Tax consequences of demolition costs in the real estate sector
TAX ALERT |
The tax consequences of a demolition in the real estate industry can vary depending on the facts. Pivotal to the analysis is whether the structure being demolished is a depreciable property. Costs or losses arising from a demolition may be partially deductible, depreciable over time, added to the capital cost of contiguous land, or result in immediate capital losses.
Primer on depreciable property and related tax consequences
Generally, depreciable property is capital property used to earn income, the capital cost of which can be written off as capital cost allowance (CCA) over time. The taxpayer’s intentions for, and use of, a building, are key facts in establishing its income-earning purpose. Other important considerations, specific to demolition, include:
- the length of time prior to demolition and whether the building was income-producing;
- any maintenance or repairs made to the building;
- the amount of income earned;
- renewal of leases, if any, and the length of the renewal; and
- costs of breaking leases, if any
A taxpayer’s depreciable property is grouped into various classes. The undepreciated capital cost (UCC) of a particular class of depreciable property represents the capital cost of all property included in that class, less CCA previously claimed and the net proceeds from any dispositions.
On disposition of the property (assuming there are no other properties in the class), if the proceeds of disposition are lower than the class’ UCC, the difference results in a terminal loss that can be deducted from the taxpayer’s income. Building assets that are greater than $50,000 are generally included in a separate asset class. As such, dispositions involving such buildings will typically result in no other properties remaining in that class. If the selling price exceeds the UCC, the excess results in recapture and is included in income. Further, a capital gain may result on disposition of depreciable property if proceeds of disposition are in excess of the property’s initial capital cost.
Non-depreciable capital property is property that is typically held as an investment, for which CCA and terminal loss are not available. Capital gains or losses may result on the ultimate disposition of the property.
Special rules reduce terminal loss where proceeds are nil
The demolition of a building is a disposition of that asset for tax purposes. The proceeds of disposition on a demolition are generally nil. Under the general rules described above, and assuming the building is a depreciable property in its own class, where proceeds of disposition are less than the building’s UCC, a demolition would normally result in a terminal loss that is currently deductible against income.
However, where a building is disposed of for proceeds that are less than the UCC of the building, as in the case of demolition where proceeds are nil, special rules can apply to re-allocate proceeds of disposition between the subjacent land and the income-earning building. Generally speaking, these rules restrict the potential terminal loss and might result in a recapture of any CCA previously taken where deemed proceeds exceed the building’s UCC.
When the income-earning building is demolished for proceeds of nil, whether a terminal loss arises depends on whether the taxpayer (or a non-arm’s length person) retains or disposes of the land that is subjacent to, or immediately contiguous to and necessary for the use of the building.
When land is retained or sold in a different year
If the land is retained for future use after the building is demolished, on demolition, the taxpayer is deemed to have proceeds of disposition of nil, plus half of the greater of the building’s UCC and its fair market value (‘FMV’) immediately before disposition or demolition. Thus, assuming in a demolition context that the building’s FMV is nil or nominal, this adjustment theoretically reduces the terminal loss incurred on the demolition of building to one half of what would otherwise be claimable.
When land is sold in the same year
Conversely, if the land that is subjacent to, or immediately contiguous to, and necessary for the use of the building, is disposed of in the same year that the building is demolished, the combined proceeds must be allocated between the building and land. This is primarily to ensure that no loss will be claimed in respect of the demolition of the building unless it is determined that no gain is reported on the land.
Broadly speaking, the proceeds of disposition of the building (nil) are increased by an amount equal to the lesser of the UCC of the building and any capital gain on the land. The proceeds from the sale of the land are reduced by the same amount.
In other words, this adjustment occurs if a capital gain is realized on the land. In this case, there is a reduction to the resulting terminal loss on the building, equal to the capital gain on the land, or the terminal loss (otherwise determined), whichever is less. This adjustment may also possibly result in recapture of CCA previously taken, to the extent that the FMV of the building exceeds its UCC.
If a capital gain is not realized on the sale of the land, the proceeds in respect of the building (nil) are not increased, as the amount of the capital gain (nil) is less than the resulting terminal loss, and that terminal loss may be claimed in respect of the demolition.
