This straightforward and cost-effective estate planning approach can provide your heirs with a significant financial advantage upon your passing. While it’s not mandatory for you to be both below the age of 65 and retired for this strategy, in most cases, this combination enhances its effectiveness. I will delve into the reasons behind this later in the article.
Key Takeaways:
- Simple and Cost-Effective: The strategy of transferring investment properties to heirs is a straightforward and cost-effective estate planning approach. Unlike trusts, this strategy doesn’t require the establishment of complex tax structures, reducing costs associated with annual reporting and consultations.
- Achieving Key Objectives: The approach consistently accomplishes two primary goals:
- It freezes taxable capital gains at the current market value of the property, offering tax deferral for potential future appreciation to your heirs.
- It provides valuable opportunities for tax and liquidity planning for both you and your heirs, which may not be available in the event of your passing.
- Timing: While not mandatory, the strategy is often more effective when executed before the age of 65 and during retirement, taking advantage of lower income levels.
- Mutation Tax: Investigate your city’s mutation tax rules, as it can be a significant cost; exemptions may apply to the sale to family members.
- Heirs Funding Assistance: If heirs lack funds, consider options like co-signing a mortgage or lending the necessary amount, ensuring compliance with prescribed interest rates. An interest-only loan can be a viable choice for those uninterested in immediate property sale proceeds, but be aware of potential tax consequences if forgiven during your lifetime.
- Attribution Rules: Pay attention to the prescribed interest rate, especially when transferring assets to a spouse or related minor child, to avoid unfavorable tax implications.
- Market Value: Avoid selling below market value as can lead to double taxation, professional property evaluation and record-keeping are essential.
- First-Time Homebuyer Benefits: Heirs who qualify as first-time homebuyers can benefit from tax credits and tax-free RRSP and FHSA withdrawals for property purchase which they intend to occupy within one year.
- Capital Gain Reserve: Explore the option of distributing capital gains over 5 years to potentially reduce tax rates and impacts on old age security income.
- Principal Residence: This strategy applies to properties other than your principal residence; remember that capital gains on principal residences are generally tax-free in Canada.
- Consult Professionals: It is highly recommended to consult with a tax advisor and notary before proceeding, as individual circumstances may vary.
The basis
The approach begins by transferring ownership of your investment properties to your heirs, with some specific considerations and advice customized to your circumstances, which are outlined in the following sections. However, it’s important to note that if your heir is your spouse, this strategy is not recommended. Investment properties can enjoy tax-free rollovers to spouses, similar to RRSP (Registered Retirement Savings Plan) accounts.
While the precise results of this approach may vary depending on individual circumstances, it consistently achieves two primary objectives: Firstly, it freezes the taxable capital gains at the present market value of your investment property, offering tax deferral for any subsequent appreciation in value to your heirs. Secondly, it also presents both you and your heirs with advantageous prospects for tax and liquidity planning that may not be accessible in the event of a passing.
Mutation tax
Mutation tax should always be researched and taken into consideration. It is a significant factor in this strategy as it will most of the time be a huge cost to your heirs. Fortunately, most cities provide a mutation tax exemption when the buyers are family members. You can research online to see if your city has this rule. For example, The city of Montreal provides this page which gives details on this exemption.
Are your heirs unable to provide the funds?
Several options are available for assisting them. Two of the most common approaches are co-signing a mortgage or lending them the necessary funds. Co-signing a mortgage offers the advantage of immediate access to the funds from your property sale.
If you opt for lending them the money, it’s essential to apply, at the very least, the prescribed interest rate. You can workout a repayment plan that suits both you and your heirs. The interest will be subject to taxation on your end while serving as a deductible against their investment property income. It’s crucial to ensure that the interest is paid before January 30th each year. Moreover, providing them with a loan doesn’t necessarily require you to have the cash readily available. Instead, the investment property can be transferred to them in exchange for a promissory note, eliminating the need for immediate cash disbursement on your part.
An interest-only loan can be an attractive choice if you’re not concerned about receiving the proceeds from selling your property. Upon your passing, this loan may be forgiven without incurring taxes. However, it’s crucial to be aware that the loan may not be forgiven while you’re alive, which could lead to unfavorable tax implications.
Attribution rules
In the earlier section, I highlighted the importance of ensuring that a loan carries at least the prescribed interest rate, this is particularly true when the recipient of your inheritance is your spouse or a closely related minor child. As mentioned previously, I advise against employing this strategy for estate planning with your spouse. However, if you choose to do so with a related minor child and the loan bears interest at a rate lower than the prescribed one, the investment property’s income may be reattributed to you, which may not align with your tax planning objectives.
Market value
In Canada, selling an investment property for less than its market value is strongly discouraged, as it can lead to double taxation. While I won’t delve into the intricate details here, the essence of the issue is that the cost for your heirs will stay at what they paid, but your proceeds will be adjusted to match the market value. To prevent this, it’s advisable to have your property professionally evaluated and maintain a record of its value at the time of sale. In Canada, transferring the property as a gift is possible but could potentially hinder your ability to employ the capital gain reserve strategy and may also expose you to the attribution rules.
