If you own a building and land used for income earning purposes – such as in your business or by renting out the property – you will often deduct capital cost allowance (“CCA”) for the building. CCA is the depreciation that is allowed for income tax purposes, and it differs from financial accounting depreciation.
The CCA that you deduct reduces the tax depreciation pool in respect of the building, otherwise known as the undepreciated capital cost (“UCC”). If you subsequently sell the building for an amount greater than the UCC, you will have recapture, which is fully included in your income. (If you sell the building for more than its original cost you will also have a capital gain.) Conversely, if you sell the building for an amount less than the UCC, you may have a terminal loss, which is fully deductible in computing your income.
On the other hand, land is not depreciable property. If you sell the land at a gain, only one-half of the gain is included in your income as a taxable capital gain (unless you bought the land with the intention of resale, in which case it would be fully included as income from a business.)
A special rule in the Income Tax Act (subsection 13(21.1) provides that if you sell the building and land and have a capital gain on the land and a terminal loss on the building, you must re-allocate some of the proceeds from the land to the building. Basically, the proceeds from the land, to the extent of the gain from the land, must be re-allocated to the building to reduce the terminal loss.
Example
You sell a building and land used in your business. Your cost of the land was $200,000 and your cost of the building was also $200,000. The UCC of the building (the only property in its class) was $150,000. You sell both for a combined $500,000 – allocated in the Agreement of Purchase and Sale as $400,000 for the land and $100,000 for the building.
Before applying subsection 13(21.1), you would have a $200,000 gain on the land (only half-taxed) and a $50,000 terminal loss on the building (fully deductible). However, the subsection 13(21.1) will re-allocate $50,000 of the proceeds from the land to the building.
Accordingly, your proceeds for the land are reduced to $350,000, resulting in a $150,000 capital gain and $75,000 taxable capital gain (income inclusion) from the land. The proceeds for the building will be $150,000, resulting in a nil terminal loss.
If there is no terminal loss before the re-allocation of proceeds, the rule does not apply.