Demolition of building upon, or shortly following, purchase
Where land is purchased with an incidental building that is intended for immediate demolition, or demolition following a short rental period, the costs of demolition (less any salvage value) and the part of the purchase price allocated to the building become part of the cost of the non-depreciable land. The demolition costs are thus not currently deductible. This is because the building will likely not be considered depreciable property if it is used to earn income for only a short time prior to its demolition. The demolition may nonetheless result in an immediate capital loss to the taxpayer if the proceeds of disposition (nil) are less than the building’s capital cost.
Thus, although an immediate write-off of the demolition costs is not permitted in these circumstances, the costs can reduce any capital gain that may be realized on a future sale of the land.
Alternatively, where a building is not demolished immediately, the facts of each case will determine whether the building is depreciable property. If the building is depreciable property, then the rules described above regarding terminal loss restriction would apply.
Demolition of income-earning building to build a new income-earning building
Where it is established that a building was acquired for the purpose of producing income and in fact has a long history of such use, the costs of its demolition in order to build a new one can be deducted in the year, rather than be considered part of the capital cost of the new building (unless the taxpayer so desires). In this case, the demolition costs are simply an outlay made or incurred by the taxpayer for the purpose of gaining or producing income from the depreciable property (building) and thus are currently deductible.
Clearing and leveling costs
The tax treatment of clearing and leveling costs are also noteworthy in the context of a demolition, but only to the extent that they are necessary for the prompt construction of an income-earning structure on the land. Clearing may involve the removal of trees, stumps, shrubbery or boulders, while levelling may involve either filling low-lying or uneven land or the removal of solid rock, mounds or even hills. These costs may also include drainage of the land or the diversion of a spring or stream.
Where construction of a depreciable building begins without undue delay following clearing and leveling, these costs usually form part of the depreciable capital cost of the structure. Otherwise, the costs must be considered a part of the cost of the land.
Demolitions in practice
Consider the following example: a taxpayer purchases land with a 45-year-old commercial retail building on it. The taxpayer continues to lease the building but informs the tenants about his intentions to demolish the building in the near future. Some tenants leave while others continue to lease portions of the building. Two years following the purchase of the land and building, the taxpayer demolishes the building and starts construction of a new commercial retail building. In the interim period, the taxpayer advertises and leases empty retail space in the building on a short-term basis.
An analysis of the depreciable nature of the building would first be required to understand the tax implications of this fact pattern. The relevant factors in this case might include the two-year period prior to demolition; the fact that the building produced income, albeit not at full capacity; the mix of long-term and short-term leases; the taxpayer’s clear intention from the outset of the purchase of demolishing the building in the near future; and the advertisement of short-term leases.
Assuming the building is depreciable property, another question that comes to mind is whether the special rules relating to the reallocation of proceeds might apply to reduce any terminal loss. To the extent it is concluded that the land that is subjacent to, or immediately contiguous to and necessary for the use of the building is retained following the demolition of the old building, any terminal loss could be reduced.
A further consideration might be the appropriate tax treatment of the demolition costs. Whether the costs are treated as current expenses, capital losses, part of the cost of the land or the new building will turn on an analysis of the circumstances including the taxpayer’s intention; the old building’s income-earning history; the period of time between demolition and construction of the new building; and the nature of the demolition costs.
Of interest here is how the conclusions might differ if the taxpayer delayed or accelerated the demolition of the building and thus lengthened or shortened, respectively, the terms of ongoing leases. Further, what would the implications be if the taxpayer purchased the land and building (for demolition) instead of vacant farmland purposely to avoid incurring re-zoning and other licensing costs that would normally be deductible in the normal course of earning income from business or property? Arguably, the demolition costs are incurred instead of re-zoning and other licensing expenses, which could suggest deductibility of the former. The specific facts of the situation will be critical to the analysis.
Emphasis on the facts
Given the government’s heightened focus in Budget 2019 on tax compliance in the real estate sector, careful adherence to the rules relating to the tax treatment of costs related to the demolition of real properties is crucial.
Accurate tax treatment of demolition losses and costs, supported by well-established facts surrounding the taxpayer’s intent, use of the building and related land, and the timing of actions taken, are key to minimizing audit challenges.