My name is Mark Goodfield. Welcome to The Blunt Bean Counter ™, a blog that shares my thoughts on income taxes, finance and the psychology of money. I am a tax partner and the managing partner of Cunningham LLP in Toronto. This blog is meant for everyone, but in particular for high net worth individuals and owners of private corporations. The views and opinions expressed in this blog do not reflect the position of Cunningham LLP. My posts are blunt, opinionated and even have a twist of humor/sarcasm. You've been warned.

Monday, September 29, 2014

Best Tax Blog! It's Bean Four Years in the Making

On September 20th, I was honoured to win the 5th Annual Plutus Award for the Best Tax Blog (after being a nominee the last two years). This is a prestigious American-based award ceremony celebrating the best in the personal finance blogosphere; winning the Plutus essentially means I won for the best tax blog in Canada and the United States.

Awards are subjective and there are several excellent tax blogs out there. Nevertheless, it was satisfying to win, for three reasons:

1) The award is selected by my blogging peers.

2) As a former jock, I am competitive and like to win anything.

3) The awards were held on the fourth anniversary of my blog which started on September 20, 2010. How, coincidental is that?

Today’s post is number 350! That is a lot of posts when you consider the technical nature of many of my topics, and the fact that I tend to write long blogs, despite advice to the contrary. I cannot believe I have been blogging for four years and have approximately 1,200,000 page reads.

I have no idea how many more blogs I have in me. I would have expected to have exhausted my material by now, but somehow, I seem to keep coming up with topics (although I do now occasionally have variations on topics previously covered).

I am often asked where I find the time to write, and how do I keep coming up with new ideas for my blogs? To be honest, I am lucky. Writing The Blunt Bean Counter does take several hours a week, but I am fortunate that I can hear something in a conversation, discuss an issue with a client, and a blog jumps out at me, and I can write it in quick order. I know for many, writing is a tortuous process.

So why am I still doing this? There are probably four reasons:

1. I enjoy educating people on tax and financial matters, while being provided the forum to voice my opinion.

2. I have met many interesting people through my blog both directly and indirectly.

3. Several readers have engaged me to be their corporate or estate accountant (unfortunately, due to my workload, I cannot take on personal tax clients anymore and have respectively turned down numerous requests).

4. The blog has given me and my firm, Cunningham LLP, visibility and credibility. I would never have imagined when I wrote my first post and two people read it (my mom and someone by accident), how much attention it would garner.

There is a fifth reason. The tax blog groupies, but shush, I don’t want my wife to know that one.

I am fortunate to have several long-time readers who offer encouragement via comments on the blog or by email, and once in a while, constructive criticism. I have had many people approach me at various functions to introduce themselves to me as readers, which I still find mildly amusing. I am often told they like my blog because I break down complex topics into somewhat understandable blog posts (you can thank my wife, who constantly tells me to write in “plain English”) and that I have a bit of a personality in my posts. But that comment is always prefaced with “for an accountant”.

The only downside to this blog is that some people think because I write a blog they can call or email me with the most complex situations, and I will provide them free tax advice. I do try and answer almost all questions posted to the comments section on my blog; although, I often provide the caveat that I “do not provide specific personal or corporate tax planning advice on this blog”. I do however, try and point the questioner in the right direction, without providing a direct answer to their fact specific question.

So where am I today? I started working on a book a couple of years ago (it is not really a tax book, but more a financial and money matter book), but I just do not have the time to get it done and am not sure I ever will. Thus, I changed gears a few months back and started putting together a Best of The Blunt Bean Counter book. In my humble opinion, it is actually not a bad read with a nice flow when my blogs are grouped together by topic area. The book is strictly being done for business promotion purposes, and I do not expect to make enough money to even buy a new suit from it.

I have a few other interesting things happening and some ideas for the future of the blog, but I will discuss those at a later date.

To circle back to my Plutus Award, I would like to thank my readers who encourage me to keep writing and the numerous financial bloggers, guest bloggers, writers, and journalists, who have helped me to achieve this level of recognition.

The blogs posted on The Blunt Bean Counter provide information of a general nature. These posts should not be considered specific advice; as each reader's personal financial situation is unique and fact specific. Please contact a professional advisor prior to implementing or acting upon any of the information contained in one of the blogs.

Monday, September 22, 2014

Corporate Small Business Owners: Beware; the Capital Gains Exemption is not a Gimme

One of the biggest misconceptions small business owners have is that they have automatic access to the $800,000 capital gains exemption (“CGE”) upon the sale of the shares of their corporations (Note: beginning in 2015, the $800,000 will be indexed for inflation). Nothing can be further from the truth. There are three complex tests that must be met in order to qualify for the exemption and something as innocuous as imposing a holding company (with significant cash and investment assets) between you and your operating company may disqualify the shares.

