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 Chartered Professional Accountant and a partner with a National Accounting Firm 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 are written solely in my personal capacity and cannot be attributed to the accounting firm with which I am affiliated. My posts are blunt, opinionated and even have a twist of humor/sarcasm. You've been warned.

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.

Monday, August 11, 2014

The Best of The Blunt Bean Counter - Transferring Property Among Family Members - A Potential Income Tax Nightmare

This summer I am posting the "best of" The Blunt Bean Counter while I work on my golf game. Today, I am re-posting my second most read blog of all-time; a post on transferring property amongst family members. As you will read, there is potential for some strange income tax results and care must be taken when transferring property to family members. I thus strongly suggest you obtain professional advice before undertaking any such transfer.

I also wrote this article for The Globe and Mail on the same topic. 

Transferring Property Among Family Members - A Potential Income Tax Nightmare


In today’s blog post, I will discuss the income tax implications relating to the transfer of property among family members. These transfers often create significant income tax issues and can be either errors of commission or errors of omission. Over my 25 years as an accountant, I have been referred some unbelievably messed up situations involving intra-family transfers of property. Most of these referrals come about because someone has read an article and decides they are now probate experts or real estate lawyers have decided they are also tax lawyers. 

Transfers of Property - Why They Are Undertaken


Many individuals transfer capital properties (real estate and common shares, being the most common) in and amongst their families like hot cakes. Some of the reasons for undertaking these transfers include: (1) the transferor has creditor issues and believes that if certain properties are transferred, the properties will become creditor protected (2) the transferor wishes to reduce probate fees on his or her death and (3) the transferor wishes to either gift the property, transfer beneficial title or income split with lower-income family members.

I will not discuss the first reason today because it is legal in nature. But be aware, Section 160(1) of the Income Tax Act can make you legally responsible for the transferor's income tax liability and there may be fraudulent conveyance issues amongst other matters.

Transfers of Property - Income Tax Implications


When a property is transferred without consideration (i.e. as gift or to just transfer property into another person's name), the transferor is generally deemed to have sold the property for proceeds equal to its fair market value (“FMV”). If the property has increased in value since the time the transferor first acquired the property, a capital gain will be realized and there will be taxes to be paid even though ownership of the property has stayed within the family. For example, if mom owns a rental property worth $500,000 which she purchased for $100,000 and she transfers it to her daughter, mom is deemed to have a $400,000 capital gain, even though she did not receive any money.

There is one common exception to the deemed disposition rule. The Income Tax Act permits transfers between spouses to take place at the transferor’s adjusted cost base instead of at the FMV of the capital property.

This difference is best illustrated by an example: Mary owns shares of Bell Canada which she purchased 5 years ago at $50. The FMV of the shares today is $75. If Mary transferred the shares of Bell Canada to her brother, Bob, she would realize a capital gain of $25. If instead Mary transferred the shares of Bell Canada to her husband, Doug, the shares would be transferred at Mary’s adjusted cost base of $50 and no capital gain would be realized. It must be noted that if Doug sells the shares in the future, Mary would be required to report the capital gain realized at that time (i.e. the proceeds Doug receives from selling the shares less Mary’s original cost of $50) and Mary would be required to report any dividends received by Doug on those shares from the date of transfer.

As noted in the example above, when transfers are made to spouses or children who are minors (under the age of 18), the income attribution rules can apply and any income generated by the transferred properties is attributed back to the transferor (the exception being there is no attribution on capital gains earned by a minor). The application of this rule is reflected in that Mary must report the capital gain and any dividends received by Doug. If the transferred property is sold, there is often attribution even on the substituted property.

We have discussed where property is transferred to a non-arm’s length person that the vendor is deemed to have sold the property at its FMV. However, what happens when the non-arm’s length person has paid no consideration or consideration less than the FMV? The answer is that in all cases other than gifts, bequests and inheritances, the transferees cost is the amount they actually paid for the property and there is no adjustment to FMV, a very punitive result.

