If you own a building that is a rental property or used in your business, a special rule in the Income Tax Act can apply when you sell the building along with the land on which the building is located (of course, in most cases, you will sell both building and land).
The rule applies if you realize a capital gain on the sale of the land and a terminal loss on the sale of the building. Only half of the capital gain is included in income. In contrast, the entire amount of a terminal loss is normally deductible in full. In general terms, a terminal loss on the sale of a building occurs when you sell the building for proceeds that are less than the undepreciated capital cost (UCC) of the building – normally meaning that the building was previously over-depreciated for income tax purposes relative to its actual value.
Obviously, the government is not enamoured with the idea that the gain on the land will only be half-taxed while the loss on the building could be deducted in full, especially since you can choose in your sale agreement how much of the sale price to allocate 4
to the building and how much to the land. Accordingly, the rule applies to re-allocate your proceeds of disposition from the land to the building to offset the terminal loss on the building, but only to the extent of your gain from the land.
Example
You own land that cost you $200,000 and a building with an original cost of $100,000 and a UCC of $80,000. You sell both for $310,000, and your sale agreement allocates $240,000 to the land and $70,000 to the building. You might even be able to demonstrate that this allocation is fair and correct, based on an expert valuation.
In the absence of the special rule, you would have a capital gain of $40,000 on the land ($240,000 − $200,000) resulting in a taxable capital gain of $20,000; and a terminal loss of $10,000 on the building (the $70,000 proceeds for the building being $10,000 lower than the $80,000 UCC). Subtracting the $10,000 terminal loss from the $20,000 taxable capital gain, your net income from the sale would (absent the special rule) be only $10,000.
The rule reallocates $10,000 of the land proceeds to the building, so you have no terminal loss. The capital gain on the building is reduced to $30,000 and taxable capital gain is reduced to $15,000. Thus, your net income from the sale is $15,000 rather than $10,000.