Life Insurance for High-Net-Worth Individuals and Corporate Business Owners - Podcast and Blog

I was recently a panelist on a video podcast titled Life Insurance for High-Net-Worth individuals (“HNW”) and Business Owners. The link to the podcast can be found here. 

The panel was moderated by Simon Kay of IPS Insurance. Simon specializes in Life Insurance for HNW individuals and corporate business owners and is the pioneer of Private Underwriting.

Private Underwriting is a very exhaustive process, but in simple terms, it allows people with underlying health and lifestyle concerns to have all underwriting requirements collected independent of any insurance company. IPS can then identify any areas that might place upward pressure on premiums and work with the client and their doctors to clarify or address any areas of concern. IPS can then set forth a position and advocate solely for their client with the insurers on a no names basis, protecting their clients' privacy. Simon can be contacted at this email: simon.kay@ipsinsurance.ca

The other panelist was Jay Hershfield. Jay is a highly regarded tax and estate specialist with an insurance expertise (which you will undoubtedly agree with once you watch the podcast) and is currently a director with Scotia Wealth Management. Jay has a wide range of experience from working with the Tax Policy Branch with the Federal Department of Finance, a Life Insurance company and with several large Financial Institutions.
 

The title of the podcast is self-descriptive and discusses in fairly simple terms why you as a HNW individual or corporate business owner would want to consider permanent insurance even if you have no need for insurance based on your financial resources.

Simon is in the midst of editing a second podcast on some of the hard questions to ask when you are considering entering into a life insurance policy. I will post that podcast in the near future. I think it is excellent and a must watch if you are considering purchasing a permanent life insurance policy, if I do say so myself :)

As the podcast focuses on permanent insurance, I below provide a brief written summary on what is permanent insurance, some of the reasons to use it and where permanent insurance is typically used by HNW individuals and corporate business owners.

What is Permanent Insurance?

Unlike term insurance which typically covers temporary needs, permanent insurance provides lifelong insurance and is often used for longer term needs. The two most common types of permanent insurance are Whole Life and Universal Life, and most policies combine a death benefit and savings component to the policies.

Why Use Permanent Insurance?

Permanent insurance can provide liquidity and efficiency for an estate. This liquidity and efficiency together with the ability to equalize an estate, can help facilitate family harmony after the passing of a parent.

Where a corporation is the beneficiary of permanent insurance, the Return on Investment is in many cases greater using insurance than where you create your own investment or sinking fund; because the insurance proceeds are credited to the capital dividend account (see this prior blog post on the capital dividend account) and can typically be paid out tax-free (subject to certain tax rules discussed in the second podcast).

Uses of Permanent Insurance?

The following are some potential uses of permanent insurance:

1. Estate planning – On death (typically upon the last spouse to pass-away), the value of your estate will be allocated in some combination to the CRA in taxes, your family or charity. Permanent insurance can be used to provide the liquidity for paying your estate tax liability, estate equalization with your family, charitable purposes or simply estate growth/maximization by leaving a larger estate to your family from the insurance pay-out.

2. Business or partnership agreements – Permanent insurance can be a very tax effective way to buy out a deceased partner or shareholder under the terms of a partnership or shareholder agreement, especially for corporate shareholders by utilizing the capital dividend account.

3. Legacy Assets – For HNW individuals, insuring the tax liability related to legacy assets such as residential or commercial real estate, cottages or a small business seems somewhat counter intuitive, as you would assume the estate can just sell those assets or others to pay the tax liability related to the legacy assets. However, on numerous occasions I have had parents express a desire to have their estate keep legacy assets after they pass away, for sentimental reasons or because they think the future appreciation will be significant. They therefore purchase permanent insurance to cover the legacy asset tax liability, to alleviate the income tax pressure on the estate.

4. Passive Income rules- Permanent insurance can shelter income tax-free within a policy, which effectively reduces taxable passive income for a corporation and therefore can potentially reduce the small business claw back for corporations.

5. Charitable – You can name a charity as beneficiary of a policy or make a bequest of the death benefit from a permanent policy to a charity of your choice and your estate will receive a charitable tax credit upon your death. You can also purchase or transfer a policy (this may result in a taxable deemed disposition, so speak to your accountant first) to a charity and you would receive a tax credit on the yearly premium payments.

This is my last blog post of 2022, so Merry Christmas and/or a Happy Holiday and a Happy New Year to you and your family.

This site provides general information on various tax issues and other matters. The information is not intended to constitute professional advice and may not be appropriate for a specific individual or fact situation. It is written by the author solely in their personal capacity and cannot be attributed to the accounting firm with which they are affiliated. It is not intended to constitute professional advice, and neither the author nor the firm with which the author is associated shall accept any liability in respect of any reliance on the information contained herein. Readers should always consult with their professional advisors in respect of their particular situation. Please note the blog post is time sensitive and subject to changes in legislation or law.

The Best of The Blunt Bean Counter - Inheriting the Cottage/Cabin/Chalet –The Great Estate Planning Challenge

This summer I am re-posting the "best of" The Blunt Bean Counter blog while I work on my golf game. Today, I am posting a November, 2014 blog titled "Inheriting the Cottage/Cabin/Chalet - The Great Estate Planning Challenge. While this post is almost eight years old, it is still relevant today and what better time to contemplate the future use of your cottage than while you are spending time there. 

