Canadian Taxes A to Z (2018): "P" is for Principal Residence Exemption

Today, "P" for for Principal Residence Exemption. Sixteen letters down. Ten to go!

PRINCIPAL RESIDENCE EXEMPTION MIGHT BE BEST TAX BREAK OUT THERE

The principal residence exemption may be the best tax break going for Canadians who own a home. As I've mentioned earlier in the alphabet, you usually must pay tax on capital gains just like on income gains (though at a lower rate). However, any capital gain on your principal residence is tax free. With home values in Canada generally rising at much faster rates than investment values, this can be a very profitable exemption!

COUPLE CAN TOGETHER ONLY HAVE ONE PRINCIPAL RESIDENCE

Prior to 1981, each spouse in a couple could designate a principal residence for the purpose of the exemption. So one could choose the cottage, and one the city home, and no one would pay tax on capital gains on either of them. However, since that time couples can only have one joint principal residence.

A couple could pick the cottage as the principal residence if they wish to avoid tax when it comes time to sell it, but for the years of its designation they would lose the exemption on their city home. So designating the cottage would probably only make sense if it had experienced a larger capital gain during the relevant period than the city home.

For a couple with a tiny city condo and a palatial waterfront cottage, picking the cottage sale to be tax free would make sense. But for most people, the city home is going to have risen more in value because it was more expensive to begin with. Picking the cottage as the principal residence would help defer tax payments for a while if it is sold prior to disposition of the city home, but if you plan to sell the city home at any time in the future the taxing of its capital gain would eventually catch up with you.

The most important requirement of the principal residence exemption is that the home must have been your principal residence for the entire time you owned it, not just at the time you are selling it. Otherwise, you'll need to take a percentage of a capital gain exemption equivalent to how long the home was your principal residence as compared to the total amount of time you owned the home.

Recent tax changes now require you to explicit claim the principal residence exemption in your tax filing.

DEATH & REBIRTH OF HOME OFFICE DEDUCTION FOR PRINCIPAL RESIDENCE

Especially controversial in recent changes was a Canada Revenue Agency fall 2016 principal residence exemption filing guide that seemed to suggest if you were claiming business use of home expense deductions for any portion of your principal residence, then the principal residence capital gains exemption would be reduced by a corresponding percentage. This could have had the effect for valuable properties of costing taxpayers hundreds of thousands in payable capital gains taxes, in exchange for only tens of thousands (at best) of home office expense deductions. 

At the end of February 2017 without any fanfare the CRA updated its website to now read: 

If only a part of your home is used as your principal residence and you used the other part to earn or produce income, whether your entire home qualifies as a principal residence will depend on the circumstances.

It remains the CRA’s practice to consider that the entire property retains its nature as a principal residence, where all of the following conditions are met:

• the income-producing use is secondary to the main use of the property as a residence;
• there is no structural change to the property;
• and no capital cost allowance (CCA) is claimed on the property.

If your situation does not meet all three of the conditions above, you may have to split the selling price and the adjusted cost base between the part you used for your principal residence and the part you used for other purposes (for example, rental or business). 

Thus the home office deduction appears to have been saved! And claiming CCA on a home was always a bad idea anyway, even if legally permissible, because of the massive recapture that might be triggered at selling time. 

Gordon S. Campbell is a tax lawyer practicing throughout Canada who has argued tax cases as high as the Supreme Court of Canada. Learn more at acmlawfirm.ca/taxlaw.

Canadian Taxes A to Z (2018): "O" is for Offence

Today, "O" is for offence. We've got 15 letters down, and 11 to go in our 26 letter tax race. 

WHAT IS A TAX OFFENCE

Offence is a generic term used to refer to a lot of different contraventions of regulatory legislation in Canada which don't qualify as "crimes." Generally, you only find crimes in the Criminal Code or Controlled Drugs and Substances Act. So contraventions of the Income Tax Act are usually termed "offences."

It's important to distinguish between getting just a little too creative in your tax accounting which leads to you making statements in your tax return which the CRA won't accept but which don't amount to offences, and outright lies or obstruction which may potentially lead to offence charges against you. Make a few math errors, make an honest mistake about claiming a deduction you erroneously thought you were entitled to, have some bookkeeping errors leading to you claiming too much mileage on your vehicle? The CRA might administratively penalize you for any of these errors by charging you interest on the tax balance owing and assessing civil penalties. But it's unlikely any of these mistakes will lead to allegation of offences. 

