My Writing > The Real Deal

Real estate side deals can attract CanRev’s unwanted attention
15 Jan 2007

Originally Published by The TaxLetter Vol. 25, No. 1, January 2007   www.adviceforinvestors.com

 

The Real Deal

Real estate side deals can attract CanRev’s unwanted attention

Eileen Reppenhagen

 

Here’s the myth: In a perfect world, all funds for real estate deals pass through the lawyer’s trust. The entire deal is recorded by the lawyer in the closing documents. The lawyer prepares an adjusted closing statement for any changes in the deal.

But who am I kidding? And since when is the world perfect? The reality is that buyers and sellers deal directly all the time, and not everything passes through lawyer’s trusts or statements of account.

When I ask lawyers about this, they cringe and clam up. Accountants and tax preparers may never hear about these side deals unless it benefits their client.

Who is responsible for documentation of adjustments?

The lawyer inadvertently records a commission of $10,000 in the closing documents. The seller is supposed to pay a $9,000 commission. Three weeks after the documents are signed, sealed, and delivered, the seller notices the error and contacts the real estate agent, not the lawyer. The agent directs his broker to pay $1,000 out of the real estate agent’s account as an adjustment directly to the seller, and the agent’s net pay is reduced accordingly. No documentation is created. So what’s the problem?

Who would care if there is documentation?

The real estate agent plans to claim a reduction in income and obtain a GST/HST refund. But the agent’s cheque to the seller is not proof of anything other than money moved from the agent to the seller. No written agreement of the reduction to $9,000 exists; it was a verbal agreement to seal the deal. What if the other party disappears, moves, dies, or decides to change the story? “What?” they ask four years later. “I sold the agent my couch, washer, and dryer. That was not an inducement.”

The seller has documentation of the $10,000. He could ignore the adjustment and record a gain that is $1,000 understated. CanRev’s auditor might question the $1,000 deposit by the seller and assess an additional unreported income to the seller. Three or four years after the event, will the seller remember the reason for a $1,000 deposit?  The deposit will be reassessed by CanRev as income, not capital, and the seller will have to include 100% of the amount in income.

What about side deals between the agent and the buyer?

Agent acts for buyer. What if an agent acts for a buyer rather than a seller? The buyer pays the agent a commission. Income to the agent and part of that income under contract law belongs to the broker. It would be fraudulent if this payment did not pass through the broker. This payment will increase the cost base for the buyer and so reduce tax when the property is sold. Depending on whether or not the buyer is a GST/HST registrant, there might be GST/HST consequences as well.

Agent acts for seller but makes deal with buyer. Real estate agents are normally paid commission by sellers who enlist their services on contract. Agents who reimburse buyers for agreeing to pay more than they want to in order to close a deal are paying an inducement. The agent needs documentation to claim an expense. The buyer needs documentation to prove they paid less (hah!).

What is interesting about this scenario is that if the seller does not know that the buyer has been paid an inducement, then the agent in fact works for the seller, not the buyer. If you were a seller, would you get upset that the agent induced the buyer to pay you more?

What about side deals between agents and “for sale by owner” sellers?

I heard a story of a real estate agent who approached “for sale by owners,” asking for a direct commission if the agent produced a buyer. Real estate agents sign a contract with their broker that all deals must be filed through a brokerage. Doing an end run around the broker is fraudulent. A deal is a deal.

Why can’t I just call this a gift?

If a payment is considered income, the buyer is required to pay tax on the income. Why would an inducement be considered income rather than a gift?

Gifts are freely given without consideration.

An inducement forms part of the consideration. It is paid in exchange for allowing the deal to close.

It might be paid after the fact directly to the buyer or another party to the deal, such as a shareholder if the company is the buyer. In that case, it would be income to the shareholder, and the shareholder might also get hit with a shareholder benefit by the company because the cost base of the property would be reduced as a consequence of their relationship.

If the payment is made in consideration for giving up something, the payment is not a gift. Something of value was exchanged. This is what happens when you agree to buy something for a higher price than you otherwise would have and to receive a payment in consideration.

Why would there be a question of income versus capital?