This blog post was written by my most popular guest poster, Katy Basi. Katy has guest posted such BBC favourites as Qualifying Spousal Trusts - What are They and Why do we Care?, a three part series on new will provisions for the 21st century dealing with your digital life, RESPs and reproductive assets and Alter Ego Trusts and Joint Partner Trusts - A Primer. Without further ado, here is Katy!

Inheriting the Cottage/Cabin/Chalet –The Great Estate Planning Challenge 

By Katy Basi

From my lovely vantage point on the dock at my dad’s cottage, looking around the lake at all of the other family cottages, I’m reminded that every cottage, cabin and chalet has a story. Some have been in the same family for generations, with or without accompanying drama. Too many more were sold to a third party against the expectations of the family, often as a result of poor estate planning.

 

The family vacation home can be the Cyanean Rocks against which an estate plan crashes and sinks. (The Cyanean Rocks, aka the Symplegades, were a pair of rocks at the Bosphorus that moved, causing major problems to boats in the area until Jason and the Argonauts defeated the rocks). There are many factors that make planning for this property more challenging than for other assets. For example:

1. Often the legal ownership of a cottage does not reflect the practical reality of the cottage situation (for the remainder of this blog, I will refer to the “cottage” as this is the term commonly used in Ontario, but no disrespect is intended to owners of cabins and chalets - many of the same principles and problems will apply!) Due to the inter-generational history of many cottages, cottage ownership is often just not as simple as ownership of a primary residence. I have seen cottage ownership being shared between siblings, or divided among parents and all of their adult children. Sometimes a child is on title “but everyone understands that the cottage belongs to mom”. A parent may own only a “life interest” in the cottage, with adult children holding the “remainder interest”. Other times, ownership was transferred to a trust in the misty reaches of time. If a trust owns your cottage, you’ll want to read my companion blog next week entitled “Cottage Trusts” to ensure that you are aware of some nasty tax traps with the cottage trust structure.


2. If an owner spends any time at a cottage with his/her family, the cottage will qualify as a matrimonial home for family law purposes, and may therefore be shareable upon a later separation or divorce of the owner (unless there is a marriage contract in place which addresses this issue). Let’s say, for example, that in your Will you leave your cottage to your son Adam and your daughter Beth as 50/50 tenants in common (not as joint tenants, as you want Adam’s children to be able to inherit his 50% interest if Adam so chooses). You shuffle off of this mortal coil, so that Adam becomes a co-owner of the cottage. Adam spends a week a year at the cottage with his wife and two children. Adam then separates, and his wife makes a claim for 50% of Adam’s 50% interest in the cottage on the basis that it is a matrimonial home. Will Adam be able to pay 25% of the value of the cottage to his ex as part of the settlement? Will he need to sell his interest in the cottage to Beth to provide the funds for this payment? If Beth cannot afford to buy Adam’s share, this issue may result in the sale of the cottage to a third party. Leaving the cottage to your beneficiaries in a cottage trust created in your Will may be helpful in this respect if marriage contracts are not doable (this planning technique is discussed in more detail in my “Cottage Trusts” blog).


3. Cottages are expensive to maintain. Not every beneficiary who wants the cottage can afford the upkeep, and not every beneficiary who can afford the upkeep wants the cottage.


4. Family members often have strong emotional attachments to the cottage. Leaving the cottage in your Will to the child with the financial resources to maintain the cottage may be the smart choice from a monetary perspective, but if this decision leads to lifelong conflict between the cottage child and the non-cottage child, it may not be the best plan taking all considerations into account.


5. Cottages are not divisible in the same way as financial assets. Cottage owners who intend to leave the cottage to more than one person need to ask themselves what the practical implications are of each beneficiary inheriting only a share of the cottage. For example, co-ownership agreements are strongly recommended whenever more than one person or family shares ownership of a cottage. These agreements can provide for the payment of maintenance expenses and utilities associated with the cottage, allocation of time at the cottage, “shared time” (everyone is welcome!) versus “private time” (my family only please…), policies on having pets/friends over to stay (allergies? replenishment of beverages required?), bringing household items to/taking household items from the cottage, etc.


6. If the cottage owner has owned the cottage for a number of years, there is often a large accrued capital gain on the cottage that is triggered upon the owner’s death. If the owner does not have sufficient liquid assets to pay the tax, and the beneficiaries do not have the funds, the cottage must often be sold simply to pay this tax bill. Insurance on the life of the owner is often recommended, where available at an affordable premium, to backfill this monetary gap. Sometimes a beneficiary is given the cottage in the Will upon the condition that the beneficiary pays the related capital gains tax, saving the other beneficiaries of the estate from bearing part of this burden. The calculation of the capital gain is often complex due to shoeboxes of receipts, collected over decades, which may or may not affect the adjusted cost base ("ACB") of the cottage, as well as principal residence issues (sometimes a cottage may be designated as a principal residence for certain years of ownership….and sometimes not!)

If you own a cottage, it is strongly recommended that you speak with a professional to ensure that your cottage estate plan is optimized. My sisters and I spent lots of idyllic summers at my dad’s cottage as children, and we’re very lucky to still be able to enjoy the cottage, and the memories it holds for us, to this day. I hope that I’ve helped my family create an estate plan whereby my children, and my nieces and nephews, will be just as fortunate, and I wish the same for you.

