disposition.

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References and Resources

• ITA – 44(5), 13(4.1)
• Article – “Income Tax Folio S3-F3-C1, Replacement Property” (Author: Government of Canada)
• Article – “Replacement Property Rules” (Author: HTK Academy)
• Graphic – “Moving Boxers Mover Moving Truck” (Creative Commons)

January 2020