The Best (Most read all-time) 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 most read blog post of all-time (over 200,000 page views); 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.

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.

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.

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 pound tax foolish.

 

Note: I will not be answering any questions on this "best of" post. The original post has 268 comments. Please scan those comments; it is likely your question has already been addressed.

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 - Personal Use Property - Taxable even if the Picasso Walks Out the Door

This summer I am posting the "best of" The Blunt Bean Counter blog while I work on my golf game. In March, 2011 I wrote this blog post on personal use property and how many families tend to "ignore" these type of items for income tax and probate purposes.

Since 2011, this has become an even larger issue in Ontario, to name one province, as recent legislation has increased the liability of executors. So if you are an executor, tread carefully with respect to Personal Use Property such as art and collectibles.

Personal Use Property - Taxable even if the Picasso Walks Out the Door

I will start today’s blog with a question. What do stamps, duck decoys, hockey cards, dolls, coins, comics, art, books, toys and lamps have in common?

If you answered that the collection of these items are hobbies, you are partially correct. What you may not know is, that these hobbies also generate some of the most valuable collectibles in the world.

When a collector dies and leaves these types of collectibles to the next generation, the collectibles can cause rifts among family members. The rifts may occur in regard to which child is entitled to ownership of which collectible and whether the income tax liability related to these collectibles should be reported by the family members.

Let’s examine these issues one at a time. Many of these collectibles somehow "miss" being included in wills. I think the reason for this is two-fold. The first reason is that some parents truly do not recognize the value of some of these collectibles, and the second more likely reason is, that they do realize the value and they don't want these assets to come to the attention of the tax authorities by including them in their will (a third potential reason is that your parents frequented disco's in the 70's and they took Gloria Gaynor singing "Walk out the Door" literally- but I digress and I am showing my age).

Two issues arise when collectibles are ignored in wills:

1. The parents take a huge leap of faith that their children will sort out the ownership of these assets in a detached and non-emotional manner, which is very unlikely, especially if the collectibles have wide ranging values; and
2. The collectibles in many cases will trigger an income tax liability if the deceased was the last surviving spouse or the collectibles were not left to a surviving spouse. 

Collectibles are considered personal-use property. Personal-use property is divided into two sub-categories, one being listed personal property (“LPP”), the category most of the above collectibles fall into, and the other category being regular personal-use property (“PUP”).

PUP refers to items that are owned primarily for the personal use or enjoyment by your family and yourself. It includes all personal and household items, such as furniture, automobiles, boats, a cottage, and other similar properties. These type properties, other than the cottage or certain types of antiques and collectibles (e.g. classic automobiles), typically decline in value. You cannot claim a capital loss on PUP.

For PUP,  where the proceeds received when you sell the item are less than $1,000 (or if the market value of the item is less than $1,000 if your parent passes away) there is no capital gain or loss. Where the proceeds of disposition are greater than $1,000 (or the market value at the date a parent passes away is greater than $1,000) there maybe a capital gain. Where the proceeds are greater than $1,000 (or the market value greater than $1,000 when a parent passes away), the adjusted cost base (“ACB”) will be deemed to be the greater of $1,000 or the actual ACB (i.e. generally the amount originally paid) in determining any capital gain that must be reported. Thus, the Canada Revenue Agency essentially provides you with a minimum ACB of $1,000.

LPP typically increases in value over time. LPP includes all or any part of any interest in or any right to the following properties:

1. prints, etchings, drawings, paintings, sculptures, or other similar works of art; 
2. jewellery; 
3. rare folios, rare manuscripts, or rare books; 
4. stamps; and 
5. coins. 

Capital gains on LPP are calculated in the same manner as capital gains on PUP. Capital losses on LPP where the ACB exceeds the $1,000 minimum noted above, may be applied against future LPP capital gains, although as noted above, these type items tend to increase in value.

