Avoiding tax and probate when passing down a rental property

Q: My husband and I would like to put my son on title of a rental house. We are thinking of just 10% (we realize that we would pay capital gains on the 10%). We are planning on putting the remaining 90% in a trust.

Question: is the 10% enough to allow the home to roll over to our son on our death without heavy taxation and probate fees?

—CC

A: First, CC, I want to summarize some of the tax and probate implications for you and your husband on death, so you know what you’re trying to avoid.

For a rental property, on the first of your two deaths, the property can pass to the survivor of you and your husband without any capital gains tax payable. If it’s held jointly, there will be no probate payable on the first death either.

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On the second death, capital gains tax will be payable. The fair market value at the time of your death, less your adjusted cost base, will be the capital gain. Half (50%) of the capital gain is taxable on your final tax return along with any other sources of income for the year. The tax payable on the capital gain could be as high as 27% depending on your province of residence and other income.

You can’t avoid capital gains by having the property pass to your son on your death at a low valuation either. You’re deemed to have “sold” the property on the second death at fair market value. And gifting the property now or in the future also happens at fair market value, resulting in a deemed sale.

If you claimed depreciation on your rental property over the years, all this depreciation is “recaptured” in the year of sale – or in this case, the year of death. This is taxed at your regular tax rate, which could be as high as 54%.

Suffice to say there could be a big tax hit, CC. But if there is other liquidity in the form of investments in your estate, that might be ok. In other cases, a large tax bill on a capital gain may force the sale of an asset like a rental property (or a cottage, business, etc.).

Every province has different probate fees payable to validate a will and allow the executors to distribute the assets. Ontario has the highest probate fees in the country at 0.5% of the first $50,000 of the estate and 1.5% of the excess. In some other provinces, probate is negligible. So, a $1,000,000 rental property in Ontario (in addition to other estate assets) could attract $15,000 of probate fees, as an example. But again, probate may be less of an issue depending on the province.

If you were to put your son on title for 10% of the rental property now, CC, you are correct that you would be deemed to have sold 10% at the current fair market value. Capital gains tax and recapture tax would be payable accordingly. This would mean that 90% of the future capital appreciation would still be taxable on the second of your deaths and probate fees payable accordingly on that proportion.

You mentioned the potential of establishing a trust. A trust is a legal relationship where trustees manage an asset for beneficiaries. Using a trust could help you reduce capital gains tax or probate. But there are different types of trusts and different benefits.

You could set up a trust with your son as the beneficiary and you and your husband could be the trustees. But if you transferred 90% of the property into the trust, this would be considered a deemed disposition and you would trigger capital gains tax and recapture today. You may also have land transfer tax payable at the city or provincial level. And the cost to set up a trust could be $5,000 or more. Ongoing costs may be $1,000 or more per year for a trust that holds only a rental property.

You would however, avoid probate fees on your death. And the future capital gains tax appreciation could accrue to the beneficiary – your son. The capital gains tax would accrue in the trust, and if the trust were structured properly, the property could be rolled out to him at cost, allowing him to defer the capital gains tax until he sold or until he died. So, this may accomplish some of your goals, albeit in exchange for incurring other costs, CC.

If you and your husband are over the age of 65, you could establish a joint partner trust. This would allow you to transfer the property, tax-deferred, into a trust. Only you and your husband could benefit from the trust income and capital during your lives – so you, not your son, would be initial beneficiaries.

On your death, the property could pass to your son without any probate fees payable. But in this case, the capital gains tax would continue to accrue until the second of your two deaths. And you’d have the initial set-up and ongoing costs.

I guess the point is, CC, you may not necessarily be able to accomplish all your goals without the exclusion of others. I think it’s important to prioritize your main goals. If it’s stopping future capital gains tax from accruing, you may need to incur some tax today. If it’s avoiding probate fees, a trust could work, but you need to figure out whether you want the rental income solely for yourselves or to be available for your son.

No matter what, there are costs involved in setting up trusts that may make them inappropriate in some circumstances. Consider your own retirement needs first and foremost and then get advice from a lawyer with strong estate and tax knowledge.

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Jason Heath is a fee-only, advice-only Certified Financial Planner (CFP) at Objective Financial Partners Inc. in Toronto, Ontario. He does not sell any financial products whatsoever.

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About Jason Heath, CFP

Jason Heath is a fee-only, advice-only Certified Financial Planner (CFP) at Objective Financial Partners Inc. in Toronto. He does not sell any financial products whatsoever.

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