First time home buyer
If your heirs qualify as a first-time homebuyers or them or their spouse have not resided in a property they owned in the past four years, they can take advantage of the first-time homebuyer’s tax credit. Furthermore, as a first-time homebuyer, they have the opportunity to withdraw up to $35,000 from their RRSP (Registered Retirement Savings Plan) account under the Home Buyers’ Plan (HBP) and the full balance of their FHSA (First-Time Homebuyer’s Savings Account) without facing any tax consequences.
If the required amount isn’t already present in their RRSP, they have the flexibility since they can control the timing, unlike a standard property purchase, to contribute the desired sum (up to $35,000) to their RRSP account, wait for a 90-day period, and then proceed with the transaction and withdrawal in accordance with the HBP regulations. They can also employ the same strategy with their FHSA, with the distinction that it doesn’t necessitate a 90-day waiting period and does not necessitate re-contributions over the span of 15 years. This approach allows them to benefit from income deductions in the purchase year while ensuring that the withdrawal remains tax-free. In cases where the funds aren’t readily available, it might make sense to consider borrowing the necessary amount to enable these contributions.
A caveat for this section is that, at the time of purchase, your heir must have the intention to occupy the property within one year in order to be eligible for tax credits and withdrawals from the tax-free accounts.
Capital gain reserve
One specific strategy you can employ involves having your heirs make five equal payments to you over the course of five years. By doing this, you can effectively establish a capital gain reserve and distribute it equally over those five years. The outcome of this approach is a potential reduction in the tax rate applied to your capital gain. This is because your income over the five-year period may fall within a lower tax bracket compared to if the entire gain was realized in a single year. If you decide to provide your heirs with a promissory note for the payment, you can coordinate with your notary and financial planner to structure the note’s repayment over a five-year period (or more) to also benefit from the capital gain reserve. This strategy can mitigate the effect on your old age security income, as detailed further in this article.
Why do this in retirement or in years where your taxable income is lower?
During your retirement, your annual taxable income is likely to be lower compared to your working years. Given Canada’s progressive tax system, the taxes you’ll owe on the capital gains from selling your investment properties will be reduced if you do so in years when your income is lower. Nonetheless, I advise implementing this strategy before reaching the age of 65; refer to the next section for an explanation of why.
Old age security recovery tax
If you decide to implement this strategy at the age of 65 or older (or while you are earning old age security between 60 and 65), it’s crucial to perform some calculations to ensure that your taxable income for the year where you realize the capital gain does not surpass the old age security income threshold. If it does, you’ll be required to reimburse the government for part or all of your old age security income. In most instances, this situation is likely to arise. It’s worth noting that in Canada, the current inclusion rate for capital gains is 50%, you should only consider this portion when estimating your taxable income for the year. If you’ve already started receiving old age security, the section about capital gain reserve within this article may help alleviate the impact.
A note on principal residence
This strategy is applicable to investment properties or any other property that isn’t considered your principal residence. Keep in mind that in Canada, capital gains on principal residences are not taxable, rendering this strategy irrelevant for such properties. If you reside in a multi-dwelling property that you own, the capital gain portion related to your principal residence won’t be subject to taxation. However, for the remaining part of the property, capital gains will be taxable. It’s important to remember that in this scenario, if the entire property is sold, your portion may no longer qualify as principal residence and any future appreciation in value will become taxable. It is advisable in this situation to only sell a portion of the property to your heirs.
Conclusion
As previously noted, I consider the strategy we’ve discussed – the transfer of your investment properties to your heirs, along with the associated considerations and additional guidance – to be a simple and cost-effective approach. This assessment is based on the absence of the need to establish complex tax structures such as trusts, which could substantially raise expenses due to obligatory annual reporting, consultations with specialists, and additional costs upon your passing. However, I strongly urge you to seek advice from both a tax advisor and a notary before proceeding with any financial transactions, as your individual circumstances may not align with the strategies discussed earlier. Furthermore, this article provides an overview of common tax planning strategies applicable in typical scenarios and may not encompass all the facets of tax planning that could be tailored to your unique financial circumstances.
Relevant references:
- Montreal – Exemptions on property transfer duties: https://montreal.ca/en/articles/exemptions-property-transfer-duties-9268
- Canada – Prescribed interest rates: https://www.canada.ca/en/revenue-agency/services/tax/prescribed-interest-rates.html
- Canada – Claiming a capital gain reserve: https://www.canada.ca/en/revenue-agency/services/tax/individuals/topics/about-your-tax-return/tax-return/completing-a-tax-return/personal-income/line-12700-capital-gains/what-happens-you-have-a-capital-gain/claiming-a-capital-gains-reserve.html
- Canada – Old Age Security pension recovery tax: https://www.canada.ca/en/services/benefits/publicpensions/cpp/old-age-security/recovery-tax.html
- Canada – Principal residence and other real estate: https://www.canada.ca/en/revenue-agency/services/tax/individuals/topics/about-your-tax-return/tax-return/completing-a-tax-return/personal-income/line-12700-capital-gains/principal-residence-other-real-estate.html
- Canada – What is the Home Buyers’ Plan (HBP)?: https://www.canada.ca/en/revenue-agency/services/tax/individuals/topics/rrsps-related-plans/what-home-buyers-plan.html
- Canada – First Home Savings Account (FHSA): https://www.canada.ca/en/revenue-agency/services/tax/individuals/topics/first-home-savings-account.html