The taxation of collectibles becomes especially interesting upon the death of the last spouse to die. There is a deemed disposition of the asset at death. For example, if your parents were lucky or smart enough to have purchased art from a member of the Group of Seven many years ago for say $2,000 and the art is now worth $50,000, there would be a capital gain of $48,000 upon the death of the last spouse (assuming the art had been transferred to that spouse upon the death of the first spouse). That deemed capital gain has to be reported on the terminal income tax return of the last surviving spouse. The income tax on that gain could be as high as $12,000.

The above noted tax liability is why some families decide to let the collectibles “Walk out the Door.” However, by allowing the collectibles to walk, family members who are executors can potentially be held liable for any income tax not reported by the estate and thus, should tread carefully in distributing assets such as collectibles.

If you are an avid collector, it may make sense in some circumstances to have the collectibles initially purchased in a child’s name. You should speak to a tax professional before considering such, as you need to be careful in navigating the income attribution tax rules.

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 Top 1% are not Happy Campers

A large percentage of my client base is made up of Canada’s “top 1%” of wage earners. They have been vociferous is expressing their unhappiness with the announced marginal tax rate increases for high income earners. They are also very concerned a second shoe will drop, that being the possibility the government will eliminate the small business deduction for many of their corporations.

So who are the “top 1%”? According to a 2013 report by Statistics Canada, Canada's top 1% earned an average income of $454,800. To be considered in the top 1% of income earners in Canada for 2013, a tax-filer would need to have a minimum total income of $222,000.

The 50% Psychological Barrier

On December 7, 2015, Finance Minister Bill Morneau confirmed that for Canadians with incomes over $200,000, their marginal tax rates will increase from 29% to 33%. If you live in Ontario and make more than $220,000, this means you will be paying 53.53% on any dollar earned over the $220,000. I am not a psychologist, but it is very clear to anyone who deals with high-net-worth individuals, that once marginal rates go beyond 50%, they break an invisible psychological barrier that impacts taxpayers thinking, if not their actions. Simply put, you are now paying more money to the government than you keep.

Potential Restriction on Claiming the Small Business Deduction

Currently, small business owners that carry on an active business pay corporate tax at a rate of 15.5% on the first $500,000 of taxable income (subject to various restrictions and sharing of the limit with related corporations). If a corporation is not eligible to claim the small business deduction ("SBD"), they would be subject to a 26.5% tax rate, an 11% increase. [Note: To be clear. This 11% increase is only an increase in the taxes you would pay at the corporate level. So instead of deferring say 38% when you leave money in your corporation (53.5%-15.5%), you would now only be deferring 27%. The absolute income tax increase to you when you when you flow your corporate money to yourself as a dividend or a salary is very small].

As discussed below, the Liberals have floated placing restrictions on the use of the SBD. This has many small business owners anxious that they may have to pay the higher 26.5% tax rate.

In a prior blog post, I noted the following comments made by Prime Minister Justin Trudeau in this article  by the National Post. The Prime Minister stated “that several studies have shown that more than half of small business owners are high-net-worth individuals who incorporate…to avoid paying as high taxes as they otherwise would”. The Post noted that “in that group are doctors and lawyers, groups that may find themselves squeezed by the policy Trudeau loosely outlined this week”.

Mr. Trudeau went on to say that “We want to focus on helping small business owners who are working hard, who are creating jobs for members of their community and serving their community. We are committed to evidence-based policies and I will make no apologies for that.”

Some tax pundits suggest that the Liberals will implement legislation similar to Quebec. In general, Quebec’s legislation says the following corporations would be eligible to claim the small business deduction: 

1. any corporation that employs more than three full-time employees in its business throughout the year or that would usually have used the services of more than three full-time employees had financial, administrative, maintenance, management or other similar services not been provided to the corporation in the year by a corporation associated with it; and

2. any corporation in the primary or manufacturing sector.

My Observations and Experience

I personally cannot ever recall my clients being so vocal over a tax increase and concerned about the possible changes to the small business deduction. I have had several voice their displeasure about these measures. I asked a couple of them if I could discuss their situations in general and they agreed.