Warning!!! Before I move forward, please note that I am “dumbing down this post”. You may think it complex, but I am leaving out significant issues, definitions and details to make it somewhat readable. Do not rely upon this blog for your capital gains planning, use it only to gain an understanding of the issues and please contact your tax advisor before undertaking any planning discussed in this post. In fact, to emphasize the complexity of this issue and how intricate and fact related the planning is, I will not answer questions and respond to comments on this post. Sorry about that.

The Capital Gains Exemption


In order to access the CGE, the shares you sell must meet the definition of a "qualified small business corporation share” (“QSBC shares”). Sounds simple, but this provision and the related provisions often prove to be a tax quagmire for many practitioners.

The shares must meet three tests to be considered QSBC shares and become eligible for the CGE.

Small Business Corporation Test


At the time you sell your shares, they must be shares of a Small Business Corporation (“SBC”). A SBC, amongst other criteria, must be a Canadian-controlled private corporation whereby all or substantially all (meaning 90% or greater) of the fair market value (“FMV”) of the assets of which at that time is attributable to assets that are used principally in an active business carried on primarily in Canada.

In plain English: at the time of the sale, the company must be using a minimum of 90% of its assets in carrying on an active business in Canada. In other words, if you have more than 10% of the FMV of your corporation in passive assets such as cash, stocks, rental real estate, you may be offside the rule.

It is important to note that the Goodwill (which is often the largest asset) of a business will count as an asset used in an active business. However, generally cash, portfolio investments and intercompany loans will not qualify as active assets.

Holding Period Ownership Test


This test requires that the shares cannot have been owned by anyone other than the individual or a person or partnership related to the individual, throughout the 24 months immediately preceding the disposition time. The two year test is very confusing. It is a rule that at its core is intended to prevent anyone not related to you from holding the shares within the last two years. However, on one hand the 24 month rule provides for exceptions such as if you transfer a proprietorship or partnership to a corporation, yet if you incorporate a new company and hold the shares less than 24 months, you will be disqualified.

In plain English: in most cases you will be required to have held the shares two years prior to the sale.

Holding Period Asset Test


If you thought the above rules were complicated, this test makes the other rules seem simple.

This test requires that throughout the 24 months immediately preceding the sale, more than 50% of the FMV of the corporation's assets must have been attributable to assets used in an active business. For this purpose, assets considered to be used in an active business consist of:

1) Assets used principally in an active business carried on primarily in Canada by the corporation or a related corporation;

2) Certain shares or debt of connected corporations; and

3) A combination of active business assets or certain shares or debt of connected corporations

In plain English: at least 50% of the company’s assets must have been used in an active business throughout the two-year period prior to sale.

Where you have a holding company ("Holdco") or stacked companies (Holdcos owning Holdcos) ultimately owning the shares of an operating company, the threshold percentage for meeting the Holding Period Asset Test may become 90% instead of 50%. These rules are far too complicated to discuss, suffice to say, if you have a chain of companies, at least one of the companies in the chain must meet the 90% threshold percentage over the two-year period.

As you can see, the CGE is no gimme. You need to ensure you hold the shares 24 months, at the time of sale 90% of the assets are used in an active business and over the prior 24 months, 50% (in some case 90%) of the FMV of the assets were used in an active business.

Traps and Obstacles


Holding Companies


Many small business owners utilize a Holdco for creditor proofing, which is often recommended. However, over years the Holdco may end up owning substantial investment assets. These assets may be problematic for the following reasons:

1. Since Holdco owns your operating company ("Opco"), you have to sell your holding company shares to a buyer to qualify for the CGE and if you have substantial assets, you need to remove them prior to a sale. This may trigger a substantial tax liability and/or cause the shares to fall offside the QSBC rules.

2. Many people use their Holdco to hold the shares of other corporations. This is very problematic when you want to sell your shares of Company A, but your Holdco not only owns Company A, but also owns shares of Company B and Company C. How do you get the shares of Company B and C out of your Holdco prior to the sale? The answer is - not easily.

As I have written in prior blogs, I often suggest rather than automatically interposing a Holdco between you and your Opco, you may wish to consider using a family trust with a corporate beneficiary (a Holdco typically owned by you). Thus, instead of the cash being plugged up in your Holdco and potentially putting you offside the QSBC rules, your Opco pays a dividend of the excess cash to your family trust which in turn allocates a tax-free dividend (in most cases) to the holding company beneficiary of the family trust.

This is a very subtle point, but now instead of having the dual problem of your Holdco company potentially having too many investment assets and/or you needing to sell your Holdco shares to access the capital gains exemption, you can now just sell the Opco shares, as the operating company is owned by the trust. The Holdco company even if it has accumulated substantial assets, is not part of the three CGE tests as it has no direct interest in the company being sold.