Katy Basi is a barrister and solicitor with her own practice, focusing on wills, trusts, estate planning, estate administration and income tax law. Katy practiced income tax law for many years with a large Toronto law firm, and therefore considers the income tax and probate tax implications of her clients' decisions. Please feel free to contact her directly at (905) 237-9299, or by email at katy@basilaw.com. More articles by Katy can be found at her website, http://www.basilaw.com/

Other Cottage Blog Posts by The Blunt Bean Counter 

Over the years I have written a couple other blog posts on cottage related topics. They include: 

 

Cottages - Cost Base Additions, are they a new CRA Audit Target?

Transferring the Family Cottage - Part 1,  Part 2, Part 3

The above blog post is for general information purposes only and does not constitute legal or other professional advice or an opinion of any kind. Readers are advised to seek specific legal advice regarding any specific legal issues.

 

This site provides general information on various tax issues and other matters. The information is not intended to constitute professional advice and may not be appropriate for a specific individual or fact situation. It is written by the author solely in their personal capacity and cannot be attributed to the accounting firm with which they are affiliated. It is not intended to constitute professional advice, and neither the author nor the firm with which the author is associated shall accept any liability in respect of any reliance on the information contained herein. Readers should always consult with their professional advisors in respect of their particular situation. Please note the blog post is time sensitive and subject to changes in legislation or law.

The Best of The Blunt Bean Counter - Transferring the Family Cottage - Part 3

In the final post of my three-part blog series on transferring the family cottage, I discuss some of the alternative strategies available to mitigate or defer income taxes that may arise upon the transfer of the cottage to your children. Unfortunately, none provide a tax "magic bullet".

Part 3 – Ways to Reduce the Tax Hit

The following alternatives may be available to mitigate and defer the income taxes that may arise on the transfer of a family cottage.

Life Insurance

Life insurance may prevent a forced sale of a family cottage where there is a large income tax liability upon the death of a parent, and the estate does not have sufficient liquid assets to cover the income tax liability. The downside to insurance is the cost over the years, which can be substantial. In addition, since the value of the cottage may rise over the years, it may be problematic to have the proper amount of life insurance in place (although you can over-insure initially or if your health permits, increase the insurance at a later date). I would suggest very few people imagined the quantum of the capital gains they would have on their cottages when they initially purchased them, so guessing at the adequate amount of life insurance required is difficult at best.

Gift or Sale to Your Children

As discussed in Part 2, this option is challenging as it will create a deemed capital gain, and will result in an immediate income tax liability in the year of transfer if there is an inherent capital gain on the cottage. The upside to this strategy is that if the gift or sale is undertaken at a time when there is only a small unrealized capital gain and the cottage increases in value after the transfer, most of the income tax liability is passed on to the second generation. This strategy does not eliminate the income tax issue; rather it defers it, which in turn can create even a larger income tax liability for the next generation. Since many cottages have already increased substantially in value, a current sale or transfer to your children will create significant deemed capital gains, making this strategy problematic in many cases.

If you decide to sell the cottage to your children, the Income Tax Act provides for a five-year capital gains reserve, and thus consideration should be given to having the terms of repayment spread out over at least five years.

Transfer to a Trust

A transfer of a cottage to a trust generally results in a deemed capital gain at the time of transfer. An insidious feature of a family trust is that while the trust may be able to claim the Principal Residence Exemption ("PRE"), in doing so, it can effectively preclude the beneficiaries (typically the children) of the trust from claiming the PRE on their own city homes for the period the trust designates the cottage as a principal residence.

This paragraph is an update to the original 2011 post. A reader of the blog recently asked a question on life and remainder interests in a cottage. When gifting or using a trust, you can transfer ownership of your cottage to your children, while still keeping a "life interest" in the cottage, which allows you continued use of the cottage and the income from the property (if any) for the rest of your life. However, the transfer/gift to the trust still triggers a capital gain for tax purposes. You are essentially just ensuring you have access and use of your cottage and the future increase in the cottage value accrues to your children from the date of the transfer. This is a complicated topic and beyond my area of expertise. You should consult your lawyer in tandem with your accountant to ensure you understand the issues in your specific situation in using a life transfer and remainder interest.

If a parent is 65 years old or older, transferring the cottage to an Alter Ego Trust or a Joint Partner Trust is another alternative. These trusts are more effective than a standard trust, since there is no deemed disposition and no capital gain is created on the transfer. The downside is that upon the death of the parent, the cottage is deemed to be sold and any capital gain is taxed at the highest personal income tax rate, which could result in even more income tax owing.

The use of a trust can be an effective means of sheltering the cottage from probate taxes. Caution is advised if you are considering a non-Alter Ego or Joint Partner Trust, as on the 21-year anniversary date of the creation of the trust, the cottage must either be transferred to a beneficiary (should be tax-free), or the trust must pay income taxes on the property’s accrued gain.

Transfer to a Corporation

A cottage can be transferred to a corporation on a tax-free basis using the rollover provisions of the Income Tax Act. This would avoid the deemed capital gain issue upon transfer. However, subsequent to the transfer the parents would own shares in the corporation that would result in a deemed disposition (and most likely a capital gain) upon the death of the last surviving parent. An “estate freeze” can be undertaken concurrently, which would fix the parent’s income tax liability at death and allow future growth to accrue to the children; however, that is a topic for another time.

In addition, holding a cottage in a corporation will result in a taxable benefit for personal use and will eliminate any chance of claiming the PRE on the cottage for the parent and children in the future so this alternative is rarely used.