One client is a serial entrepreneur in northern Ontario. At a very young age, she built up a hi-tech company and sold a division of the business to a major corporation. At that time she had over 75 employees. She subsequently rebuilt her original company with a new product and incorporated a very successful second company. Following the announcement of the increase in tax to almost 54%, she has started implementing a departure plan, with the intention to set-up offshore and leave Canada within the next ten years. There are several reasons why she wishes to leave Canada, many being philosophical in nature (I would like to list them, as they are very sound and interesting objections, however, we agreed to limit my discussion to her general situation), but the tax increase was the straw that broke the Camel’s back so to speak.

Most people would probably agree, this is not the type of person you wish to chase from Canada.

A second client is a professional nearing retirement age. He basically said to me that why should he continue to work when he does not need the money. He says he is now planning to retire early. He also told me, he had recently attended two Christmas parties and all the room was talking about was the personal tax increase and the possibility many professionals will lose their access to the small business deduction.

The above is an example of tax law changing behaviour in a non-productive way. 

What the Youth of the World have to Say

During a recent dinner, the tax issue was brought up by a guest (not by me, I have enough of this issue at the office). My children who are young adults had this to say:

1. Are individuals who want to leave Canada being selfish? They make a lot of money, so why do they mind paying income tax?

2. If individuals could tell the government what buckets to put their tax dollars towards, would that make it more palatable?

I found both of these comments very insightful, although said through the prism of youth.

Are you selfish if you are willing to leave a country because you do not wish to pay high levels of income tax? Since this discussion would be a book on its own, I will only say the following. I think that every person has and is entitled to, their own marginal income tax “breaking point”. In addition, as noted above, I would trivialize the discussion by saying income tax increase alone may cause some people to leave Canada. While that may be the case for some, I would suggest for most others, while income tax increases maybe a trigger for them considering leaving Canada, it is only one of several considerations.

I loved the tax bucket idea and would suggest many individuals who would consider leaving a country because of taxes would possibly reconsider if they could actually allocate their tax dollars to where they think would be the most useful. However, since this is a fanciful notion and would essentially eliminate the need for government, it is a bit of a non-starter.

The issue of high marginal tax rates is very contentious. This short blog post cannot do the topic any justice. However, it is clear that taxing the wealthy can lead to splits among socioeconomic status, political leanings and philosophical differences on taxation and the common good. What I can tell you is: there is significant unhappiness amongst the top 1%, and probably the top 20%, and if and when legislation comes in restricting the small business deduction, I think it may manifest itself further. Here’s hoping sound business decisions do not become clouded by tax considerations.

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.

He Shoots, He Blogs, He Scores!

In June, a Tax Court of Canada case, Berger v. The Queen (2015) was published. The case revolved around sports, income tax, and blogging. Now that’s my type of case and a topic I have to write about. There is a further “kicker” in this case for me. I grew up with Howard Berger, the appellant, a well-known sports reporter and journalist at the FAN 590 in Toronto.

Howard was a sports fanatic from the get-go with an encyclopedia-like mind for dates, events, statistics, and he used to take me to Toronto Toro games. For those of you too young to remember, the Toro’s were part of the World Hockey Association from 1973-1976 and included such luminaries as Gilles Gratton and his Tiger Mask, Shotgun Tom Simpson and even Frank Mahovlich. 

The Case

The case deals with whether Howard could claim business losses from operating his hockey-based sports blog, carried on under the name Berger Bytes. Running and setting up the blog (which was created shortly after Howard was laid off from his job at the FAN 590) resulted in start-up losses of $26,540 and $37,866 respectively on his 2011 and 2012 tax returns. The CRA felt these losses should be denied because the personal element of following around the Toronto Maple Leafs and writing about the Leafs and hockey was for Howard's personal enjoyment as opposed to conducting a business activity for a profit.

 

The Facts

Most of the facts below are taken directly from the judgement issued by The Honourable Justice Campbell J. Miller and are noted in quotes.