Safe Income


I have no desire to get into this complicated issue. However, where a Holdco or Opco has other assets such as excess cash, shares in other corporations or real estate that a purchaser does not require, it is often necessary to transfer these assets out of Opco or Holdco (known as purification). This is often done by cross share redemptions that result in dividends. All you need to know for purposes of this post is that if an operating company pays a dividend to another corporation in contemplation of a sale and the dividend exceeds the recipient’s proportionate share of safe income (in very simple terms, retained earnings of the dividend payer) the excess portion becomes a taxable capital gain. This can be very problematic when you are trying to purify your corporation of excess assets prior to the sale to qualify for the CGE and you definitely require your tax advisor's assistance.

Cumulative Net Investment Loss


The Cumulative Net Investment Loss (“CNIL”) account tracks an individual’s net historical investment income. Essentially it is the sum of your investment income, such as interest and dividends, less investment expenses such as interest expense, carrying charges, losses from limited partnerships and resource deductions from flow-through shares. If the cumulative balance is negative, this balance restricts access to the CGE. The negative balance can in many circumstances be eliminated by having your company pay you a dividend prior to any sale, subject to the safe income rules noted above.

Allowable Business Investment Losses


An Allowable Business Investment Loss (“ABIL”) typically results from capital losses on shares and debt in private Canadian corporations. If an individual has realized an ABIL in a prior year, it will reduce his or her CGE available to claim. Thus, you need to confirm if you have ever made such a claim prior to utilizing your CGE.

Insufficient Dividends


This issue is way beyond the scope of this article, however, where it is reasonable to conclude that a significant portion of the gain is attributable to the fact that a minimum amount of dividends has not been paid annually on any class of shares in the corporation, other than classes of "prescribed shares”, the CGE can also be restricted. Ask your accountant if this is an issue for you.

Planning


Prudent planning would suggest that you and your advisor consider these rules far in advance of any potential sale, so you can monitor whether your corporation is onside the rules. Where the corporation falls offside you can “purify” the corporation of any offending assets. Purification should be ongoing, because if you have to purify at the last minute, there is a good chance you will not meet the various criteria to qualify for the exemption.

If you are still with me, I am sure you will agree that you should never assume your corporation’s shares will qualify for the CGE. The morass of rules requires you and your advisors to carefully navigate the rules to ensure your shares will qualify when you decide to sell your corporation.

The blogs posted on The Blunt Bean Counter provide information of a general nature. These posts should not be considered specific advice; as each reader's personal financial situation is unique and fact specific. Please contact a professional advisor prior to implementing or acting upon any of the information contained in one of the blogs.

Monday, September 15, 2014

Form T1135 – Permanent Changes for 2014 and Beyond

Last year I wrote several times about the onerous requirements proposed by the Canada Revenue Agency (“CRA”) in respect of Foreign Reporting and the related Form T1135, for taxpayers that held foreign investments with a cost of $100,000 or more. The proposed changes caused a huge compliance issue for financial institutions, accountants and taxpayers alike. As a result, the CRA eased its initial requirements and announced in late February, 2014, that for the 2013 tax year only, taxpayers could elect to report based on much less strict “transitional rules”.  

After further consultations with external stakeholders, the CRA announced that it has implemented several permanent changes to Form T1135 for the 2014 and later tax years. For the typical Canadian investor who holds foreign stocks, bonds and funds with Canadian institutions, these changes will simplify life substantially from the initial proposals. For those Canadians who own stocks, real estate, etc. outside Canada, the rules remain arduous. The changes are detailed below:

  • Foreign property held in accounts of Canadian registered securities dealers or a Canadian trust company will have the option of reporting foreign property using the “aggregate reporting method”, whereby the aggregate value of all foreign property in an account is reported rather than reporting the details of each property. If this reporting method is chosen, all property held within a Canadian registered securities dealer or a Canadian trust company must be aggregated on a country-by-country basis. Aggregate totals for the income earned and the gains/losses realized from all dispositions in the tax year must still be reported on a country-by-country basis.

  •  For investments which qualify for reporting under the “aggregate reporting method”, the amounts to be reported, on a country-by-country basis, will be the total highest month-end fair market value for the year and the total fair market value at the end of the year. (This is pretty much what the transitional rule was for 2013).

  •  The 2013 transitional Form T1135 provided a reporting exclusion if the taxpayer received a T3 or T5 slip from a Canadian issuer in respect of a particular specified foreign property. For 2014 and thereafter, the T3 or T5 slip exclusion has been eliminated, therefore all income will have to be reported regardless of whether a T3 or T5 slip has been issued. Although this exclusion made things easy for some people in 2013, the fair market requirement allows you to basically just review your investment statements for 12 months and report the highest market value and then just report your December 31, 2014 market value. The only time consuming task will be to summarize your income earned and capital gains realized for the year. However, many institutions and investment managers will likely summarize all or most of this information for you.

The CRA only accepted the 2013 version of Form T1135 for the 2013 taxation year and the 2014 taxation year until July 31, 2014. The 2014 version of Form T1135 must now be used for 2014 and later tax years. Here is the new version of the T1135. For the "typical Canadian", you will only be concerned with category 7.