In English, what these last two sentences are saying is that if you legally gift something, the cost base and proceeds of disposition are the FMV. But if say your brother pays you $5,000 for shares worth $50,000, you will be deemed to sell the shares for $50,000, but your brothers cost will now only be $5,000; whereas if you gifted the shares, his cost base would be $50,000. A strange result considering he actually paid you. This generally results in “double taxation” when the property is ultimately sold by the transferee (your brother in this case), as you were deemed to sell at $50,000 and your brothers gain is measured from only $5,000 and not the FMV of $50,000.

Transfers of a Principal Residence - The Ultimate Potential Tax Nightmare


I have seen several cases where a parent decides to change the ownership of his or her principal residence such that it is to be held jointly by the parent and one or more of their children. In the case of a parent changing ownership of say half of their principal residence to one of their children, the parent is deemed to have disposed of ½ of the property. This initial transfer is tax-free, since it is the parent’s principal residence. However, a transfer into joint ownership can often create an unforeseen tax problem when the property is eventually sold. Subsequent to the change in ownership, the child will own ½ the principal residence. When the property is eventually sold, the gain realized by the parent on his or her half of the property is exempt from tax since it qualifies for the principal residence exemption; however, since the child now owns half of the property, the child is subject to tax on any capital gain realized on their half of the property (i.e. 50% of the difference between the sale price and the FMV at the time the parent transferred the property to the child, assuming the child has a principal residence of their own).

An example of the above is discussed in this Toronto Star story that outlines a $700,000 tax mistake made by one parent in gifting their principal residence to their children.

I have been engaged at least three times over the years by new clients to sort out similar family transfer issues.

Transfers for Probate Purposes


As noted in the first paragraph, many troublesome family transfers are done to avoid probate tax. Since I wrote on this topic previously and this post is somewhat overlapping, I will just provide you the link to that blog post titled Probate Fee Planning - Income Tax, Estate and Legal Issues to consider.

Many people are far too cavalier when transferring property among family members. It should be clear by now that extreme care should be taken before undertaking any transfer of real estate, shares or investments to a family member. I strongly urge you to consult with your accountant or to engage an accountant when contemplating a family transfer or you may be penny wise but $700,000 tax foolish.

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 4, 2014

You Have Been Named An Executor- Part 2- Now What?

This summer I am posting the "best of" The Blunt Bean Counter while I work on my golf game. Today, I am re-posting the second of a 3 part series I wrote on executors. This post is my 10th most read post and deals with the duties upon being named an executor; which is unfortunately, a surprise appointment in many cases.

The first post in this series recounts the fascinating betrayal of Paul Penna (founder of Agnico-Eagle Gold Mines Ltd.) by a close friend who was named the executor of his estate; while the third blog, a guest post by Heni Ashley discusses the issue of whether you should use a corporate executor.


You Have Been Named An Executor- Part 2- Now What?


As I noted in the first installment of this series, I have been an executor for three estates. I have also advised numerous executors in my capacity as the tax advisor/accountant for the estates of deceased taxpayers. The responsibility of being named an executor is overwhelming for many; notwithstanding the fact many individuals appointed as executors had no idea they were going to be named an executor of an estate. In my opinion, not discussing this appointment beforehand is a huge mistake. I would suggest at a minimum,you should always ask a potential executor if they are willing to assume the job (before your will is drafted), but that is a topic for another day.

So, John Stiff dies and you are named as an executor. What duties and responsibilities will you have? Immediately you may be charged with organizing the funeral, but in many cases, the immediate family will handle those arrangements, assuming there is an immediate family in town. What’s next? Well, a lot of work and frustration dealing with financial institutions, the family members and the beneficiaries.