1. “In 1992, the FAN 590 became an all sports station and Mr. Berger, though initially covering all sports, became by 1994 a hockey, and specifically a Maple Leafs, reporter. He had a regular twice a day slot reporting on FAN 590 and developed a sports fan following for his insights into hockey and the Maple Leafs. Part of his job as an employed sports reporter was to follow the team at both games and practices, including attending their away games. He developed significant contacts with media relations personnel on teams across the National Hockey League.”

2. Howard became concerned about his prospects with the FAN 590 following the 2008 economic downturn and a change in management.

3. “Since 2006 part of his job with FAN 590 had been to write 3 or 4 blogs a week for the FAN 590 website: indeed, he described this as becoming an important part of his job. Given his ongoing concern about his future with FAN 590 he devised a plan that, if he lost his job, he would continue to write a hockey sports blog and make a living doing so. His plan was simple: he would write a quality hockey blog that would attract sufficient readership that sponsors would want to advertise on his site”.

4. “On June 1, 2011 when Mr. Berger was indeed let go by FAN 590. He started his first blog that same month and has been blogging ever since.”

5. He established Bergerbytes.ca in September, 2011.

6. In 2011, Howard reported $26,540 of expenses (approximately $24,000 that related to travel following the Toronto Maple Leafs for flights, car rentals and hotel), these expenses were denied by the CRA on the basis the expenses were personal in nature and not incurred in the course of a commercial activity or business.

7. In 2012, Howard reported $37,866 of expenses (approximately $35,000 that related to travel following the Toronto Maple Leafs for flights, car rentals and hotel). In 2012, he received $7,500 in advertising revenue from a lawyer. These expenses were denied by the CRA on the basis the expenses were personal in nature and not incurred in the course of a commercial activity or business.

 

Business vs Personal Expenses

 

For all intents and purposes, the sole issue at law in this case was whether Howard was operating a business for profit or was this truly a personal hobby and pursuit?

Prior to the Supreme Court case of Stewart v Canada (2002) there was a “reasonable expectation of profit” test the CRA would often apply. However, following Stewart, the key test has become whether the business carried on was commercial. Thus, there is no need to determine whether there was a reasonable expectation of profit or to review a taxpayer’s business decisions or planning or forecasts where a commercial business is carried on.

Yet, where there is a personal component to the supposed business activity, there must be evidence to support that you carried on that business for profit. Justice Miller noted, “The Supreme Court of Canada points out that even where there is a personal pursuit, if it is undertaken in a sufficiently commercial manner, the venture will be considered a source of income. The court stipulated in this analysis that “this requires the taxpayer to establish that his or her predominant intention is to make a profit from the activity and that the activity has been carried out in accordance with objective standards of business-like behaviour”.”

The Supreme Court in Stewart cited the below factors to be considered in whether an operation was carried on for business. These factors and the related comments by Justice Miller are noted below:

1. The profit and loss experience in past years:

Justice Miller noted “that for a sports fan like Mr. Berger to be traveling to New York City, for example, to watch the Maple Leafs play the Rangers, does have a personal element, as does the blogging itself. Indeed, while presented with no evidence in this regard, common sense suggests “blogging” is by its nature as much a recreational pastime as possibly a commercial practice. I conclude that there is a personal element to Mr. Berger’s activities: they are not clearly commercial as that concept is defined by the reasoning in Stewart.”

2. The taxpayer’s training:

Justice Miller stated “In commercial terms, Mr. Berger was in a start-up phase and the nature of the activity was such that immediate profits in this media-type business would be unlikely. Like a struggling artist (singer, dancer, writer…) in the early stages of a career, some businesses inherently take time.

Mr. Berger has taken a commercial activity, sports writing, for which he got paid for 20 years and used that experience to attempt to continue to get paid. As indicated earlier, this is not just a sports enthusiast having a crack at making money from his passion. Mr. Berger has some impressive credentials to suggest his approach.”

3. The taxpayer’s intended course of action:

Justice Miller said “I find Mr. Berger did intend to pursue profit and did take, in those 18 months, commercial steps to do so. There will come a time, however, where continuing on this course without any sponsors knocking on his door can only lead to a conclusion that a commercial expectation has been overtaken by personal dreams. I do not have years after 2012 in front of me.”

