It’s that time of year again, to settle accounts with the tax man and consider how a little foresight and strategy can not only ease the impact on your pocket book, but also pre-empt family discord down the road.
I am talking about estate planning for the disposition of a property that is not your primary residence. It could be an investment property or it could be the family cottage. There are the capital gains issues to consider, but just as important are the family dynamics that can come into play.
The tax burden
First, are the capital gains taxes, which can be punishing.
Take, for example, a property that you purchased for $50,000. Today, at fair market value, that property sells for $150,000. If you sell at that price, half of that $100,000 in appreciation – $50,000 – is treated, and taxed, as income for the current tax year. And depending on your base net income, a very large percentage of the sale proceeds could very well be taxed at the maximum federal tax rates of 26 and 29 per cent, plus whatever your province of residence adds to that.
The financial impact can be further compounded if you have in past years deducted any depreciation on the property from your ordinary income. Say, for example, that you took a total of $15,000 in depreciation on that property you purchased for $50,000. If you then sell for $150,000, your gain for capital gains purposes is now considered to be $115,000, not $100,000. This means $57,500 will now be added to your taxable income for the current tax year, instead of just $50,000. This is called recapture of depreciation.
The family burden
I realize that I may be restating the obvious to this audience, but what I often find is that people fail to appreciate the most disruptive, and even destructive, variable in this scenario – the relationships with family. You can find any number of resources on estate planning strategies, from the banks to the Canada Revenue Agency website, to offset and or defer the capital gains burden. These include:
• Taking advantage of downturns in the market to transfer the asset into a living trust when its market value is low, thereby reducing the amount of capital gains.
• Selling the property to an heir and taking back a demand mortgage with deferred payments, which can spread the capital gains payable over five years.
• If you have taken depreciation, begin paying that back in installments when it is most convenient for you to do so.
But most of this sage advice and technical know-how fails to address the human side of the equation.
I was once involved with a file where four children were left a cottage property. The capital gains arising from the disposition of the property by the parents were not the issue. The issue was the fact that the property was valuable. One of the children had no interest in maintaining ownership – they just wanted their 25-per-cent share of that value.
The other three children didn’t want to sell, but they didn’t have the money to buy the other out, either. The situation deteriorated to the point where the one sibling was ready to pursue legal action to have the courts order a sale.
Who was right and who is wrong is not the issue in this kind of situation. Regardless of the outcome, a serious rift will be left in the family.
Joint ownership also becomes untenable when it passes unto the third generation. Instead of having a few children sharing ownership, there are now a horde of grandchildren. Such a scenario can quickly become a nightmare.
The best option may be to simply sell the property outright, or pass it on to only one child. The challenge with the latter option is then being able to provide some kind of compensation to the other beneficiaries so they feel that they have been fairly treated and won’t harbour resentment. If this isn’t possible, the only fair option, again, is to sell the property to an arm’s length third party.
Those capital gains lurk everywhere
Beneficiaries with shares in a business face the same tax issues if the values of those shares have appreciated. And the same decisions must be made between selling to a third party or in some way transferring ownership to their heirs.
Many people attempt to dodge the bullet by holding on to their assets rather than selling and leaving the problem to their estates. An alternative is to sit down with the right advisor who can yield workable solutions to mitigate the short-term tax hit.
But in many cases, there is a very real risk that, if you dispose of a property, the capital gains taxes will slice off so much value that what you’re left with to reinvest cannot produce as much investment income as you had before you sold.
But the disposition of assets can’t be put off indefinitely. Death will eventually catch up with you and if you haven’t planned appropriately, it is your estate, and your heirs, who will suffer for it.
To discuss this or any other valuation topic in the context of your property, please contact me at email@example.com. I am also interested in your feedback and suggestions for future articles.