However for more blatant actions (or inactions) like "forgetting" to file tax returns for ten years, ignoring repeated information demand letters sent to you by the CRA, or understating your real income by $100,000 are all good ways to be accused by the CRA of offences. Since the Income Tax Act is a regulatory statute, you can be liable for most of its offences (other than tax evasion) even if you didn't wilfully intend to commit the offence.

YOU CAN BE CONVICTED OF MOST TAX OFFENCES WITHOUT INTENT

Thus it's a bit like speeding on the highway: you might not have intended to drive 40 km over the limit, but if you got a bit distracted and your foot got a little heavy on the gas, saying you didn't mean to speed isn't going to help you in court. Same with taxes: saying you didn't mean to forget about filing your tax returns and ignore all those demand letters the nice people at the CRA sent to you won't really help you when you're charged with an offence. 

THE CRA HAS A HIGH CHARGING THRESHOLD FOR OFFENCES

The CRA tends to have a fairly high offence charging threshold. Meaning, they'd much rather go after you for more minor contraventions through administrative means by imposing administrative monetary penalties, rather than hauling you into court on offence charges. So not filing your returns for a year or two, or "forgetting" to report $10,000 in income on your return isn't likely to lead to you facing an "offence." But don't file for many years, or forget to report a few hundred thousand dollars on your return, and you might wind up with a court date. 

CHARGING THRESHOLD LOWER WHERE AGGRAVATING FACTORS

Sometimes the CRA's charging threshold will be lowered if there are other aggravating features of tax misconduct. For instance, if your unreported income was derived from criminal activity, the CRA might charge you with an offence even if it's only a few thousand dollars that are unreported. 

The message here is that the best way to avoid any allegations of tax offences is to avoid any hint of impropriety when filing your returns. I'm not suggesting that with sound accounting advice you shouldn't push the envelope in aggressively claiming deductions. Just be sure you can later defend those deductions when challenged, don't "forget" about any significant income, and make sure you file your returns on time, year after year, even if you can't afford to pay your full tax bill. The CRA always surprisingly accommodating in making payment arrangements, and the prescribed rate of compound interest remains a quite reasonable 5.1%. 

Gordon S. Campbell is a tax lawyer practicing throughout Canada who has argued tax cases as high as the Supreme Court of Canada. Learn more at acmlawfirm.ca/taxlaw.

Canadian Taxes A to Z (2018): "N" is for Non-Refundable Tax Credit

Today, N is for non-refundable tax credit.  Why the qualifier "non-refundable" and not just the term "tax credit"? Because some tax credits can actually result in the government sending you a cheque, such that in a way you make a profit off the credit. Non-refundable credits can at best reduce your payable tax to zero, but you'll never get a dollar back directly from the government (unless you've overpaid your tax instalments or deductions, leading to a refund).

CREDITS APPLY TO BOTH FEDERAL AND PROVINCIAL TAXES

You can receive non-refundable tax credits against both federal and provincial payable income taxes. The credit equals a "base amount" times the applicable tax rate. So, for example, the spousal credit can net you a $1771 credit federally, and an even greater $1892 credit against Alberta provincial tax, but only a tiny $523 credit against Ontario provincial tax.

SOME CREDITS ARE CLAIMABLE BY EITHER SPOUSE

Some non-refundable tax credits can be claimed by either spouse. Usually it will be the higher earning spouse who claims the credit. These include:

1. amount for infirm dependants 18 or older;
2. home buyer's amount;
3. adoption expenses;
4. caregiver amount;
5. tuition and education amounts.

CANADIAN DIVIDENDS CAN LEAD TO A GOOD CREDIT

The Dividend Tax Credit for Canadian Dividends is an important one for investors, as it effectively reduces the tax rate payable on dividend income. But foreign dividends don't qualify for the dividend tax credit. And even within Canadian dividends, there is a split between:

1. Canadian public corporations which are eligible for the enhanced dividend tax credit (commonly known as "eligible dividends";
2. Canadian-controlled private corporations (CCPCs) which are eligible for the regular or small business dividend tax credit.