Below is a laundry list of many of the duties and responsibilities you will have as an executor:

  • Your first duty is to participate in a game of hide and seek to find the will and safety deposit box key(s).  If you are lucky, someone can tell you who Mr. Stiff's lawyer was and, if you can find him or her, you can get a copy of the will. Many people leave their will in their safety deposit box; so you may need to find the safety deposit key first, so you can open the safety deposit box to access the will.
  • You will then need to meet with the lawyer to co-coordinate responsibilities and understand your fiduciary duties from a legal perspective. The lawyer will also provide guidance in respect of obtaining a certificate of appointment of estate trustee with a will ("Letters Probate"), a very important step in Ontario and most other provinces. 
  • You will then want to arrange a meeting with Mr. Stiff's accountant (if he had one) to determine whether you will need his/her help in the administration of the estate or, at a minimum, for filing the required income tax returns. If the deceased does not have an accountant, you will probably want to engage one. 
  • Next up may be attending the lawyer’s office for the reading of the will; however, this is not always necessary and is probably more a "Hollywood creation" than a reality. 
  • You will then want to notify all beneficiaries of the will of their entitlement and collect their personal information (address, social insurance number etc).
  • You will then start the laborious process of trying to piece together the deceased’s assets and liabilities (see my blog Where are the Assets for a suggestion on how to make this task easy for your executor). 
  • The next task can sometimes prove to be extremely interesting. It is time to open the safety deposit box at the bank. I say extremely interesting because what if you find significant cash in the box? If you find cash, you then have your first dilemma; is this cash unreported, and what is your duty in that case?
  • It is strongly suggested that you attend the review of the contents of the safety deposit box with another executor. A bank representative will open the box for you and you need to make a list on the spot of the boxes contents, which must then be signed by all present.
  • While you are at the bank opening the safety deposit box, you will want to meet with a bank representative to open an estate bank account and find out what expenses the bank will let you pay from that account (assuming there are sufficient funds) until you obtain probate. Most banks will allow funds to be withdrawn from the deceased’s bank account to pay for the funeral expenses and the actual probate fees. However, they can be very restrictive initially and each bank has its own set of rules. 
  • As soon as possible you will want to change Mr. Stiff's mailing address to your address and cancel credit cards, utilities, newspapers, fitness clubs, etc. 
  • As soon as you have a handle on the assets and liabilities of the estate, you will want to file for letters of probate, as moving forward without probate is next to impossible in most cases. 
  • You will need to advise the various institutions of the passing of Mr. Stiff and find out what documents will be required to access the funds they have on hand. In one estate I had about 10 different institutions to deal with and I swear not one seemed to have the exact same informational requirement. 
  • If there is insurance, you will need to file claims and make claims for things such as the CPP benefit. 
  • You will need to advertise in certain legal publications or newspapers to ensure there are no unknown creditors; your lawyer will advise what is necessary.
  • It is important that you either have the accountant track all monies flowing in and out of the estate or you do it yourself in an accounting program or excel. You may need to engage someone to summarize this information in a format acceptable to the courts if a “passing of accounts” is required in your province to finalize the estate. 
  • You will also need to arrange for the re-investment of funds with the various investment advisor(s) until the funds can be paid out. For real estate you will need to ensure supervision and/or management of any properties and ensure insurance is renewed until the properties are sold. 
  • A sometimes troublesome issue is family members taking items, whether for sentimental value or for other reasons. They must be made to understand that all items must be allocated and nothing can be taken.  
  • You will need to arrange with the accountant to file the terminal return covering the period from January 1st to the date of death. Consider whether a special return for “rights and things” should be filed. You may also be required to file an “executor’s year” tax return for the period from the date of death to the one year anniversary of Mr. Stiff's death. Once all the assets have been collected and the tax returns filed, you will need to obtain a clearance certificate to absolve yourself of any responsibility for the estate and create a plan of distribution for the remaining assets (you may have paid out interim distributions during the year).
The above is just a brief list of some of the more important duties of an executor. For the sake of brevity I have ignored many others (see Jim Yih's blog for an executor's checklist).

The job of an executor is demanding and draining. Should you wish to take executor fees for your efforts, there is a standard schedule for fees in most provinces. For example in Ontario, the fee is 2.5% of the receipts of estate and 2.5% of the disbursements of the estate.

Finally, it is important to note that executor fees are taxable as the taxman gets you coming, going and even administering the going.

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.