Options


I have been asked a couple times about the reporting of options for T1135 purposes. One of my tax managers spoke to a CRA representative and was told that all options (including sold cash secured puts, covered calls, bought and sold in-the-money calls) should be included on Form T1135 under “Category 6 – Other Property Outside Canada” as specified foreign property pursuant to subsection 233.3(1) - “a property that is convertible into, exchangeable for, or confers a right to acquire a property that is Specified Foreign Property”. The CRA representative noted that as of August 1, 2014, these amounts should be reported under the new Category 7 using the aggregate reporting method assuming that the options are held in an account with a Canadian registered securities dealer.

Finally, the CRA told us that the cost amount would be the acquisition cost of the option, and not the value of the stock exposure.(Please be advised this is telephone advice and the CRA, Cunningham LLP and myself make no representation as to its accuracy). 

The blogs posted on The Blunt Bean Counter provide information of a general nature. These posts should not be considered specific advice; as each reader's personal financial situation is unique and fact specific. Please contact a professional advisor prior to implementing or acting upon any of the information contained in one of the blogs.

Monday, September 8, 2014

Just Do It – Write Your Financial Story! What the Heck are You Waiting For?

I am back from my summer blogging sabbatical and I am cranky. Not because I worked on my golf game and it is only marginally better. Nope, I am cranky because you, my readers, are listening to my suggestions but you’re not following up on them.

So what am I ranting about? Let me tell you. I have written a number of times about ensuring you update or prepare a will, ensuring you have powers of attorney ("POA") for both your financial affairs and health, and have also posted a couple detailed blogs on stress testing your finances should you die suddenly.

I have been pleased that many readers, friends, and acquaintances have told me that these posts have been very helpful. I have been delighted when they inform me they intend to take action in getting their financial house in order, to ensure their spouse/partner can carry on somewhat seamlessly should they pass away.

The problem is when I see them and ask if they have followed through; the answers I get are either: (a) I have started or (b) it is on my list of things to do.

Even financial experts like Ellen Roseman procrastinate. As Ellen wrote in this article, it was her 2013 New Year’s resolution to put her financial house in order. However, six months later Ellen wrote she had made little progress in “writing her financial story”. When I saw Ellen several months later at the Canadian Bloggers Conference, she informed me she still had not completed her New Year’s resolution. I have not spoken to Ellen lately, so she may have completed her task, but it is more fun to use a financial expert as Exhibit A :).

Ellen is not alone. A friend of a friend who is a very sophisticated financial person has told me on three different occasions how useful my blogs on this topic were, but yet, each time I ask him about his progress, I get silence.

So how do we break this log jam? If you are the financially savvy spouse/partner (in most marriages/relationships, one spouse/partner tends to handle the finances and the other spouse/partner often pays little or no attention to the finances) how about asking your spouse/partner tonight at dinner if you were to die suddenly, would he/she know where your will is, what assets you have, where to find the insurance, any of the passwords to your financial accounts, etc.? I would suspect the answer is no (after they blame you for ruining their dinner). Now sit back and think for a minute… not only will your family be in mourning (unless they are hoverers), but consider the financial and emotional stress you will be putting your spouse/partner under as they attempt to untangle your financial web.

Getting Your Financial House in Order


There a four key components to getting your house in order.

1. Discuss – Sit down with your spouse/partner and discuss whether your will(s) reflect your current financial situation and life realities. Determine what awareness they have of your financial situation and how easily they/you could carry on if you/they passed away.

2. Dig – Go through all your financial documents and pull together information in respect of your bank accounts, insurance policies, investment accounts, assets, passwords, loans and LOCs etc.

3. Document – Document the above in one location, be it your safety deposit box, a safe or via one of the Internet vaults.

4. Update – Some of you may be sitting back smugly saying “I have done this already Mark”. However, this is an ongoing process. You need to update your financial story annually. I know this because I updated my list six months ago and recently noticed that five passwords had to be changed because sites were compromised, or I was required to change passwords. I also moved some assets around to new locations.

If I have not guilted you into action, I am not sure what else I can do. All other alternatives I can offer you allow you to procrastinate, so I am not sure they will help. Writing your financial story, as penned by Ellen, is vital. I truly urge you at minimum to update your will(s), ensure you have POAs and create a list of your financial assets, life insurance, passwords, etc. If you do not do this, your family may not only face a devastating loss if you were to pass away, but a financial nightmare.

The blogs posted on The Blunt Bean Counter provide information of a general nature. These posts should not be considered specific advice; as each reader's personal financial situation is unique and fact specific. Please contact a professional advisor prior to implementing or acting upon any of the information contained in one of the blogs. 

