There are a few things to keep in mind if you’re plan­ning to give the cot­tage to your kids, Tim Cest­nick writes

The Globe and Mail (Alberta Edition) - - SPORTS - TIM CEST­NICK FCPA, FCA, CPA(IL), CFP, TEP, au­thor and co-founder and CEO of Our Fam­ily Of­fice Inc. Tim Cest­nick He can be reached at tim@our­fam­i­ly­of­fice.ca.

Un­less you plan your strat­egy, cap­i­tal gains could bump you into a higher tax bracket

The Vic­to­ria Day week­end has arrived, and for many Cana­di­ans, this means a trip to the cot­tage to en­joy the place – and per­form some main­te­nance. My neigh­bour, Wal­ter, is head­ing to his cot­tage in Muskoka to spend some time with his kids and grand­chil­dren. Last year, his big main­te­nance project was to get rid of the old out­house on the prop­erty. Ev­ery­thing went well until, later that evening in the dark, his grand­son fell into the hole be­fore it could be filled in. It was a crappy ex­pe­ri­ence for sure.

This week­end, Wal­ter is go­ing to un­veil a plan to trans­fer the cot­tage to his kids this sum­mer. Wal­ter is a wid­ower, he’s 78 years old, and wants to see the kids en­joy own­er­ship of the cot­tage now. We talked about a few things he should keep in mind as he plans to give the kids the cot­tage. Here’s the gist of the con­ver­sa­tion we had.

THE TAX RULES

Any time you trans­fer an as­set to some­one other than your spouse, you’ll be deemed to have sold it at fair mar­ket value. The re­sult? You could face a tax­able cap­i­tal gain if the as­set has ap­pre­ci­ated in value. When Wal­ter bought his cot­tage in 1985, he paid $120,000. He’s added about $80,000 of cap­i­tal im­prove­ments over time, so his cost amount for tax pur­poses is $200,000. To­day, the cot­tage is worth $700,000. So, if he gifts the prop­erty to his kids, he’ll trig­ger a $500,000 cap­i­tal gain. The tax bill on this could be $130,500 since re­port­ing this gain will push him into the high­est tax bracket in On­tario.

THE STRAT­EGY

To elim­i­nate the tax on the trans­fer, Wal­ter should con­sider us­ing his prin­ci­pal res­i­dence ex­emp­tion (PRE) to shel­ter the gain on the cot­tage from tax. If he does this, he won’t be able to des­ig­nate his city home as his prin­ci­pal res­i­dence for the same years, so he could end up pay­ing some tax on the city home.

In Wal­ter’s case, he wants to save his PRE for his city home (it has the big­ger gain per year of own­er­ship; but speak to a tax pro be­fore de­cid­ing which prop­erty to shel­ter with the PRE). So, I sug­gested an­other idea to re­duce the tax bill on the cot­tage: He could take ad­van­tage of the “cap­i­tal gains re­serve” in our tax law. This pro­vi­sion al­lows you to re­port a tax­able cap­i­tal gain over a pe­riod as long as five years. Sure, he’d still pay tax, but re­port­ing the gain over five years al­lows him to keep that money in his pocket longer.

Fur­ther, in his case, re­port­ing the gain over five years also re­sults in a reduction of the over­all tax bill be­cause the amount of the cap­i­tal gain re­ported each year will not push him into the high­est tax bracket in any of those years, whereas re­port­ing the cap­i­tal gain in 2018 alone would do just that. In his case, Wal­ter would save $10,575 in taxes by spread­ing the tax bill over five years.

How can he take ad­van­tage of the cap­i­tal gains re­serve? He’ll need to struc­ture the trans­fer of the cot­tage as a sale at fair mar­ket value, not a gift. Fur­ther, he’ll have to en­sure that he doesn’t have a le­gal right to the sale pro­ceeds im­me­di­ately (oth­er­wise he’ll pay tax this year, the year of sale), but set this up so that he has a right to the pro­ceeds only over the next five years – or longer.

So, Wal­ter could sell the prop­erty for its value of $700,000 to the kids and take back a prom­is­sory note for that amount. The terms of the note will give him a right to de­mand pay­ment of one­fifth of the sale pro­ceeds each year for the next five years.

Wal­ter doesn’t have to ac­tu­ally de­mand pay­ment (so the kids don’t have to come up with the money to pay him if he so chooses), but he’ll pay tax over five years even if he doesn’t de­mand pay­ment or col­lect the sale pro­ceeds (five years is the long­est our tax law will al­low the re­serve to be claimed).

Rather than tak­ing back a prom­is­sory note, Wal­ter could set up a mort­gage on the prop­erty, which en­sures that, if any of his kids’ mar­riages break up, he could call for pay­ment on the mort­gage. This could help to pro­tect the cot­tage from be­com­ing an as­set that dis­ap­pears through a di­vorce.

Fur­ther, Wal­ter can for­give the prom­is­sory note or mort­gage upon his death, with no tax con­se­quences to his kids.

ISTOCK

Lots of Cana­di­ans will spend the Vic­to­ria Day week­end open­ing up their sum­mer va­ca­tion homes. For those who want to pass those prop­er­ties on to their kids, tax plan­ning is es­sen­tial.

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