ACCOUNTING ADVICE RECOMMENDED WHERE SIGNIFICANT INVESTMENTS

You'll probably be able to figure out many of the available personal non-refundable tax credits yourself when completing your return, but if you have significant investments then getting the advice of an accounting professional would be prudent. In either case, make sure you carefully go over the fairly lengthy laundry list of available non-refundable credits to ensure you don't miss one you might benefit from!

Canadian Taxes A to Z (2018): "M" is for Marginal Tax Rate

In the continuing Canadian Taxes A to Z 2018 odyssey, I'm like the marathon runner who is past the half way point on the course. 14 letters down, 12 to go! I promise to keep up the pace, and finish prior to tax deadline time. Today, M is for Marginal Tax Rate. 

MARGINAL TAX RATES LEAD TO TAKE HOME INCOME

To know your marginal tax rate is to know how many cents of every dollar you make will stay in your pocket if you continue to earn more income throughout the year. The reason we don't just use the term "tax rate" without the word "marginal" is because we don't use a flat tax system in Canada (nor does any country with a "progressive" tax system).

Marginal tax rate is the percentage rate that will be applied to the next dollar you earn. To take Ontario as an example, your combined federal and provincial tax rate on the first $42,960 you earn is 20.05%. That doesn't mean you'll necessarily lose that much of your income, since you'll be entitled to various deductions, but the "margin" bump up to the next tax bracket (24.15%) happens when you earn more than $42,960.

The top bracket in Ontario of 53.53% kicks in at over $220,000 in net income (there are several in between brackets). Meaning you get to keep just slightly more than 46 cents of every dollar you earn.

A lot of countries now try to keep their top marginal rates under 50%, since they saw that income tax rates which used to range up to about 80% at the top end simply encouraged a flight of the wealthy (and their capital) to lower tax jurisdictions.

TOP PROVINCIAL TAX BRACKETS SIMILAR BUT KICK IN AT DIFFERENT TIMES

Other provinces have different rates at different marginal brackets. The finishing top marginal tax rates tend to be somewhat similar among the provinces, but may kick in much sooner (or later) than in Ontario.

In Quebec, on the first $43,055 of income you pay at a rate of 27.53% (almost 50% higher than in Ontario). The top marginal rate of 53.31% is very similar to Ontario's top rate, but kicks in at $205,842 in income, sooner than Ontario's top marginal rate.

By comparison, in Alberta, on the first $46,605 you pay at a rate of 25%, meaning for lower income earners Alberta actually taxes you more than in Ontario! But the high end tax bracket for Alberta doesn't max out until you hit $307,547 in income, and then at a rate of only 48%. Meaning Alberta taxes the poor more, and the rich less than in Ontario. 

HOW TAX POLICY FAVOURS PASSIVE OVER ACTIVE INCOME

The other thing to know about marginal tax rates in Canada is that you only pay tax on capital gains at 50% of the normal rate. So even if you're in the top tax bracket in Ontario, your marginal tax rate for capital gains would only be 26.76%. You'll also get a bit of a tax break on marginal rates for Canadian dividend income.

Some think it unfair that those with active income (from employment or self-employment) pay taxes at a higher rate than those with passive investment gains. But like a lot of things tax, that's just the way it is. Not unlike it being potentially unfair that those whose primary owned residence goes up massively in value pay no tax at all on those capital gains, whereas those who rent get no similar tax break.

Gordon S. Campbell is a tax lawyer practicing throughout Canada who has argued tax cases as high as the Supreme Court of Canada. Learn more at acmlawfirm.ca/taxlaw.

Canadian Taxes A to Z (2018): "L" is for Listed Personal Property

Today, L is for Listed Personal Property (LPP). Most Canadians, even those who run businesses, will never have heard of LPP. But if you're a "collector" you're probably all too familiar with its taxing limitations.

LPP IS AN INCOME TAX ACT INVENTION

Like Capital Cost Allowance (CCA), LPP is a term unique to the Income Tax Act, rather than one in common accounting use. LPP includes personal chattels (meaning not real estate) that usually appreciate in value over time. Most chattels depreciate, and thus you can claim CCA on them. You can't claim CCA on LPP.

LPP includes:

1. prints, etchings, drawings, paintings, sculptures and other similar works of art;
2. jewellery;
3. rare folios, manuscripts and books;
4. stamps;
5. coins. 