Plutus Award Nomination


I want to thank everyone who nominated me for a Plutus Award in the category of “Best Tax Blog”. This is the third year in a row I have been nominated as a finalist in this category and it’s about time a Canadian Tax Blog took the coveted Plutus Award away from my American counterparts. It would just continue the Tim Horton's/Burger King trend of Canadian tax being King:)

The other nominees are:

Tax Girl - Written by Kelly Phillips Erb of Forbes Magazine.
Joe Taxpayer - Written by an everyday Joe, who likes numbers.
TaxProfBlog - Edited/written by Paul L. Caron of Pepperdine University School of Law.
The Wandering Tax Pro -Written by 40 year tax preparer Robert Flack. Got to love this guy. On his site it says " Before contacting me with questions about how a blog post relates to your specific situation, please be aware that I do not give free tax advice to non-clients by e-mail, comment response, or phone. So don't waste your time". Now this guy should be called The Blunt Bean Counter!

Monday, September 1, 2014

The Best of The Blunt Bean Counter - Is it Morbid or Realistic to Plan for an Inheritance?

This summer I am posting the "best of" The Blunt Bean Counter while I work on my golf game. Today is my last re-post (where did the summer go?) and I selected a post on whether it is morbid or realistic to plan for an inheritance. I selected this post because it seems to polarize people. They either think it abhorrent to consider planning for an inheritance or don't understand why it is not practical financial planning.

I recently followed this post up with Inheriting Money - Are you a Loving Child, a Waiter or Hoverer, a post that discusses four types of behaviour by those who will inherit money.


Is it Morbid or Realistic to Plan for an Inheritance?


I have written several blog posts on estate planning and inheritances, including “Taking it to the Grave,” a blog I wrote for the Canadian Capitalist, in which I discuss whether parents should distribute future inheritances in part or in whole while they are alive and “How your Family Dynamic can affect your Estate Planning”  in which I discuss how parents have to navigate a minefield of family issues with respect to the determination of executors, the distribution of family heirlooms and the distribution of hard assets.

These blogs elicited a wide range of opinions and comments that I found fascinating. Some people believe they are better off because their parents made them work for everything and they don’t want any financial assistance from their parents either during their life or after they pass away. Others state that as long as parents are careful to ensure they don’t destroy their children’s motivation, partial inheritances make sense. Finally, others say they have been sickened as they observe children waiting at a parent’s deathbed salivating at the thought of their inheritance.

All this leads me to another very touchy subject; should a child (let’s assume the child is at least 40 years old) plan their own future based on a known or presumed inheritance? To add some perspective to this issue, it is interesting to note that a recent survey by the Investors Group states that 53% of Canadians are expecting an inheritance, with over 57% of those, expecting an inheritance greater than $100,000.

Inheritances can be categorized as either known or presumed inheritances. An inheritance would be categorized as known, when a parent(s) has/have discussed the contents of their will with their child(ren) or at least made known their intentions. In these cases, while the certainty of the inheritance in known, the quantum is subject to the vagaries of the parent(s) health, the parent(s) lifestyle, the income taxes due on the death of the last to survive parent and the economic conditions of the day. (Speaking of discussing the will with your children, it is very interesting to note that my blog post One Big Happy Family until we discuss the Will which had limited initial traction, is now by far and away the most read blog I have ever written).

An inheritance may be presumed where the financial circumstances of the family are obvious. A child cannot help but observe that the house their parents purchased 30 or 40 years ago for $25,000 is now worth $800,000 to $1,000,000, or that the cottage their family bought for $100,000 many years ago can be subdivided and is now worth $700,000.
Many average Canadian families have amassed significant net worth just by virtue of the gains on their real estate purchases. These families would not be considered wealthy based on lifestyle or income level, yet their legacy can have a significant impact upon their children. Inheritances are not only an issue for wealthy families.

I think most people will agree that where an inheritance will be so substantial that it will be life changing; parents need to downplay the inheritance issue and/or manage the inheritance by providing partial gifts during their lifetime. Rarely can a child become aware of a life-changing inheritance without losing motivation and experiencing a change in their philosophical outlook on life.

Although life changing inheritances are rare, life "affecting" inheritances are not. So, should children change how they live and how they plan for the future based on a known or presumed future inheritance? In my opinion, if the inheritance is known and will be substantial enough to alter a child’s current or future living standard, the answer is a lukewarm yes, subject to the various caveats I discuss below.

I think it is imprudent to ignore reality and where an inheritance has the attributes I note above, it should be considered as part of your future financial plan. However, I would discount the amount used for planning purposes significantly, to account for inherent risks. Those risks include the longevity of a parent, economic downturns that reduce your parent(s) yearly income stream,  potential medical costs and finally, the ultimate risk one takes in planning for an inheritance; the risk of somehow falling out of favour and being removed from your parent(s) will.

Where there is a presumed inheritance, I would suggest you need to be ultra conservative if you want to plan for the inheritance, since not only are you guessing at the inheritance amount, but you face an additional risk that your parent(s) may have offsetting liabilities such as a mortgage or line of credit of which you are unaware.

So what do the experts have to say on this matter? In the press release for the Investors Group survey, Christine Van Cauwenberghe, Director, Tax and Estate Planning, says that "Knowing the dollars and cents behind your inheritance can have an impact on your financial plans. It is smart to know what you can expect so you can plan accordingly and family dialogue is a good place to start."