4. The capability of the venture to show a profit:

Justice Miller stated “I conclude the lack of evidence on this aspect, while not helpful to Mr. Berger, is also not fatal. I simply have not been convinced one way or the other that this venture is capable of showing a profit.”

Verdict

Justice Miller concluded that “Mr. Berger had a predominant intention to make a profit, and in the first 18 months behaved in a reasonable business-like manner to pursue that end. As I hope I have made clear to Mr. Berger, my view is limited to the short term start-up phase of his venture.”

As such, all the expenses were allowed as business expenses, save some small meal expenses.

This case is a very interesting example of the considerations the courts will have where there is a personal element in a business venture. The case also reflects that were possible, you should ensure there is no personal element to your business, so that the CRA is precluded from looking for a profit motive.

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.

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

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

CRA Audit- Will I Be Selected?

This summer I am posting the "best of" The Blunt Bean Counter while I work on my golf game (after this weekend's 2 birdie, 5 par and 3 triple bogey performance, I still need lots of work on my consistency). Today, I am re-posting a February, 2011 blog on your chances of being selected for audit. This is my third most read post of all-time and has over 150 comments; I wonder why :)

CRA Audit- Will I Be Selected?

I am often asked how the Canada Revenue Agency (“CRA”) selects its audit victims; oops, I meant to say taxpayers subject to audit. Through experience I know certain taxpayers, certain claims and certain industries seem to trigger audits. With that in mind, I will list below what I have seen and how I believe the CRA selects certain individuals and businesses for audit.

Reasons for Individuals and Corporations

 

I would suggest there is nothing worse than a scorned lover, a business partner you have had a falling out with or a dismissed employee to trigger a CRA audit. These individuals know your little secrets; a cash deal here, an offshore account there and a conference you expensed that was really a vacation. These people are also vindictive and in some cases, they make statements and claims that are not factual in nature; however, the claims are enough to bring the CRA to your door.

Update: The CRA has introduced the "snitch line" which offers a reward for tipsters who inform on taxpayers hiding money offshore, as per this National Post Article.

CRA also loves net worth audits. These are audits undertaken because you live in a 3,000 square foot home, have a Porsche and kids in private school, and yet show minimal income on your tax return. Typically the CRA either stumbles upon these situations, or information from one of the individuals noted in the preceding paragraph provides a lead.

Reasons Specific to Individuals

We see far more desk audits (information requests in regard to certain deductions claimed) than full blown audits for individuals. You can expect an inquiry if you claim any of the following:

• a significant interest expense,
• an allowable business investment loss (usually if you held shares in a bankrupt private Canadian company),
• tuition from a university outside Canada (typically the child and parent are tied together as most children transfer $5,000 of their tuition claim to their parents),
• a child care claim for a nanny; even if you have filed a T4 for the nanny with CRA. Why CRA cannot crosscheck their records is baffling and befuddling.

In all the above cases you are just providing back-up information, these are not audits.

In past years individuals who purchased any tax shelter other than an oil & gas or mineral flow through have been audited. However, in most cases the CRA is auditing the tax shelter itself and the individual investors just get reassessed personally.

Full blown audits seem to occur with regularity in regard to individuals who earn commission income or self employment income and claim expenses against that income. In those cases, CRA gravitates to auto expense claims, requesting logs books they know one in 100 people actually keep, and advertising and promotion expenses they consider personal in nature.

Reasons Specific to Corporations

Corporations seem to be selected for three distinct reasons.

They carry on a business that is CRA’s flavour of the year; some prior flavours have been pharmacies, contractors and the real estate industry and any other industry CRA feels is a “cash is king” industry.

Corporations file General Indexed Financial Information known as GIFI. This information provides a comparative year to year summary of income and expenses. It is suspected by many accountants that CRA uses this information to review year to year expense and income variances of the filing corporation and to also compare corporations within a similar industry sector to identify those outside the standard ratios, but we don't know that for certain.