In summary, where there is a large unrealized capital gain on a family cottage, there will be no income tax panacea. However, one of the alternatives noted above may assist in mitigating the income tax issue and allow for the orderly transfer of the property.

I strongly encourage you to seek professional advice when dealing with this issue. There are numerous pitfalls and issues as noted above, and the advice above is general in nature and should not be relied upon for specific circumstances.

This site provides general information on various tax issues and other matters. The information is not intended to constitute professional advice and may not be appropriate for a specific individual or fact situation. It is written by the author solely in their personal capacity and cannot be attributed to the accounting firm with which they are affiliated. It is not intended to constitute professional advice, and neither the author nor the firm with which the author is associated shall accept any liability in respect of any reliance on the information contained herein. Readers should always consult with their professional advisors in respect of their particular situation. Please note the blog post is time sensitive and subject to changes in legislation or law.

The Best of The Blunt Bean Counter - Tranferring the Family Cottage - Part 2

In the second installment of my April, 2011 three-part series on transferring the family cottage, I discuss the income tax implications of transferring or gifting a cottage to your children. Many people are unaware these gifts or sales, often create an immediate income tax liability.  

Part 2 – Tax Issues

As discussed in Part 1 of this series, you can only designate one property as a principal residence per family after 1981. In order to explore the income tax implications associated with transferring ownership of a cottage, I will assume both a city residence and a cottage have been purchased subsequent to 1981, and I will assume that the PRE has been fully allocated to your city home and the cottage will be the taxable property.

Many parents want to transfer their cottage to their children while they are alive, however any gift or sale to their children will result in a deemed capital gain under the Income Tax Act equal to the fair market value (“FMV”) of the cottage, less the original cost of the cottage, plus any renovations to the cottage. Consequently, a transfer while the owner-parent(s) is/are alive will create an income tax liability where there is an unrealized capital gain (i.e. Your cottage is worth $500,000 and the cost is $200,000, you will have a $300,000 capital gain even though you did not actually sell the cottage).

Alternatively, where a cottage is not transferred during one parent’s lifetime and the cottage is left to the surviving spouse or common-law partner, there are no income tax issues until the death of the surviving spouse/partner. However, upon the death of the surviving spouse/partner, there will be a deemed capital gain, calculated exactly as noted above. This deemed capital gain must be reported on the terminal (final) tax return of the deceased spouse/partner.

Whether a gift or transfer of the cottage is made during your lifetime, or the property transfers to your children through your will, you will have the same income tax issue: a deemed disposition with a capital gain equal to the FMV of the cottage, less its cost.

It is my understanding that all provinces (with the exception of Alberta, Saskatchewan, and parts of rural Nova Scotia) have land transfer taxes that would be applicable on any type of cottage transfer. You should confirm whether land transfer tax is applicable in your province with your real estate lawyer.

So, are there any strategies to mitigate or alleviate the income tax issue noted above? In my opinion, other than buying life insurance to cover the income tax liability, most strategies are essentially ineffective tax-wise as they only defer or partially mitigate the income tax issue. In Part 3 of this series I will summarize the income tax planning options available to transfer the family cottage.

This site provides general information on various tax issues and other matters. The information is not intended to constitute professional advice and may not be appropriate for a specific individual or fact situation. It is written by the author solely in their personal capacity and cannot be attributed to the accounting firm with which they are affiliated. It is not intended to constitute professional advice, and neither the author nor the firm with which the author is associated shall accept any liability in respect of any reliance on the information contained herein. Readers should always consult with their professional advisors in respect of their particular situation. Please note the blog post is time sensitive and subject to changes in legislation or law.

The Best of The Blunt Bean Counter - Transferring the Family Cottage - Part 1

In April 2011, I wrote a  three-part series on transferring the family cottage for the Canadian Capitalist blog. Since many Canadian's are at their cottage and the topic is apropos, I will re-post the blogs over the next three weeks,

Part 1 deals with the historical nature of the income tax rules, while Part 2 will deal with the income tax implications of transferring or gifting a cottage, and finally in the third post, I discuss alternative income tax planning opportunities that may mitigate or defer income tax upon the transfer of a family cottage.

Part 1 – There Is No Panacea

Canadians love their cottages. They are willing to put up with three-hour drives, traffic jams, never-ending repairs and maintenance, and constant hosting duties for their piece of tranquility by the lake. However, I would suggest the family cottage is one of the most problematic assets for income tax planning purposes, let alone the inherent family politics that are sure to arise.

For purposes of this discussion, I will just assume away the family politics issue. I will assume the children will each grab a beer, sit down at a table, and work out a cottage-sharing schedule to everyone’s satisfaction; and while they are at it, agree on how they will share the future ownership of the cottage when their parents transfer the cottage or pass away. I would say this is a very realistic situation in Canada, not!!!

Let’s also dismiss any illusions some may harbour that they can plan around the taxation issues related to cottages (or even avoid them entirely). I can tell you outright that there is no magical solution to solving the income tax issues in regard to a family cottage, just ways to mitigate or defer the issues. Many cottages were purchased years ago and have large unrealized capital gains.

So let’s start by taking a step back in time. Up until 1981, each spouse could designate their own principal residence (“PR”) which, in most cases, made the income tax implications of disposing or gifting a family cottage a null and void issue. The “principal residence exemption” (“PRE”) in the Income Tax Act essentially eliminated any capital gain realized when a personal use property was sold or transferred. Families that had a home in the city and a cottage in the country typically did not have to pay tax on any capital gains realized on either property when sold or gifted.