Ted Rechtshaffen, a certified financial planner at Tri-Delta Financial, in a National Post article I discuss below, says "he may be in the minority but he encourages clients to count on their inheritances when planning to some degree." He however, goes on to say he tells clients to be super-conservative. Finally, he concludes with "I know it goes against the grain because you are counting on money you don't have", adding, "it depends where your parents are in their life cycle and how clearly they have signalled their intentions".

I think Christine and Ted's comments clearly point out the conundrum here, for which there is no black and white answer. It is probably unwise to ignore a known potential inheritance, but because the final inheritance is subject to so many variables, you must risk assess that inheritance and discount its quantum by a significant amount, such that your planning becomes a paradoxical situation.

But what if you see no risk in your parent(s) financial situation deteriorating and you feel you will never be removed from the will, how can your financial planning be affected? For argument’s sake, let’s say your inheritance will be large enough to affect your future planning, but not large enough to affect your motivation or change your lifestyle.

The most obvious change to your financial plan may be to underfund your RRSP. Most Canadians struggle to make yearly RRSP contributions. They live in mortal fear that they will not have enough money to live the retirement they envision. But, if you know your parent(s) have enough funds to live out their life/lives comfortably, and say your inheritance will be in the $300,000 to $500,000 range, do you need to make your maximum RRSP contributions?

Other planning issues include whether you should purchase a home out of your price range or underfund your children’s education fund, knowing that you will receive an inheritance to pay off the mortgage or to pay off any education related loans. Alternatively, you may over fund your child’s education by sending them to a private school you would never had considered without knowledge or presumption of a future inheritance.

How you deal with debt could also be affected. If you have debt, should you just limit it to a manageable level and not concern yourself with paying it down? Or alternatively, should you pay it off because you can reallocate funds once committed to your RRSP, TFSA or RESP, knowing your inheritance will cover your RRSP, TFSA or RESP?

We have all heard about about the huge debt level many Canadians are carrying. Based on comments made by Benjamin Tal, deputy chief economist for the CIBC, one wonders if at least subconsciously some of this debt level in being carried because people know they have an inheritance coming? Mr.Tal in an article in the Toronto Star on Baby boomers set to inherit $1 trillion says "people talk about how much debt there is without looking at the size of the potential assets to come. Debt is relative to your income today, but your wealth tomorrow will improve when an inheritance comes."

So, have I seen people bank on an inheritance? Yes. To date, where I have observed such behaviour, the inheritances have come as expected. However, these cases may not be predictive of future cases.

Is it morbid to plan for an inheritance? Clearly, it is. Would most people rather have their parents instead of the inheritance? Yes. This topic is a very touchy subject and an extremely slippery slope, but to ignore the existence of a significant future inheritance that would impact your personal financial situation may be nonsensical.  However, if your financial planning takes into account a future inheritance, you should ensure you have discounted that amount to cover the various risks and variable that could curtail your inheritance and be extremely conservative in your planning.

Post script:


As the expression goes "Those who hesitate are lost". I started writing this blog back in late November, but could not come to a conclusion (if one can call the lukewarm recommendation I suggest above a conclusion) until recently on whether one should or should not plan for an inheritance. Thus, this blog post just sat. In the interim there have been two excellent articles on this topic. The first by Garry Marr of the Financial Post, titled Windfall no sure thing from which I quote Mr.Rechtshaffen above and another article by Preet Banerjee of the Globe and Mail, titled An inheritance should be a windfall, not a financial plan.

In Preet's article he notes the potential flaws of incorporating an inheritance into your financial plan. He also concludes with some words of wisdom "There are enough variables affecting your own financial success. Ideally, you shouldn’t bank on an inheritance in your financial plan, but rather treat it as an unexpected windfall. Most people would rather give it up in exchange for having their parents back".

The blogs posted on The Blunt Bean Counter provide information of a general nature. These posts should not be considered specific advice; as each reader's personal financial situation is unique and fact specific. Please contact a professional advisor prior to implementing or acting upon any of the information contained in one of the blogs.

Monday, August 25, 2014

The Best of The Blunt Bean Counter - The Income Tax Implications of Purchasing a Rental Property

This summer I am posting the "best of" The Blunt Bean Counter while I work on my golf game (or more accurately, my golf game in rain conditions). Today, I am re-posting my most read blog of all-time; a post on the income tax implications of purchasing a rental property. This post has over 300 comments; so many that I have stopped answering questions on this topic. As there are many excellent questions within the 300 comments, I posted a new blog a few months ago highlighting those questions. I called that post, Rental Properties - Everything You Always Wanted to Know, but Were Afraid to Ask.

