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.

Cottage Trusts

Last week Katy Basi wrote a blog post on the various estate planning challenges in passing on your cottage to your family. Today, in part 2 of her series, Katy discusses the use of cottage trusts to facilitate the transfer of your cottage. I thank Katy for her excellent series.

Cottage Trusts

By Katy Basi

 

This blog is a follow-up to my previous blog on the topic of inheriting a cottage, cabin or chalet. There are three main reasons that I have come across for a cottage in Ontario to be owned by a trust:

1) Minimization of estate administration tax, aka probate tax. Ownership of a cottage by a trust was a popular strategy in Ontario in first half of the 1990’s as a way to avoid having to pay probate tax on the value of the cottage. (In the first half of the 1990’s the Ontario government increased the rate of probate tax from its then fairly negligible rate to its current level (1.5% of the fair market value of an estate over $50,000)). A number of cottage owners were convinced to transfer the cottage to a trust in order to avoid probate tax on the value of the cottage upon their death. Many of these trusts are now reaching their 21 year anniversary. Without professional planning, a cottage trust will be required to pay tax on any accrued capital gain on the cottage due to the “21 year deemed disposition rule”. Given the increase in Ontario cottage prices over the last 21 years, very significant tax bills could result. There is often planning that can be undertaken to avoid this capital gain, usually involving a transfer of the cottage to one or more beneficiaries of the trust, but this planning must be undertaken a number of months before the 21st anniversary. If this is your situation, do not delay in getting professional advice!

2) Protection from having to share the value of the cottage upon separation or divorce. As noted in my previous cottage blog, a cottage often qualifies as a matrimonial home for family law purposes, in which case the value of the cottage is shareable upon a separation or divorce (as part of a process called “equalization”). If the cottage is instead owned by a discretionary trust, with a number of beneficiaries, and no guaranteed right of the beneficiaries to any of the income or capital of the trust, the argument can be made that none of the beneficiaries actually own the cottage or have any right to the cottage that can be valued, so that no equalization payment should be made. I advise my clients that a family court may “look through” any trust, including a cottage trust, and allocate a value to a discretionary trust interest. However, if three siblings would otherwise co-own a cottage, each having a one-third interest subject to potential equalization, this situation may be ameliorated by having a discretionary family trust own the cottage with the three siblings as trustees, and the siblings and all of their children as potential beneficiaries. If each sibling has two children, there will be 9 beneficiaries. The value of a 1/9 interest in the trust will be far less than the value of a 1/3 direct ownership interest, and there is a chance that a sibling’s interest will be valued at nil due to the discretionary nature of the trust.

3) “Wait and see” trust. When a cottage owner wants to give their children the option of inheriting the cottage, but is unsure as to whether the children will be able to deal with the practical issues of cottage ownership, and the even greater challenges of cottage co-ownership, a “wait and see” trust may be a good option. The cottage owner leaves the cottage to a cottage trust in his or her Will. The cottage trust is structured to last for the length of time that the parent thinks will be required for the children to figure out a workable long term plan for the cottage. If there are sufficient funds in the estate, the parent may leave a “cottage maintenance fund” as part of the cottage trust in order to reduce the financial burden on the children of maintaining the cottage for the duration of the trust. Upon the termination of the cottage trust, the children figure out if they will co-own the cottage, whether one child will buy out the other children’s interests, or whether the cottage will be sold to a third party.

Transferring a cottage to a trust during the lifetime of the owner can trigger capital gains tax, unless the trust qualifies as an alter ego trust or a joint partner trust. In addition, the trust itself is a separate taxpayer which pays tax at the highest marginal rate, resulting in higher tax bills, under certain circumstances, compared to ownership by the previous owner. Cottage trusts are often created in the Will of the cottage owner as a method of assisting the beneficiaries to keep the cottage in the family, given that any accrued capital gain on the cottage is taxable upon the death of the owner in any event (especially where the owner does not leave the cottage to his or her spouse). Cottage trusts are not appropriate for all situations, but they can be a lifesaver under the right circumstances.

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@katybasi.com. More articles by Katy can be found at her website, katybasi.com.

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.

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. Please note the blog post is time sensitive and subject to changes in legislation or law.

Dealing with Financial Windfalls & how to stave off the Money Leeches

I am always intrigued when I read an article about a lottery winner or superstar athlete who has filed for bankruptcy. Although it is almost akin to purchasing one of the movie star rags in the supermarket, I can’t stop myself from reading about the trials and tribulations of those that blow immense fortunes.

Why I am intrigued is somewhat puzzling. As an accountant, I have come across many people who have come into money suddenly and I have observed first-hand how that sudden fortune can be overwhelming for those without a financial background.

Against the above backdrop, I found an interesting article in Advisor.CA by Stanley Tepner, First Vice President and Investment advisor with CIBC Wood Gundy titled Dealing With Financial Windfalls.

Mr. Tepner describes a financial windfall as “any distribution of financial assets that leaves the recipient with dramatically greater liquid wealth than they had been accustomed to managing before the distribution. The windfall may be the result of a major inheritance, the sale of a business or property, or the proceeds of divorce or insurance settlements.”