LPP GIVES YOU A BREAK ON CAPITAL GAINS

Profits on the sale of LPP are reportable capital gains. However, the base value of LPP for capital gains purposes is $1000. So if you buy stamps for $700, and sell them for $1200, you only have a $200 capital gain to report (the increase from the $1000 deemed based value). 

LPP losses can only be used to offset other LPP gains, not other income. 

LPP LIMITS THE DEDUCTIBILITY OF HIGH VALUE ART

What this all means is that you can't invest crazy sums in art, hoping that it will create all sorts of losses for you when you go to sell it that you can deduct against other income. Likewise, you can't spread high end art all over your office, hoping to depreciate its value as regular CCA. Though less expensive pieces should be deductible as regular office expenses. 

Gordon S. Campbell is a tax lawyer practicing throughout Canada who has argued tax cases as high as the Supreme Court of Canada. Learn more at acmlawfirm.ca/taxlaw.

Canadian Taxes A to Z (2018): "K" is for Know Your Income

Today, the letter K is for Know Your Income. Eleven letters down, 15 to go!

Okay, so I needed to stretch a bit today to find a "K" word. In the U.S., Tax Girl @taxgirl has a huge advantage for some of these tricky letters in writing her [American] Taxes A to Z for Forbes because the I.R.S. seems to love appending letters to the end of its endless list of forms and instruments.

Like 401K fund. I mean, really, how easy is it to find a "K" tax word to write about in Canada? I concede she has to come up with new letters for the many years she's been running the series. Personally, I don't know how she does it, but still.

In Canada, I can't even find an appropriate "K" word to talk about in a dictionary of accounting, far less in the Income Tax Act. But K does stand for knowledge. And as we all know, knowledge is power. In the tax context, and otherwise.

WHY KNOWING YOUR INCOME IS THE GRUNDNORM OF THE CANADIAN TAX UNIVERSE

While for those who are self-employed, "know your expenses" is also an important point, for ALL Canadians "know your income" is the fundamental principle for getting your taxes right and avoiding hassles from the CRA. In Canada's self-reporting, self-assessment system, you tell the government how much you made and how much tax you owe, rather than the government telling you.

It's easy to forget about all your sources of income. Many Canadians have several jobs in the course of a taxation year. Maybe a series of consecutive full time jobs that are seasonal. Maybe several concurrent part time jobs that equal a full time income. Perhaps a little bit of independent contractor work. Plus some interest income from investments. And a capital gain from an empty lot that you inherited years ago, and just never got around to selling until this year. All those income numbers need to be added up if you're to know your true income.

KNOW YOUR EMPLOYMENT INCOME EVEN WITHOUT A T4

You're supposed to get T4 slips from employers telling you how much you made, and what kind of deductions (like taxes paid in advance) that they took off. But sometimes employers might forget to send you a T4, or the T4 might get lost in the mail because you moved. It's your job to track down all the T4s you need to complete your taxes. The CRA won't like the excuse that you never reported that $25,000 of tree planting income because you never received a T4 for it.

KNOW YOUR SELF-EMPLOYMENT INCOME

Same with self-employment. It's your job to keep track of how much you made. Don't guess. You might overreport income just as easily as under report it. With overreporting, you'll pay more tax than you deserve to pay. Whereas with underreporting, you'll be hit with all sorts of interest and penalties by the CRA.

KNOW YOUR CAPITAL GAINS

Lastly, with capital gains or investment income, you likewise can't just "forget" to report it. You need to know how much you made.

When I was practicing as a Federal Crown tax prosecutor in the Toronto area I prosecuted a family who had jointly pooled their savings to buy some vacant investment farm land that had future development potential. They sold the property ten years later for a six million dollar profit. Smart and prudent, right?  Not if all of the family investors then "forget" to report the capital gains as income on their respective tax return. That's a lot of tax evasion.

So know your gross income from all sources. That's the starting point for completing your tax return. Only once you know your gross income, can you do your damnedest to take advantage of all legally available deductions to make your net income (and thus your tax burden) as small as possible.

Gordon S. Campbell is a tax lawyer practicing throughout Canada who has argued tax cases as high as the Supreme Court of Canada. Learn more at acmlawfirm.ca/taxlaw.