The Income Tax Implications of Purchasing a Rental Property



Many people have been burned by the stock market over the past decade and find the stock market a confusing and complex place. On the other hand, many people feel that they have a better understanding and feel for real estate and have far more comfort owning real estate; in particular, rental real estate. While both stocks and real estate have their own risks, some proportion of both these types of assets should typically be owned in a properly allocated investment portfolio. In this blog, I will address some of the income tax and business issues associated with purchasing and owing a rental property.

The determination of a property’s location and the issue as to what is a fair price to pay for any rental property is a book unto its own. For purposes of this blog, let’s assume you have resolved these two issues and are about to purchase a rental property. The following are some of the issues you need to consider:

Legal Structure


Your first decision when purchasing a rental property is whether to incorporate a company to acquire the property or to purchase the property in a personal/partnership capacity of some kind. If you are purchasing a one-off property, in most cases, as long as you can cover off any potential legal liability with insurance, there is minimal benefit of using a corporate structure. 

In 2011, in Ontario, there is no tax benefit to purchasing the property in a corporation given the fact that the corporate income tax rate for passive rental income is identical to the highest personal marginal income tax rate, 46%. Given their is no income tax incentive to utilize a corporation, when you include the cost of the professional fees associated with a corporation, in most cases, the use of a corporation does not make sense.

In addition, if the property is purchased in one’s personal capacity, any operating losses can be used to offset other personal income. If the property runs an operating loss and is owned by a corporation, those losses will remain in the corporation and can only be utilized once the rental property incurs a profit.

If you decide to purchase a rental property in your personal capacity, you must then decide whether the legal structure will be sole ownership, a partnership or a joint venture. Many people purchase rental properties with friends or relatives and/or want to have the property held jointly with a spouse. Where it has been determined that the property will be owned with another person, most people fail to give any consideration to signing a partnership or joint venture agreement in regards to the property. This can be a costly oversight if the relationship between the property owners goes astray or there is disagreement between the parties in terms of how the rental property should be run.

One should also note that there are subtle differences between a partnership and a joint venture. This is a complicated legal issue, but for income tax purposes if the property is a partnership, the capital cost allowance (“CCA”) known to many as depreciation, must be claimed at the partnership level. Thus, the partners share in the CCA claim. However, if the property is purchased as a joint venture, each venturer can claim their own CCA, regardless of what the other person has done. This is a subtle, but significant difference.

Allocation of Purchase Price


Once the rental property is purchased, you must allocate the purchase price between land and building. Land is not depreciable for income tax purposes, so you will typically want to allocate the greatest proportion of the purchase price to the building which can be depreciated at 4% (assuming a residential rental property) on a declining basis per year. Most people do not have any hard data to support the allocation (the amount insured or realty tax bill may be useful) so it has become somewhat standard to allocate the purchase price typically 75% -80% to building and 25% - 20% to the land. However, where you have some support for another allocation, you should consider use of that allocation. Typically for condominium purchases, no allocation or, at maximum, an allocation of 10% is assigned to land.

Repairs and Maintenance


If you are purchasing a property and it is not in a condition to rent immediately, typically, those expenses must be capitalized to the cost of the building and depreciation will only commence once the building is available for use. When a building is purchased and is immediately available for rent or has been owned for some time and then requires some work to be done, you must review all significant repairs to determine if they can be considered a betterment to the property or the repairs simply return the property back to its original state. If a repair betters the property, the Canada Revenue Agency’s ("CRA") position set forth in Interpretation Bulletin 128R paragraph 4, is that the repair should be capitalized and not expensed. This is often a bone of contention between taxpayers and the CRA,

CCA


CCA (i.e. depreciation for tax purposes) is a double-edged sword. Where a property generates net income, depreciation can be claimed to the extent of the property’s net income. Generally, you cannot create a rental loss with tax depreciation unless the rental/leasing property is a principal business corporation. The depreciation claim tends to create positive cash flow once the property is fully rented, as the depreciation either eliminates or, at minimum, reduces the income tax owing in any year (depreciation is a non-cash deduction, thereby saving actual cash with no outlay of cash). Many people use the cash flow savings that result from the depreciation claim to aggressively pay down the mortgage on the renal property. The downside to claiming tax depreciation over the years is that upon the sale of the property, all the tax depreciation claimed in prior years is added back into income in the year of sale (assuming the property is sold for an amount greater than the original cost of the rental property). This add-back of prior year’s tax depreciation is known as recapture.

People who have owned a rental property for a long period, sometimes reach a point in time where they have such large recapture tax to pay, they don’t want to sell the rental property. Personally, I do not agree with this position, since it is really a question of what will be your net position upon a sale and are you selling the property at a good price. However, recapture is always an issue to be considered, especially for older properties that have been depreciated for years.

Also, if you have taken tax depreciation on a property and you decide at some point in time to move into the property, you will not be able to defer the gain under the “change of use” rules in the Income Tax Act. I discuss these "change of use" rules in a guest blog "Your principal residence is tax exempt" I wrote for The Retire Happy Blog.

