Don’t fool with the taxman when transferring your cottage
By Tim Cestnick
Last week I took my son, Win, to Dairy Queen on his eighth birthday. He was half-way through his ice cream when he said: “Dad, people who have a plastic leg have to be careful not to eat too much ice cream – it can hurt them.” Now, I’m no expert on prosthetic limbs. But I had to believe there was a flaw in Win’s thinking. “What makes you think that?” I asked. “Well,” he continued, “I read it in a book at school.”
“So, what happens if they eat too much ice cream” I wondered.
“I don’t know,” he replied, “library time was over and I didn’t finish reading the book.”
Some things sound so crazy you have to wonder whether they’re true.
Tax can be like that sometimes. For example, what if I told you that your kids could live to regret the day you decide to be generous to them by selling them the cottage at a bargain price?
What child would pass up that opportunity? Maybe yours. Consider Jack’s story.
The law Jack visited me to ask about a deal he was about to make with his kids. Jack owns a cottage worth $500,000, for which he paid $100,000. He’d like to transfer the property to them for a price. In his generosity Jack suggested $100,000. Jack had the legal documents drafted, then visited me – just in time for me to stop him.
You see, if Jack sells the cottage to his kids for $100,000, paragraph 69(1)(b) of Canadian tax law will deem Jack to have received fair market value ($500,000) for the property just the same. So, Jack may pay tax as though he sold it for $500,000. On the flip side, the kids will have an adjusted cost base (ACB) in the property equal to what they pay for it – just $100,000. This gives rise to a double-tax problem.
How so? If the kids were to sell the property for its true value of $500,000 after buying it from Jack for $100,000, the kids could pay tax on the $400,000 capital gain.
But Jack will have already paid tax on that $400,000 value because he will be deemed to have sold the property for $500,000 to the kids. Any time you sell an asset at a price below fair market value to someone who does not deal at arm’s-length to you, you’ll be deemed to have sold the asset at fair market value. But that person’s ACB will be the actual bargain purchase price.
The result is a double-tax problem.
The solution A better solution in Jack’s situation is for Jack to sell the property to his kids at fair market value. Now, if he doesn’t care to collect the $500,000 from them, he can take back a promissory note instead of cash. Jack can then collect any portion of that note – or not – as he sees fit. Jack can forgive any unpaid portion of the note at the time of his death with no adverse tax consequences. In this case, Jack is still considered to have sold the cottage for $500,000, but his kids will have an ACB of $500,000, avoiding the double-tax problem.
Finally, Jack could defer tax on his capital gain by structuring the note so that he cannot demand payment over a period of less than five years.
This will allow him to spread the tax on his capital gain over a period as long as five years. Alternatively, he could avoid tax altogether by designating the cottage as his principal residence. Speak to a tax pro to do these things properly.
(As for prosthetics and ice cream? I think the two are compatible. No need to see your tax professional about that one.)