Often, when you transfer property to a non-arm’s length person such as a corporation that you control, you have a deemed disposition of the property for proceeds equal to the fair market value (FMV) of the property. Assuming the FMV exceeds the cost of the property, the transfer can trigger capital gains or ordinary income.
However, a special election under the Income Tax Act (a “section 85” election) allows you to transfer property on a tax-free or partially tax-free basis to a corporation if you receive at least one share of the corporation as consideration for the transfer. The election allows you to incorporate your business or investments on a tax-deferred basis.
In general terms, you and the corporation make a joint election under which you choose an elected amount for the property. The elected amount becomes your proceeds of disposition of the property transferred to the corporation. So if the elected amount equals your tax cost of the property, you will have no gain on the transfer and no tax payable.
In addition, the elected amount becomes the corporation’s cost of the property.
Furthermore, the elected amount, less the value of any non-share consideration that you receive on the transfer, becomes your cost of the shares received as consideration from the corporation.
You own real estate capital property with a tax cost of $200,000 and a fair market value (FMV) of $500,000. You transfer the property to your corporation in consideration for 100 common shares in the corporation and $50,000 cash. The amount you and the corporation elect under section 85 is $200,000
The deemed proceeds of disposition on the transfer of the real estate will be $200,000, resulting in no capital gain or loss and no tax payable for you. The corporation’s cost of the property will be $200,000. Your cost of the 100 common shares will equal $150,000 ($200,000 elected amount minus the $50,000 non-share consideration).
Although you would often choose an elected amount to completely defer any gain, you can choose an elected amount that will generate a gain, such as if you have losses that can offset the gain. In the above example, suppose you have a $30,000 net capital loss (half of actual capital losses) from last year that you are carrying forward. If you elect $260,000 on the transfer of the real estate, there will be a $60,000 capital gain, $30,000 of which will be a taxable capital gain included in your income. However, you will have no tax payable on the transaction if you used the $30,000 net capital loss to offset that taxable capital gain. At the same time, your corporation’s cost of the property will be bumped up to $260,000, and your cost of the 100 common shares will be increased to $210,000 ($260,000 elected amount minus the $50,000 non-share consideration).
Limits on the elected amount
The elected amount on the property transferred to the corporation is subject to the following general limits:
- It cannot exceed the FMV of the property;
- It cannot be less than the lesser of the FMV of the property and its tax cost; and
- It cannot be less than the FMV of the non-share consideration (sometimes called “boot”) that you receive on the transfer.
Filing deadline for section 85 election
The joint election is due by the earlier of your tax-filing due date and the corporation’s tax-filing due date for the taxation year in which the transfer of property takes place. An election may be filed late within 3 years of this date, although with a monetary penalty. The CRA has the discretion to allow a later election if it is “just and equitable” in the circumstances.