Reasonable Expectation of Profit Test


Previously, if a rental property historically incurred losses for a period of time, the CRA may have challenged the deductibility of these losses on the basis that the taxpayer had no “reasonable expectation of profit”. Fortunately, the CRA's powers with respect to the enforcement of this test have been severely limited. The test has been reviewed by the Supreme Court of Canada and their view is that where the activity lacks any element of personal benefit and where the activity is not a hobby (i.e. it has been organized and carried on as a legitimate commercial activity) “the test should be applied sparingly and with a latitude favouring the taxpayer, whose business judgement may have been less than competent.” Consequently, concerns previously held in respect to utilizing losses from rental properties, even if the properties are not profitable for some period of time, are now mitigated.

Purchasing a rental property requires a considerable amount of thought and due diligence prior to the actual acquisition. Having a basic understanding of the income tax consequences can assist in making the final determination to purchase the rental property.

Bloggers Note: I will no longer answer any questions on this blog post. There are over 300 questions and answers in the comment section below. I would suggest your question has probably been answered within those Q&A. Thanks for your understanding.

The blogs posted on The Blunt Bean Counter provide information of a general nature. These posts should not be considered specific advice; as each reader's personal financial situation is unique and fact specific. Please contact a professional advisor prior to implementing or acting upon any of the information contained in one of the blogs.

Monday, August 18, 2014

The Best of The Blunt Bean Counter - Are Money and Success the Same Thing?

This summer I am posting the "best of" The Blunt Bean Counter while I work on my golf game. The work is actually beginning to pay off. While playing the Hoot at Osprey Valley (the 3 courses at Osprey are typically listed in the top 100 Canadian courses), I missed two makeable putts on 16 & 17 or I would have broken 80.

Today, I am re-posting a two-part blog on "Are Money and Success the Same Thing?" This post was described by The Big Cajun Man (blogger behind Canadian Personal Finance blog) as a very Zen post. I figured Zen was good for reading while sitting on your cottage dock with a glass of wine.

Are Money and Success the Same Thing?


Moneyville runs a weekly feature called Fame and Fortune, where famous people discuss various financial lessons they have learned and provide financial advice. The last question is always “Are money and success the same thing?” In the columns I have read, I do not ever recall a featured guest answering yes to this question. Yet, the fact that the question is asked insinuates that some people feel the answer is yes. I would further suggest, that we all have met people who we think would answer yes to this question; or should answer yes, based on their actions.

In my opinion, the brevity of the Moneyville column forces a cliché answer from most of the guests. The guests typically say things such as “money is fleeting” or “money does not buy love” or “people should not be defined by their money”. However, this simple question is actually very complex when you peel back the layers. Success can be defined and interpreted in so many ways. I believe that money and success are not one and the same, but are so closely intertwined in some circumstances, that money may allow you to buy certain variations of success, while in other situations it can derail success.

Today, I will not get into how we look at money, a topic I discussed in a July 2011 blog post, but will focus solely on the success side of the question.

What is Success?


The definition of success is elusive. If you ask 100 people, you would probably get 100 different answers as to how they define success. So I turn to some famous and less famous people and their definitions and interpretations of success (and money) are as follows.

Ralph Waldo Emerson, a famous American essayist and poet, wrote this poem about success (although there is some debate if he indeed wrote this poem):

"What is success?
To laugh often and much;
To win the respect of intelligent people
and the affection of children;
To earn the appreciation of honest critics
and endure the betrayal of false friends;
To appreciate the beauty;
To find the best in others;
To leave the world a bit better, whether by
a healthy child, a garden patch
Or a redeemed social condition;
To know even one life has breathed
easier because you have lived;
This is to have succeeded."

John Wooden, considered by many as the greatest basketball coach ever, had this definition, “Success is peace of mind, which is a direct result of self-satisfaction in knowing you made the effort to do your best to become the best that you are capable of becoming."

According to John Maxwell, an evangelical Christian author, success is when “Those who know you the best love you the most.”

A less spiritual interpretation of money and success is provided by American author and motivational speaker Wayne Dyer who states, “Successful people make money. It's not that people who make money become successful, but that successful people attract money. They bring success to what they do.”

Finally, and I am not sure who said this, but another more financial oriented definition of success is “The world defines success in terms of achieving one's goal, acquiring wealth, status, prestige and power.”

I have been told by other bloggers that the average reader only pays attention for 400 words (I assume my readers are not average, since I breach the 400 word limit regularly) and since I am already over 600 words, I will stop here. However, tonight, when you are relaxing in your La-Z-Boy recliner (ignore the screaming kids and barking dog), contemplate how you would answer the question of whether money and success are one and the same? I will conclude my thoughts tomorrow.

Here is the link to the second part of this series, should you wish to read more on this Zen topic.

The blogs posted on The Blunt Bean Counter provide information of a general nature. These posts should not be considered specific advice; as each reader's personal financial situation is unique and fact specific. Please contact a professional advisor prior to implementing or acting upon any of the information contained in one of the blogs.