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By Julie Cazzin with Allan Norman
Q: My parents own real estate and would like to give two of their rental properties (a condo and a townhouse) to me. Is there a way of setting up a trust to transfer rental property without tax implications? I read about a common estate-planning strategy where you can do an estate freeze with a discretionary family trust, which locks in the current value of an investment portfolio or a business. I also read there are tax-deferral benefits. Is this true? And what would the benefits be? — Thanks, Lisa B.
FP Answers: Lisa, as I’m sure you know, it’s easy for your parents to leave you two of their rental properties through their will. The challenge is how to do it effectively in a way that minimizes the tax and ensures you actually receive the properties.
Capital gains tax accrues over time as the rental properties grow in value above the adjusted cost base (ACB). The tax owing is based on the difference between the ACB and the fair market value, or selling price, and is triggered when a property is sold or there is a deemed disposition that can occur on death.
As a reminder, only 50 per cent of a capital gain is taxable and 50 per cent of the gain is tax free. For example, on a $100,000 capital gain, only $50,000 is taxable based on the combination of all your annual taxable income.
An Ontario resident with a top tax rate of 53.53 per cent would pay $26,765 in tax on a $100,000 capital gain. Keep this number in mind as you think about what you are trying to accomplish with an estate freeze or trust.
Additional tax may also come about due to something called recapture. In a nutshell, owners of rental property can claim a capital cost allowance and deduct building depreciation of up to four per cent annually against their income. At the time of sale or deemed disposition, if the property hasn’t depreciated at the rate claimed, there is recapture and additional tax is owed.
There is also probate, which varies province by province. In Ontario, there is no probate on the first $50,000 of estate value, but $1.50 on every dollar above $50,000, so the probate would be $15,000 on a rental property worth $1 million.
Those are the major tax issues when transferring a rental property from one generation to the next. But the next question is where does the money come from to pay the tax?
If all the assets are in real estate, there would be no money in the estate to pay the tax, leaving the executors to come up with the money. This sometimes occurs when life insurance is used or a building is sold to come up with the cash to pay the tax.
Lisa, you have recognized these issues and you’re now wondering if an estate freeze or moving the properties to a trust will help with the transfer and minimize tax.
Typically, an estate freeze is associated with a corporation or holding company, and parents exchange their common shares for preferred shares. This effectively caps the capital gain on their share ownership and the future growth of the company lies with the children, the common shareholders.
The tax deferral you questioned comes about because the tax on the future gain is not realized until the children pass or sell their shares. You can’t defer the capital gain your parents have currently accrued past their deaths.
How does an estate freeze help you? It may not. Are your parents’ properties already in a corporation? If not, they’d have to set up a corporation and issue shares, which means legal and accounting fees — initial and ongoing. Plus, income from rental properties held in the corporation is considered passive income and is taxed at a rate of about 50 per cent, depending on the province.
Fees are often ignored when conceptualizing strategies such as this, but should be weighed against the cost of the problem being solved. If annual accounting fees are about $3,000 per year and if your parents live another 20 years, that is $60,000, not accounting for inflation and other associated fees, your time and an extra layer of complication. Have you projected the estimated future capital gain on the properties and know the size of the problem?
You will also want to consider your plans for the rentals once your parents pass: keep them or sell them? If you sell, what is your plan to get the money out of the corporation in a tax-efficient way?
What about transferring the properties into a joint partner trust, which can be done without generating tax? Of the tax issues discussed, it is only probate that will be minimized since the capital gains tax will still have to be paid on the passing of your parents. Plus, you will have legal and accounting costs, and the income earned in the trust will be taxed at the highest marginal rate of your province.
Can my dad draw up a will on his death bed? And if so, how?
What is the best way to split RRIF income to get the $2,000 tax credit?
Lisa, I don’t want to give the impression that neither of these ideas will work. They may, but I don’t have enough details to say. The issue you may be facing is likely best solved with the combined effort of a lawyer, accountant and a financial planner. I think it is great that you are thinking the way you are. Start with the big picture concepts to get the ideas flowing, and then slow down and think them through.
Allan Norman provides fee-only certified financial planning services through Atlantis Financial Inc. and provides investment advisory services through Aligned Capital Partners Inc., which is regulated by the Investment Industry Regulatory Organization of Canada (IIROC.ca). Allan can be reached at [email protected]