If you own a building and the surrounding land that is used in your business, or as a rental property, you can depreciate the cost of the building for income tax purposes. The tax depreciation is called “capital cost allowance”, and the depreciation pool at the end of every year is called the undepreciated capital cost (UCC).
If you sell the building for an amount that is less than the remaining UCC pool, you will have a terminal loss, which is normally fully deductible in computing your income.
If you sell the land for more than your adjusted cost base of the land, half of the resulting capital gain is included in your income as a taxable capital gain. (Unless you are in the business of selling land or you bought the land with the intention of resale, in which case it would be fully included as income from a business.)
So, if you sold both the building and the land as indicated above, at first blush you would have a fully deductible loss on the building but only a one-half inclusion on the land.
Unfortunately, the Income Tax Act provides a re-allocation rule in these circumstances. Generally, you must re-allocate some of the proceeds from the land to the building: the proceeds from the land, not exceeding the gain from the land, must be re-allocated to the building to reduce the terminal loss.
You sell a building and land used in your business. Your adjusted cost base of the land is $300,000 and the UCC pool of the building (the only property in its UCC class) is $150,000. The total sales price is $500,000, comprised of $400,000 for the land and $100,000 for the building.
Initially, you would compute a $100,000 capital gain on the land and a $50,000 terminal loss on the building. However, the re-allocation rule will shift $50,000 of the proceeds from the land to the building.
Accordingly, your proceeds for the land will be reduced to $350,000, resulting in a $50,000 capital gain and a $25,000 taxable capital gain. The proceeds for the building will be increased to $150,000, resulting in a nil terminal loss.
The re-allocation rule does not apply if there is no initial gain on the land, or if there is no initial terminal loss on the building.