The whole issue of what is on account of income and what is on account of capital is interesting and can be very expensive if the outcome is income and not capital, of which, of course, only 50% is included in income. Is an inducement on account of capital if it is consideration for a post closing price adjustment? The question of whether something is capital or income always goes to the intent and to the facts. Each situation is unique and considered on its own merits.

CanRev does not care if there is a law against inducements!

Some people will say that inducements are kickbacks or bribes and are illegal and unethical. The Criminal Code of Canada s.380 talks about fraud and says that if something is done by trickery, deceit, falsehood, or other fraudulent means where there is deprivation or deceit, it could be a criminal offense. If all parties are agreeable, then there is nothing criminal. That is way too simplistic, but CanRev doesn’t care.

The question of whether or not inducements are legal or ethical is not an issue for tax purposes. The Income Tax Act does not address inducements, kickbacks, and bribes directly, which is confusing. What it does is address is tax payable on income. The Income Tax Act describes income as profits from all sources (including, believe it or not, crimes). Profits are reported net of expenses.

Taxpayers are allowed to reduce profits by deductions for payments to earn a profit from a business or investment regardless of the legality of the venture.

Without documentation that is corroborated by independent third parties, it can be difficult to prove your claim for an expense or adjustment to cost or proceeds. For income tax purposes, both parties to the transaction have to be willing to admit to the transaction. If the party paying it out does not have concurrence from the receiving party as to the reason for the payment, it is difficult to prove a claim.

Get it in writing!

Tax audits usually occur three or four years after the fact. Do you know where the other party to your verbal agreement will be in three or four years? They might be six feet under or suffering from Alzheimer’s or dementia.

Payment is not considered adequate documentation. Like handshakes, even though we all say they are contracts, without a witness, undocumented agreements are hard to prove unless a judge believes you.

As a tax preparer, I regularly request clients document the source of every deposit to all bank, credit, and investment accounts. Why? That’s easy: To minimize audit risk, of course!

 


Real property: the party line

Most people do not realize that you must report the sale of a principal residence (defined in the Income Tax Actin s. 54) as a capital transaction and claim the Principal Residence Exemption in s. 40(b) in order to reduce the tax on the capital transaction to nil. For more information about the Principal Residence Exemption, refer to CRA Interpretation Bulletin IT 120-R6, Principal Residence. (CanRev typically does not enforce the requiremen.) tAnother Interpretation Bulletin, IT-268R3, discusses inter vivostransfers of farm property to a child.

CanRev can require that you report all capital property dispositions for even as little as $1.00 in proceeds. Proceeds of personal property such as antiques, jewelry, coins, stamps, artwork, restored or antique cars — anything where the proceeds exceed $1,000 — must be reported. If you have not kept your capital cost calculations, the adjusted cost base is automatically $1,000.

As for gifts, s. 69(1)(c) and s. 248(30) and (31) of the Income Tax Act cover gifts, advantage, and in (38) artificial transactions and series of transactions. In addition, s. 245, the General Anti-Avoidance Rule (GAAR) — CanRev’s catchall “gotcha” tax rule — should also be reviewed for arrangements or events where a transaction or series of transactions could result in a tax benefit.

CanRev has several guides to reference for more information. Publication T4036, Rental Guide, and the Publication T4037, Capital Gains Guide, provide extensive information about capital property calculations and reporting requirements.

Several forms to check out with regard to the Principal Residence Exemption include:

  • T2091 and Worksheet T2091-WS, Designation of a Property as a Principal Residence by an Individual.
  • T1255, Designation of a Property as a Principal Residence by the Legal Representative of a Deceased Individual.

These are, of course, available on the CanRev Website, www.cra-arc.gc.ca.

For anyone interested in more reading, the Realtor’s Code of Ethics may provide guidance ( www.crea.ca), and there well might be a law against these types of inducements. The OECD provides discussion about corruption and deductibility of bribes paid to foreign officials from an international perspective. In Canada there was some legislation proposed in 2004 relating to bribes (it’s available on the Department of Justice Canada Website, www.justice.gc.ca).


Eileen Reppenhagen, Certified QuickBooks ProAdvisor writes and speaks about accounting and tax.  She is a regular contributor to Canadian MoneySaver, The TaxLetter and Intuit’s award winning online publications for accountants and QuickBooks ProAdvisors, ProConnection Newsletter and Advisor Advantage.  

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