Buildings used to earn rental income or for business purposes are considered depreciable property. As such, tax depreciation, or CCA as discussed above, can be claimed on a building. Land is not depreciable.
When CCA is claimed on a building, the amount claimed reduces the undepreciated capital cost (“UCC”) in respect of the building. If the building is subsequently sold, the proceeds of disposition (to the extent of the original cost of the building) in excess of the UCC at that time is treated as “recapture” and is fully included in income. On the other hand, if the building is sold for proceeds less than the UCC, the remaining UCC pool can be fully deducted from income as a “terminal loss”.
Any gain on the sale of the land on which the building is situated will be a capital gain, only half of which is included in income (assuming the land is capital property – if it was bought for the purposes of resale, then these rules do not apply and any gain is taxed as business income).
Historically, the government has been concerned about situations in which the sale of a building would generate a terminal loss, while the sale of the land would generate a capital gain. The government is not keen on you claiming a full deduction for the building terminal loss while only including half of the gain on the land in your income. An extreme example would occur if you demolished the building and therefore generated a terminal loss, and sold the land at a capital gain.
Accordingly, the Income Tax Act has a rule that re-allocates the proceeds of disposition when you sell a building with a terminal loss and the related land at a capital gain. Basically, the proceeds from the land are re-allocated to the building to bring the terminal loss from the building down to zero. But the re-allocation is limited to the amount of the capital gain from the land.
Example 1
You own a building with an original cost of $200,000 and UCC of $100,000, and you sell it for $80,000. You sell the land on which the building is situated and realize a capital gain of $30,000. In the absence of the re-allocation rule, you would have a terminal loss of $20,000 on the building, and a taxable capital gain of $15,000 from the land (one-half of the $30,000 capital gain).
Because of the re-allocation rule, $20,000 of the proceeds from the sale of the land will be shifted to the proceeds of the building, so you will have no terminal loss. Your capital gain on the land will be reduced to $10,000, one-half of which will be included in your income as a taxable capital gain.
Example 2
You own a building with an original cost of $200,000 and UCC of $100,000, and you sell it for $80,000. You sell the land on which the building is situated and realize a capital gain of $12,000. In the absence of the re-allocation rule, you would have a terminal loss of $20,000 on the building, and a taxable capital gain of $6,000 from the land (one-half of the $12,000 capital gain).
Because of the re-allocation rule, $12,000 of your proceeds on the sale of the land will be shifted to the proceeds of the building, so that your terminal loss will be reduced from $20,000 to $8,000. Your capital gain on the land will be reduced to zero.