However, for any year after 1981, a family unit (generally considered to be the taxpayer, his or her spouse or common-law partner, and unmarried minor children) can only designate one property between them for purposes of the PRE. Although the designation of a property as a PR is a yearly designation, it is only made when there is an actual disposition of a home (New rules have been put in place in respect to selling your PR, see this blog I wrote on the topic in Oct, 2017).

For example, if you owned and lived in both a cottage and a house between 2001 and 2011 and sold them both in 2011, you could choose to designate your cottage as your PR for 2001 to 2003 and your house from 2004 to 2011, or any other permutation plus one year (the Canada Revenue Agency [“CRA”] provides a bonus year because they are just a giving agency).

In order to decide which property to designate for each year after 1981, it is always necessary to determine whether there is a larger gain per year on your cottage or your home in the city. Once that determination is made, in most cases it makes sense to designate the property with the larger gain per year as your personal residence for purposes of the PRE. 

This site provides general information on various tax issues and other matters. The information is not intended to constitute professional advice and may not be appropriate for a specific individual or fact situation. It is written by the author solely in their personal capacity and cannot be attributed to the accounting firm with which they are affiliated. It is not intended to constitute professional advice, and neither the author nor the firm with which the author is associated shall accept any liability in respect of any reliance on the information contained herein. Readers should always consult with their professional advisors in respect of their particular situation. Please note the blog post is time sensitive and subject to changes in legislation or law.

The New Principal Residence Reporting Requirements – Large Implications for the Average Canadian

On October 3, 2016, the Government announced administrative changes to the reporting requirements for the sale of a principal residence (“PR”) and the designation of the principal residence exemption (“PRE”), which provides for the tax-free sale of your home. The changes were premised on closing a tax loophole that allowed non-residents to buy homes and later claim a tax exemption on the sale by using family members or trusts. While I think the changes in reporting requirements were made in part to close this loophole, a skeptical person may think the government used the “foreign-buyer loophole” issue, to remedy lax reporting requirements for the sale of a PR by all Canadians.

In fact, I suggest the Government will get significantly more revenue from resident Canadians who have been misreporting the sale of their PR, than they will from foreign buyers. I see three (there are more than three, but these are the most obvious) potential areas the new rules will catch the average Canadian:

1. Misunderstanding of the rules where you own both a home and a cottage 
2. Divorce
3. Flipping of houses

The New Reporting Requirements

Starting with the 2016 tax year, the new rules will require you to report the sale of your PR on Schedule 3 - Capital Gains or Losses, of your personal tax return. You will now be required to designate the property as your PR on Schedule 3. Previously, the administrative position of the Canada Revenue Agency (“CRA”) was that you were not required to report the sale of your PR if the property was your PR for every year you owned it.

If you do not designate the property as your PR for all the years you owned the property (such as where you had sold your cottage in a prior year and claimed the PRE for certain years), you are required to also file Form T2091.

I would not be surprised, if in the future, the CRA has follow-up information requests on PR sales, requesting the history of any prior PR sale that was not reportable under the old system to ensure there has been no duplication of the PRE.

History and Rules

Prior to 1982, a taxpayer and their spouse could each designate their own PR and each could claim their own PRE. Therefore, where a family owned a cottage and a family home, each spouse could potentially claim their own PRE, one on the cottage and one on the family home, and accordingly the sale or gifting of both properties would be tax-free.

However, for any year after 1981, a family unit (generally considered to be the taxpayer, his or his spouse or common-law partner and unmarried minor children) can only designate one property between them for purposes of the PRE. Although the designation of a property as a PR is a yearly designation, it is only made when there is an actual disposition of a home. For example, if you owned and lived in both a cottage and a house between 2001 and 2016 and sold them both in 2016, you could choose to designate your cottage as your PR for 2001 to 2003 and your house from 2004 to 2016 or any other permutation +1 (see formula calculation and discussion of the +1 rule below).

In order to decide which property to designate for which years after 1981, you must determine whether there is a larger gain per year on your cottage or your home in the city. Once that determination is made, in most cases it makes sense to designate the property with the larger gain per year as your personal residence for purposes of the PRE.

As if the above is not complex enough, anyone selling a cottage and claiming the PRE must also consider the following adjusted cost base adjustments:

1. If your cottage was purchased prior to 1972, you will need to know the fair market value (“FMV”) on December 31, 1971; the FMV of your cottage on this date became your cost base when the CRA brought in capital gains taxation.

2. In 1994 the CRA eliminated the $100,000 capital gains exemption; however, they allowed taxpayers to elect to bump the ACB of properties such as real estate to their FMV to a maximum of $100,000 (subject to some restrictions not worth discussing here). Many Canadians took advantage of this election and increased the ACB of their cottages.

3. Many people have inherited cottages. When someone passes away, they are deemed to dispose of their capital property at the FMV on the date of their death (unless the property is transferred to their spouse). The person inheriting the property assumes the deceased's FMV on their death, as their ACB.

4. Most people have made various capital improvements to their cottages over the years. For income tax purposes, these improvements are added to the ACB you have determined above. Examples of capital improvements would be the addition of a deck, a dock, a new roof or new windows that were better than the original roof or windows, new well or pump. General repairs are not capital improvements and you cannot value your own work if you are the handyman type.

