ARCHIVED - Options on Real Estate

From: Canada Revenue Agency

What the "Archived Content" notice means for interpretation bulletins

NO: IT-403R

DATE: May 29, 1984

SUBJECT: INCOME TAX ACT
Options on Real Estate

REFERENCE: Section 49 (also section 9 and subsections 55(1) and 245(2))

This bulletin replaces and cancels Interpretation Bulletin IT-403 dated January 9, 1978. Current revisions are designated by vertical lines.

1. This bulletin is concerned with the treatment of options for the acquisition or disposition of real estate, other than a principal residence. Where a purported lease-option transaction is in reality a sale of the property involved, IT-233R, "Lease-Option Agreements; Sale-Leaseback Agreements", would have application.

2. In normal circumstances involving lease-option agreements where a true lease exists, a reasonable rental paid prior to the exercise of the purchase option by the lessee is considered to be rental expense to the lessee and income to the lessor, even where a rebate or discount on the purchase price is given at the time the option to purchase is exercised for a portion of the previous rentals paid. Upon exercise of the purchase option, the option price for the property, less adjustments for previous rentals paid, if any, will constitute the cost of property to the lessee purchaser, subject of course to the further inclusion of the adjusted cost base of the option, if any, as provided in subparagraph 49(3)(a)(ii). However, where the option is exercised by a purchaser after December 11, 1979, rental payments in respect of the property were deductible by the purchaser or a person not dealing at arm's length with the purchaser in computing income and the purchase price of the property is less than fair market value at the time the option is exercised, the purchaser will be deemed to have acquired the property in accordance with subsection 13(5.2) as discussed in 10 and 11 of IT-233R.

3. Where the grantor of an option purchases it back from the grantee and they are dealing at arm's length, the Department takes the position that the adjusted cost base of the property to the grantor is generally increased by the amount of the purchase price of the option from the grantee. The grantee on the other hand is considered to have disposed of an option and any resulting gain or loss is subject to the capital gains or loss rules. However, where a taxpayer grants an option and repurchases it in the same taxation year, the taxpayer may net the proceeds received with the subsequent purchase price paid. If the taxpayer decides to do so, any excess of proceeds over purchase price would be subject to the capital gains rules but any excess of purchase price over proceeds would increase the adjusted cost base of the taxpayer's property. Where, at any time after January 12, 1981, a taxpayer disposes of a capital property that is an option to acquire real property which the taxpayer, or a person with whom the taxpayer was not dealing at arm's length, had been renting and had been entitled to deduct the rent in computing income, the amount by which the proceeds of disposition of that option exceed its cost to the taxpayer will, by virtue of subsection 13(5.3), be deemed to be an excess as contemplated by subsection 13(1) and will thus be included in the taxpayer's income.

4. The exercise of an option to purchase or dispose of property does not constitute a disposition of property. Where the taxpayer is a corporation, its pre-1972 capital surplus on hand as defined in subsection 88(2.1) is not affected by the exercise of an option to acquire property since no disposition arises to give rise to proceeds of disposition for the purposes of those provisions such as paragraph 88(2.1)(b). There is a disposition by the vendor of the property to which the option relates.

5. Where a taxpayer has granted a non-arm's length non-commercial option on property that is capital property, the Department will apply the provisions of subsection 55(1) in respect of the disposition of that property on the exercise of the option in the following circumstances:

(a) the price of the option and the exercise price together are materially less than the fair market value of the property otherwise determined at the time of the exercise of the option; and

(b) the reason for the material difference is not some unexpected event that occurred between the granting of the option and the exercise of the option (e.g., the unexpected discovery of gravel or minerals on the property).

Where the exercise price has been used as the fair market value for purposes of subsection 70(5) on the death of the taxpayer or as the disposition price on the sale of the property to another non-arm's length party, subsection 55(1) will be invoked at that particular time if the conditions as set out in (a) and (b) above prevail, after being suitably altered to substitute "death" or "sale", as the case may be, for "exercise of the option". A non-commercial option is one that arm's length parties would not consider entering into and may involve an unrealistically long option period, a low option price or an exercise price that does not fully recognize expected future events (e.g. inflation, zoning change, market trends) that will affect the price of the property over the option period.

6. Where real estate is inventory to the grantor of an option to acquire the property, the proceeds from the granting of the option are income to the grantor. Where the option is a non-arm's length non-commercial option (see 5 above), the provisions of subsection 245(2) will apply where a benefit is indicated at the time the option is exercised. Generally, the benefit is considered to be the amount by which the full fair market value of the property at the time the option is exercised exceeds the sum of the amount paid for the option and the exercise price. "Full fair market value" means the amount that would have been the fair market value of the property if the option had not existed.

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