The final reason is that it is just your turn. I have no knowledge of this, but it seems like CRA just runs down a list and if you don’t get caught in regard to #1 or #2, your turn just eventually comes up.

In all cases it is imperative you keep your source documents to provide to the auditor; CRA more then ever wants source documents. It is also vitally important if you and not your accountant are meeting with the auditor, that you try and keep your cool. In the end, the auditor is just doing his or her job and if you treat them badly, you are not doing yourself any favours.

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.

The Dynamics of the Investment Advisor/Accountant Relationship

I have several clients in common with Pat O’Keeffe, First Vice-President and Investment Advisor at CIBC Wood Gundy. Pat and I have often discussed the dynamics of the relationship between the investment advisor (“IA”) and the accountant (“CPA”), and why our relationship works while other IA/CPA

relationships fail. One of Pat’s responsibilities with Wood Gundy is continuing education, in which he is charged with the responsibility of improving the quality of service the IAs offer and to increase their knowledge on all aspects of being a leading edge advisor to higher net worth clients. Pat thought it would be instructive for me to speak to his advisor group in downtown Toronto (which I did a few weeks ago) to provide an accountant’s perspective on the dynamics of this relationship. I summarize my talk in today's post. [Note: I use CPA above because that is my designation. I am not purposely slighting other accounting designations, so please do not send me nasty emails].

I understand some aspects of this post may come off as arrogant, as I am telling IAs what to do and how to act. However, I know I don’t have all the answers. Please also understand I was asked to speak to the CIBC Wood Gundy advisors from a CPAs perspective and this is my interpretation of the relationship and I am blunt (and some would say a bit arrogant :).

You may be asking yourself, why the heck should you care about the IA/CPA relationship? I suggest that my expectations of an IA should become the minimum expectations you have of your IA.

Although I do not discuss this today, if you have a team of advisors, you need to ensure your IA, CPA, lawyer, insurance agent and banker all integrate their advice into one efficient coordinated plan. If your advisors operate at cross purposes, while trying to protect their own fiefdom and fees, you are the ultimate loser in this battle of professional egos.

How the Ideal IA/CPA Relationship Should Work

During my presentation, I suggested and it was agreed upon by the CIBC advisors present, that the ideal IA/CPA relationship should be as follows:

• Client centric – The best interests of the client should always be the first priority

• No turf battles – Many financial issues have an investment and tax component. It is important the IA does not overstep their expertise and provide tax advice to cut out the CPA, while the CPA needs to stay within their tax and advisory expertise and not attempt to provide investment advice. I know I have a good relationship with an IA when they call me for tax or financial advice on clients I have no vested interest in; because they know I will help them with their client. This also works the other way where I can call an IA for an opinion on what another IA is doing or for an explanation of an insurance product, etc.

• Proactive – Whether the IA has a new insurance idea or the CPA thinks a prescribed rate loan is appropriate, the IA and CPA should work together to ensure they are providing proactive advice before the client hears it at a cocktail party or seminar put on by another IA or CPA.

• Financial Hero’s – In a strong IA and CPA relationship, the synergies of the relationship should result in both parties becoming hero’s in the client’s eye. For example, an IA recently referred me a client that was not a good fit for the firm she was using. By working together with the IA and because of my knowledge and experience in working with owner-managers, we were able to not only lower the client’s fees, but provide more practical and proactive income tax advice. The client was very pleased with both of us.

The Accountant is the Trusted Advisor

During my presentation, I suggested to the IAs that some studies have concluded that the CPA is the client’s most trusted advisor. I further suggested that whether they agreed or not with that assertion, they needed to understand and acknowledge that dynamic. Although, I work very well with many IAs, over the years I have had reason to suggest to a few clients that their IAs were weak and should be replaced. In most cases they have replaced their IAs. My point here; if you are an IA, you should try and work with your client’s CPA, as it is in your own interest to have them as an ally as opposed to an enemy.