The Actual PRE Formula

The actual calculation to determine your principal residence exemption is equal to:

The capital gain on the sale of your home multiplied by:

The number of years you have lived in your home plus 1 
The number of years you have owned the property

The one year bonus is meant to ensure you are not penalized when you move from one house to another in the same year.

The Three Potential Issues for Resident Canadians

Misunderstanding of the Rules Where You Own a Home and a Cottage

As noted above, the PRE rules are extremely complex and the formula is often misunderstood. Many Canadians have simply understood or pretended to understand that any sale of a home or a cottage was tax-free if it was used by you and your family. Since there were no reporting required on your tax return until these changes, the CRA could not track whether you were properly reporting the sale of your PR. The new reporting will now allow the CRA to track overlapping ownership periods (i.e. you bought your home in 1990 and your cottage in 2000 and sold your cottage in 2016 and claim the PRE for 16 years. The CRA will now have a record that you have used 16 years of your PRE and you cannot claim those 16 years when you sell your home). This required filing will also force you to consider any prior PRE claims that may have occurred during the 16 years above (say for example you had sold the home you purchased in 1990 in 2010 and purchased a new home that same year. Under this circumstance you could not claim 16 years PRE on your cottage).

As noted above, I would expect at some point in the future, to see information requests and audits of reported gains by the CRA, specifically asking about prior PRE claims to ensure there was no overlapping of of PRE claims.

Divorce

In June of this year, I wrote a post on the income tax implications of divorce where you owned a home and a cottage and the various misunderstandings of how to claim the PRE exemption that arise on divorce. You can read this post if it is of interest to you, but some of the key points I made were as follows:

1. A couple can only claim one PRE during the marriage (other than when a spouse who was throughout the year living apart from and was separated under a judicial or written separation agreement). This one PRE rule per couple is clearly noted in this interesting case, Balanko v The Queen.

2. It is vital that the right to the PRE or the allocation of the PRE must be accounted for in any marriage settlement, for both purposes of the actual claim, and the related income tax one of the spouses may incur. If the use of the exemption is not addressed in the separation agreement, it is then a first-come, first-served claim.

I would suggest that many divorced couples have inadvertently double claimed the PRE.

Flipping of Houses & Condominiums

The CRA has been going after “house and condominium flippers” for the last few years. However, since there has been no reporting requirement for the sale of a PRE, if a “flipper” felt or considered the sale to be of their PR, the CRA was constrained in tracking these house flips. While prior sales may be hard to audit, the new rules force someone flipping a house to report the gain as a PRE and I am sure any sale of homes and condominiums that are of short duration will be subject to follow-up or audit.

Assessment and Penalties

For the sale of a PR in 2016 or later years, the CRA will only allow the PRE if you report the sale and designation on your tax return. If you fail to report the sale, you will have to ask the CRA to amend your return. Under the proposed changes, the CRA will be able to accept a late designation but a penalty may apply, equal to the lesser of $8,000 and $100 for each month you are late from the original required filing. This is a potentially fairly large penalty for non-compliance. The period of re-assessment will also be extended where a disposition has not been reported.

Wow, what some may have seen as a fairly innocuous change to catch non-residents, will certainly have substantial implications on resident Canadians going forward and in some cases, on previous non-filings related to PRE claims.

This site provides general information on various tax issues and other matters. The information is not intended to constitute professional advice and may not be appropriate for a specific individual or fact situation. It is written by the author solely in their personal capacity and cannot be attributed to the accounting firm with which they are affiliated. It is not intended to constitute professional advice, and neither the author nor the firm with which the author is associated shall accept any liability in respect of any reliance on the information contained herein. Readers should always consult with their professional advisors in respect of their particular situation. Please note the blog post is time sensitive and subject to changes in legislation or law.

The Income Tax Implications of Divorce Where You Own a Home and a Cottage

A few months ago, I was at a party when one of the party-goers started chatting to me about their
divorce. I ended up fielding various financial questions for which I referred them back to the matrimonial lawyer (I should have known they were not talking to me because of my bubbly personality).

But all was not lost. One of the questions they asked me about was the income tax implications of transferring their principal residence to their name, and the cottage to their spouse, as part of their divorce. As these transfers are often “messed up” and/or ignored in divorce agreements, I realized they had a least provided me a future blog topic. So today, I discuss the implications of transferring your home or cottage to your spouse upon divorce.

Principal Residence Exemption

In general, where you have lived in your home since its purchase, any gain upon the sale of that home is tax exempt because of the principal residence exemption (“PRE”). Where you own a house and cottage, things get more complicated, as you and your spouse may only designate one residence between you for purposes of the PRE, for each tax year after 1981 (prior to 1982, each spouse could designate one principal residence and thus you could possibly claim the PRE on both your home and cottage).

If you are happily married and own a home and cottage, in general, when you dispose of the properties, you would allocate the PRE to the property with the largest yearly capital gain. This calculation can be complex and typically leaves one property as taxable, or at least partially taxable (i.e. you may have owned your home 5 years before you purchased your cottage, so you have 5 years of PRE to claim on your home).

Where a couple is divorcing, how you allocate the PRE claim on your cottage and home is often problematic.

Spousal Rollover on Divorce

Unless you elect otherwise, where you transfer capital property, the Income Tax Act provides for a tax-free rollover to your former spouse if the transfer is in settlement of their property rights (transfers by title pursuant to a court order or provincial legislation also are provided for). In plain English, you can transfer, say a cottage, to your former spouse with no immediate income tax consequences, although, they assume the cost base of that cottage.