In my CA practice, I have seen several individuals come into windfalls. Some by virtue of their business or professional situations are better prepared to handle their sudden increased wealth. In my experience, individuals who sell a business for millions of dollars have often built a strong professional network around themselves as their business grew and typically they will have less problems dealing with the windfall as they already have an advisory team in place. The biggest issue many of these people face is boredom, as they miss the excitement of the deal and the “buzz” of business activity. Many of these people often rejoin the workforce in some capacity.

On the other hand, people who have a financial windfall from an inheritance or divorce are often knocked off balance and they require a strong professional support group to be put in place as soon as possible. The loss of personal and financial equilibrium I have observed in these cases is why I find Mr. Tepner’s advice for these cases compelling. He suggests that “as enticing as it is for financial advisors to demonstrate investment acumen or planning smarts, the best piece of advice you can give to a new windfall recipient is to stop and do nothing. Clients should not make any consequential decisions until they have had time to absorb their new circumstances.”

Stanley goes on to say that his advice applies as much to spending and giving money away as it does to investing the new found wealth. I find this advice bang-on. People who have inherited money or received a large divorce settlement are often still grieving the deceased or the end of their marriage (I will ignore the cynical who say many are waiting for their inheritance at the death bed or the divorced person married for the money in the first place). In addition to dealing with the emotional issues attached to death and divorce, money attracts two different types of unwanted attention: relatives and friends looking for a hand-out and those looking to invest those funds.

If a windfall recipient follows Stanley’s advice and parks the money in a short-term savings vehicle such as a GIC, they not only provide themselves some breathing and thinking room, but they will have a built in “out” when approached by the various money leeches. This is an important second step to take not discussed in the article. By in essence freezing the funds (or telling a little white lie that you have frozen the funds; but actually locking in the funds is a better alternative to resist temptation) you cannot gift, loan or otherwise invest that money for say six months or longer. This is a bit of a twist on Stanley's advice, but a strategy I suggest someone coming into a windfall consider, since it stops the leeches dead in their tracks.

By the end of six months or whatever period is selected, the recipient will have had adequate time to consider whether they wish to gift, loan or otherwise invest their money. Hopefully they will have taken advantage of some outside counsel and thus, any decision to give money away will not be impetuous.

Dealing with a financial windfall can be stressful. I would suggest that if you or someone you know is in this position, or will be in the future, you do nothing and freeze all decisions relating to money for six months to one year.

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.

Accessing RRSPs before Retirement- the Holy Grail Revisited via life events

In searching the Internet for statistics on another matter, I recently stumbled upon a December, 2004 Statistics Canada Perspective document written by Philip Giles and Karen Maser on “Using RRSPs before retirement”.  Although this paper is now over six years old, is very apropos given my blog in March “The Kid in the Candy Store: Human Nature, RRSPs Free Cash and the Holy Grail.”. Mr. Giles and Ms. Maser examine the financial implications of seven life events and how these events might precipitate the removal of funds from an RRSP.

Before I move on with the details of the above noted paper, I want to reference the tremendous statistical effort by Mike Holman in his blog entitled Canadians Are Not Withdrawing From RRSPs At An Alarming Rate. Whereas I attempted to anecdotally reflect that RRSPs are the Holy Grail, Mike breaks down the statistics to reflect RRSP withdrawal rates are not as alarming as some purport.

Anyways, back to the 2004 document. I feel the statistics in this document speak in part to my conclusion that RRSPs are often accessed under financial duress in response to “life events”, and are not necessarily being used to supplement income or being used for discretionary purchases.

The authors listed the following as life events that could precipitate RRSP withdrawals and explored whether these life events did in fact contribute to RRSP withdrawals:

Death of a spouse: The paper concludes that the death of a spouse had the greatest effect on RRSP withdrawals. The authors note “The death of a spouse is a unique event in that it is generally unexpected and may often occur before adequate financial planning has taken place. In such a situation, RRSPs could provide a needed or useful source of funds.”

Separation or divorce: The impact of separation and divorce was smaller than for most of the other life events.

Involuntary job loss, starting a business: The authors surprisingly note that there was not an appreciable effect on RRSP withdrawals for those who lost their job, whereas starting a business was a factor. However, where these events resulted in an RRSP withdrawal, the withdrawal is large.

Birth of a child: This event has little effect.

Buying a house: Withdrawals under the Home Buyers Plan were excluded for purposes of the study. The purchase of a new house had only a slight effect on RRSP withdrawals, although, were money was withdrawn; it was of a more substantial nature.

Returning to school full time: For the major income earner, this event had little effect on RRSP withdrawal behaviour, except if a spouse was returning to school.

The reasons Canadians withdraw funds from their RRSP are varied; however, I am still convinced, most withdrawals are made from a position of need and this document reflects the life events that have the greatest effect upon RRSP withdrawals.


The Money Index

I would like to thank Tom Drake of the Canadian Finance Blog for including my blog on his Money Index listing. The Money Index was recently nominated for the Globe and Mail’s best Canadian investing blog, even though technically it is an updated directory of various blogs.

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.