The Grey Areas of the Relationship

The following issues are often contentious and can cause a fracture in the IA/CPA relationship:

1. Who is responsible for determining the adjusted cost base of a personal tax client’s investments?

Most CPAs feel it is the IAs responsibility in all cases for personal clients. During my presentation, there was full agreement by the CIBC advisors on this point. The reason for this is unless an CPA is specifically engaged to track a client’s stock investments, they have no idea what stocks and bonds their clients are buying throughout the year and they have no reason to track such.

2. Who is responsible for determining the adjusted cost base of a corporate client’s investments?

The IAs again felt this was their responsibility. I surprised them by stating that in this case I felt we had a joint responsibility, since for corporate clients, CPAs track the ACB of the client’s investments when we prepare their financial statements.

3. Who is responsible for providing information to complete the T1135 Foreign Income Verification Form?

As I have discussed several times on this blog, the new reporting requirements that force taxpayers to report individual stocks held in Canadian Institutions that do not pay dividends (postponed until 2014 as per the recent transitional announcement) will be a massive issue next year. IAs told me they consider the determination of the fair market value of foreign stocks held during the year, their responsibility. However, they noted that should the rules not change for 2014; the systems of all Canadian Financial Institutions will need to be tweaked to provide reporting on the dividend exception issue.

4. Who is responsible for Income Tax Attributes?

I suggested it was the CPAs responsibility to provide the IA any capital loss carryforward information and RRSP and TFSA contribution limits. However, I told them I thought it was the IAs responsibility to contact the CPA to confirm this information before making any of these contributions.

How to Lose the Accountant as Your Advocate

During my presentation I suggested to the IAs that the following actions or inaction could alienate their client’s accountant:

1. Give the CPA a hard time when they ask for duplicate tax slips. We are only asking because the client did not receive the slip or has misplaced the slip.

2. Don’t provide the CPA adjusted cost base information or realized capital gain/loss reports. As noted above, in my opinion, this is clearly the IAs responsibility.

3. Don’t assist with flow-through information. Flow-through limited partnerships are a strange animal. They start under one entity and are converted into a mutual fund typically a couple years later. CPAs often have a hard time following the conversion process because (a) the share conversions are never one to one, so it is hard to know which flow-through was converted to which mutual fund and (b) it is very time intensive work sorting this out and CPAs do not have time to waste on this during tax season.

4. Practice income tax. In prior years I have had a couple clients' IA transfer stocks with huge unrealized capital

losses to their RRSPs. The result, the tax-loss is denied and lost forever. I have also had IAs suggest to clients that they purchase very large quantities of flow-through shares without discussing their suggestion with me. Clients can become very upset with their IA when I prepare their income tax return and tell them they owe substantial minimum tax because of the excessive flow-through purchase. I have also seen IAs make transfers for probate purposes without considering the income tax costs amongst many other transgressions.

How an IA can Lose a Client

I suggested to the group that the following acts may cause them to lose a client:

• Not taking into account the client’s area of business. For example, should your asset allocation be heavy in REITs if the client’s personal corporation holds significant rental properties?

• Cause a RRSP or TFSA over-contribution because you did not confirm the contribution limits with the CPA. I don’t think IAs understand how upset clients get when this happens and what a huge strike this is against them over such a small issue.

• Have client pay tax on capital gains when the client has large unrealized losses. In November, I touch base with many of my client’s IAs, or they call me, to discuss whether there is an opportunity to tax loss sell. Although it may make investment sense to not sell stocks with unrealized losses, IAs need to speak to their clients in November or December to explain their rationale for not selling; so the client is not upset in April when they incur a large income tax bill.

• Don’t review annual returns with clients. Most IAs are very good about this, but if you ignore your client and don’t have at minimum a yearly meeting, know that I am asking my client if they have reviewed their returns for the year with you. If  they say no, I will usually figure it out myself and then compare the returns to index returns. 

Finally, if you're an IA, the reality is I like many other CPAs; prefer to work with other quality advisors, whether they are IAs, lawyers, valuators, bankers etc. For both yours and your clients benefit, you should strive to be one of those quality advisors.

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.