The Issue

One would think that based on the PRE and the tax-free spousal rollover, that where a divorcing couple has a home and cottage, things should be simple. However, since a couple can only claim one PRE during the marriage (other than when a spouse who was throughout the year living apart from and was separated under a judicial or written separation agreement) that is definitely not the case. This one PRE rule per couple is clearly noted in this interesting case, Balanko v The Queen.

Consequently, it is vital that the right to the PRE or the allocation of the PRE must be accounted for in any marriage settlement, for both purposes of the actual claim, and the related income tax one of the spouses may incur. If the use of the exemption is not addressed in the separation agreement, it is then a first-come, first-served claim.

In this article, the authors on page 1122 suggest that you consider at the time of separation or divorce that you complete a principal residence designation Form T2091.

Example

Say Tom and Katie are seeking a divorce and jointly own a family home (the home cost $300,000 and is now worth $1,000,000) and cottage (the cottage cost $500,000 and is now worth $1,000,000). In their divorce settlement, they agree that Tom will take the home and Katie the cottage (in real life, the house and cottage values and related income tax costs may be disproportionate and the value and tax discrepancy is equalized in some manner). This cross transfer of title can be done tax-free as discussed above; Tom assumes a cost base of $300,000 on the family home, and Katie a cost base of $500,000 on the cottage.

Katie has plans to sell the cottage immediately and to buy a new house. Katie’s lawyer and tax advisor decide to keep silent on the issue as to who can claim the PRE, since they know she will claim it first. Should Katie claim the PRE, Tom could be stuck with a tax liability approaching $175,000 when he eventually sells the home.

Luckily for Tom, he has hired sharp advisors. They raise the issues during the divorce negotiations. After some back and forth, the parties agree that Katie will claim the PRE; however, Tom is entitled to an extra $87,500 in family assets to equalize him for his future income tax liability.

If you and your spouse have a home and cottage and are unfortunately in divorce proceedings, or in a dissolving marriage, it is imperative your family lawyer and/or tax advisor consider/negotiate which spouse will be entitled to the PRE and whether a PR designation and/or tax equalization payment needs to be considered.

This blog post is for general information purposes only. The author is not a lawyer and the discussion above does not constitute legal or other professional advice or an opinion of any kind. The information above is provided solely to raise awareness of the issue. Readers are advised to seek specific legal advice regarding any specific legal issues.

This site provides general information on various tax issues and other matters. The information is not intended to constitute professional advice and may not be appropriate for a specific individual or fact situation. It is written by the author solely in their personal capacity and cannot be attributed to the accounting firm with which they are affiliated. It is not intended to constitute professional advice, and neither the author nor the firm with which the author is associated shall accept any liability in respect of any reliance on the information contained herein. Readers should always consult with their professional advisors in respect of their particular situation. Please note the blog post is time sensitive and subject to changes in legislation or law.

The Best of The Blunt Bean Counter - Cottages - Cost Base Additions, are They a New CRA Audit Target?

This summer I am posting the "best of" The Blunt Bean Counter blog while I work on my golf game. Today, I am re-posting a May, 2012 blog on cost base additions to your cottage. You may want to print this out and read it while you have a beer at your cottage next weekend and then search your cottage for all your missing receipts :)

Cottages - Cost Base Additions, are They a New CRA Audit Target?

Canadians have a love affair with their cottages. They enjoy the fresh air, the tranquility, the loons calling out, drinks on the dock, the gathering of friends and family and in many cases; they often enjoy a substantial financial profit on their cottage properties.

When a cottage property has increased in value, it often brings unwanted income tax and estate planning issues. I wrote about some of these issues a year ago April, in a three part series for the Canadian Capitalist titled Transferring the Family Cottage - There is no Panacea. In Part 1, I discuss the historical nature of the income tax rules, while in Part 2 I discuss the income tax implications of transferring or gifting a cottage and finally in Part 3 I discuss alternative income tax planning opportunities that may mitigate or defer income tax upon the transfer of a family cottage.

Today, I want to discuss the fact that the CRA seems to be looking at cottage sales as audit targets and in particular, they are reviewing additions to the original adjusted cost base (“ACB”) of the cottage.

Income Tax Issues

Before I charge ahead with this post, I think a quick income tax primer is in order. Prior to 1982, a taxpayer and their spouse could each designate their own principal residence (“PR”) and each could claim their own principal residence exemption (“PRE”). Therefore, where a family owned a cottage and a family home, each spouse could potentially claim their own PRE, one on the cottage and one on the family home, and accordingly the sale of both properties would be tax-free.

Alas, the taxman felt this treatment was too generous and changed the Income Tax Act. Beginning in 1982 a family unit (a family unit of the taxpayer includes the taxpayers spouse or common-law partner and unmarried children that are 18 years old or younger) could only designate one principal residence between them for each tax year after 1981.

As if the above is not complex enough, anyone selling a cottage must also consider the following ACB adjustments:

1. If your cottage was purchased prior to 1972, you will need to know the fair market value (“FMV”) on December 31, 1971; the FMV of your cottage on this date became your cost base when the CRA brought in capital gains taxation.

2. In 1994 the CRA eliminated the $100,000 capital gains exemption; however, they allowed taxpayers to elect to bump the ACB of properties such as real estate to their FMV to a maximum of $100,000 (subject to some restrictions not worth discussing here). Many Canadians took advantage of this election and increased the ACB of their cottages.

3. Many people have inherited cottages. When someone passes away, they are deemed to dispose of their capital property at the FMV on the date of their death (unless the property is transferred to their spouse). The person inheriting the property assumes the deceased's FMV on their death, as their ACB. 

The Principal Residence Exemption

As noted above, if you owned a cottage prior to 1982, you can make a PRE claim for those years on your cottage. Where the per year gain on your cottage is in excess of the per year gain on your home, you may want to consider whether for years after 1982, it makes sense to allocate the PRE to your cottage instead of your home, if you have not already used the PRE on prior home or cottage sales. In these cases, I would suggest professional advice due to the complexity of the rules. In completing the PR Designation tax form (T2091), there are cases where you may need the ACB and FMV at December 31, 1981, but I will ignore this issue for purposes of this discussion.

Putting together the pieces of the ACB Puzzle

So how do all these rules come together in determining your ACB? First, if you owned your cottage prior to 1972, you will need to determine the FMV at December 31, 1971 as that is your opening ACB. If you purchased the cottage after 1971, but before 1994, your ACB will be your purchase cost plus legal and land transfer costs. Next, you will have to determine whether you increased your ACB by electing to bump your ACB in 1994.

If you inherited the property, you will need to find out the FMV of the cottage on the date of the death of the person you inherited the property from. If the property was inherited before 1994, you will have to determine whether you increased your ACB by electing in 1994.

Finally, most people have made various capital improvements to their cottages over the years. For income tax purposes, these improvements are added to the ACB you have determined above. Examples of capital improvements would be the addition of a deck, a dock, a new roof or new windows that were better than the original roof or windows, new well or pump. General repairs are not capital improvements and you cannot value your own work if you are the handyman type. I would argue however, that the cost of materials for a capital improvement would qualify if you do the work yourself.

Unfortunately, many people do not keep track of these improvements nor do they keep their receipts (in addition, I suspect one or two cottage owners may have done the occasional cash deal with various contractors for which there will not be a supporting invoice), which brings us to the CRA, who appear to be auditing the sale of cottages more intently.

I think it was six pages back I said something about a quick income tax primer before I discussed the CRA audit issue :(

The Audit Issue

Anyways, on to the audit issue (or more properly called an information request). Some accountants think the CRA is going directly to cottage municipalities to determine cottages that have been sold and then tracking the owners to ensure they have reflected the disposition for income tax purposes. Others think the CRA is just following up reported dispositions of cottages on personal income tax returns. In either event, we have seen a couple information requests/audits recently.

So once the CRA decides to review your cottage sale, what are they looking at and what information are they requesting?

Amongst other things they are asking you to support the adjusted cost base of the property, by providing the following:

a. your copy of the original purchase agreement stating the purchase price;

b. the statement of adjustments where the purchase of the property involved the services of a lawyer;

c. if the property was either inherited or purchased in a non-arms length transaction, indicate the FMV of the property on the date of acquisition and supply documentation to support your figure. If the property was inherited, indicate the date of acquisition;

d. a schedule of all capital additions to the property. The schedule must indicate the nature of the addition or improvement (i.e. new roof) as well as the cost.

A and B above just provide the CRA the original ACB. Item C is interesting in that where there was a family sale or inheritance, the CRA is asking for validation of the sale price, but surely it is also cross-checking to see if the family member reported the sale of the cottage and in the case of a deceased person, to ensure the terminal income tax return of the deceased reported the value of the cottage at death.

Item D is where the CRA is zeroing in on; the capital additions, which as I noted above, are often not tracked and source documents are often not maintained.

The CRA is also asking for support of the proceeds of disposition, requesting such items as a copy of the accepted offer to purchase, the statement of adjustments and the full name of the purchaser in addition to their relationship, if any, to you (i.e. relative or otherwise).

They are also asking if while owned by you, was the property your principal residence for any period of time. This relates to the discussion above on whether the gain was larger on your cottage than your house and thus you designated your cottage. The CRA will then most likely confirm you did not sell any other residence during that time period.

Another request is that if you elected to report a capital gain on the property in 1994, they want you to supply a copy of the form T664, Election to Report a Capital Gain on Property Held at the end of February 22, 1994, that was filed with your 1994 income tax return. This is interesting since many people have not kept their older tax returns and I don’t think the CRA keeps its returns that far back. I am not sure what the CRA is doing in cases where taxpayers have destroyed their elections.

In conclusion, if you have sold a cottage in the last couple years, make sure you have all your documentation in place should you receive an information request, and if you currently own a cottage, use this road map to ensure you have updated your cottage ACB and have a file for any documentation needed to support that ACB.

Bloggers Note: Here is a link to an excellent BDO tax memo titled "Calculating cottage capital gains: have you accumulated all eligible costs? " which you may also wish to read. 

This site provides general information on various tax issues and other matters. The information is not intended to constitute professional advice and may not be appropriate for a specific individual or fact situation. It is written by the author solely in their personal capacity and cannot be attributed to the accounting firm with which they are affiliated. It is not intended to constitute professional advice, and neither the author nor the firm with which the author is associated shall accept any liability in respect of any reliance on the information contained herein. Readers should always consult with their professional advisors in respect of their particular situation. Please note the blog post is time sensitive and subject to changes in legislation or law.