Estate Planning

Estate Planning: Taking it to the Grave or leaving it all to your kids?

July 10, 2011

16 comments

Today’s guest post tackles a sensitive question in estate planning: when to disburse an inheritance to heirs. The post is courtesy of Mark Goodfield, a professional accountant who writes the The Blunt Bean Counter Blog. Mark covers accounting, tax and wealth management issues on his blog and if you haven’t checked out his site, please do so. It is excellent. Now, over to Mark…

I am often engaged to provide estate planning. Many people born to the “silent generation” have amassed great wealth; a 2006 Decima Research study estimated that over one trillion dollars in wealth could be transferred between 2006-2026. After twenty-five years of discussions regarding the distribution of wealth, it is my opinion, that where an estate will clearly have excess funds when the parents pass away, that the excess wealth should be transferred in partial gifts during a parent’s lifetime.

It is my observation from these meetings that people form four distinct groups: those that will take their wealth to their grave (or leave it to their pet Chihuahua), those that will distribute their wealth only upon their death, those that may not be able to afford their grave (as they give and give to their children) and the most common, the middle ground of the extremes, those who are willing to distribute their wealth, but in many cases harbour concerns their wealth will be “blown” or lead to unmotivated children.

In this blog, understanding my opinions may be diametrically opposed to some readers, I will talk about these varied groups.

For those who wish to take their wealth to the grave, there is often a deep rooted family issue, and the chill in the room makes it very clear that advisors should stay clear of delving into these family issues.

In the case of those who wish to distribute their wealth upon their death, the issue is typically philosophical. That is, one or both of the parents feel that their children need to make their own way in the world and that leaving them money during their lifetime will do their children a disservice or destroy their moral compass. This is a touchy area, but I often suggest that if the parents feel their children are well-adjusted, they should consider providing partial inheritances. A partial inheritance can facilitate a child’s dream, such as climbing Mt. Kilimanjaro while the child is physically able, or assist with the down payment on a cottage. The selling point on partial distributions is that the parents can share vicariously in the joy of the experience they facilitate.

In the third situation, the parents spend every spare nickel on their children’s private school, dance lessons, hockey teams, etc., while younger and then assist in buying houses, cars, etc., when their children are older, to the detriment of their own retirement, let alone the distribution of their wealth. In these cases I suggest the parents pare back the funds they spend on their children and/or make the children contribute to their own activities. It is imperative the parents impart upon their children that they are not an ATM and that there are family budgetary limits to be adhered to, often easier said than done.

The majority of families fall into the last category. They are willing to distribute their “excess” wealth while alive, but in many cases harbour concerns their wealth will be “blown” or lead to unmotivated children. Dr. Lee Hausner, an advisor to some of the wealthiest families in the United States, suggests in various articles of hers that I have read, that parents do not transfer money during career-building years so the children learn to be productive members of society. Children should be taught they have choices to make (ie: distribute money for one thing they want but not three things they want) and they should learn to be philanthropic amongst other things. I think this advice stands on its own whether you are one of the wealthiest families in the United States or just a family that has been lucky enough to accumulate more assets then you will ever require.

How one distributes their wealth is an extremely private issue and each individual has their own thoughts and reasons for their actions. However, in my opinion, where the parents have the financial wherewithal, they should consider making at least partial gifts during their lifetime.

Update: Mark posted a follow-up article on his blog discussing the lessons everyday Canadian families can learn from estate planning tips for wealthy families.

Ways to Reduce the Tax Hit from the Family Cottage

April 19, 2011

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Mark Goodfield, the accountant behind The Blunt Bean Blog concludes the series on transferring the family cottage by outlining some ways to reduce the tax hit. Thank you for the excellent series, Mark. I sure learned a lot.

In today’s final blog in my three part series (Part 1 of the series is available here and Part 2 here) on transferring the family cottage, I will discuss some of the alternatives available to mitigate and defer the income taxes that may arise on the transfer of a family cottage.

Life Insurance

Life insurance may prevent a forced sale of a family cottage where there is a large income tax liability upon the death of a parent and the estate will not have sufficient liquid assets to cover the income tax liability. The downside to insurance is the cost over the years, which can be substantial. The cost of insurance over decades of potentially increasing premiums, all the while ensuring the insurance policy is large enough to cover the income tax liability, is problematic (alternatively one can wait until later in life to insure and take a chance on whether they can still obtain insurance). I would suggest very few people imagined the quantum of the capital gains they would have on their cottages when they initially purchased them, so guessing at the adequate quantum of life insurance required is difficult at best. Purchasing a large last to die insurance policy may do the trick; however, the ultimate insurance cost over time has to be balanced against taking those funds and investing them to cover off the future income tax liability.

Gift or Sale to Your Children

As discussed in the second blog, this option is challenging as it will create a deemed capital gain and will result in an immediate income tax liability in the year of transfer if there is an inherent capital gain on the cottage. The upside to this strategy is that if the gift or sale is undertaken at a time when there is only a small unrealized capital gain and the cottage increases in value after the transfer, most of the income tax liability is passed on to the second generation. This strategy does not eliminate the income tax issue; rather it defers it, which in turn can create even a larger income tax liability for the next generation.

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

Transfer to a Trust

A transfer of a cottage to a trust generally results in a deemed capital gain at the time of transfer. An insidious feature of a family trust (check out this post another way to use the family trust to reduce income taxes) is that while the trust may be able to claim the principal residence exemption (“PRE”), in doing so, it can effectively preclude the beneficiaries (typically the children) of the trust from claiming the PRE on their own city homes for the period the trust designates the cottage as a principal residence.

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

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

Transfer to a Corporation

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

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

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

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

[Note: See Mark’s comment in response to Earl about the concept of legal and beneficial ownership in the context of joint ownership with a right of survivorship. As Mark states, this area is a minefield, so please ensure you obtain proper legal advice before attempting to transfer a cottage into joint ownership with a right of survivorship.]

Transferring the Family Cottage: Tax Issues

April 18, 2011

25 comments

In today’s post Mark Goodfield, a professional accountant and the writer behind the excellent Blunt Bean Blog, continues the series on estate planning issues surrounding the family cottage. Click here for Part 1 of the series.

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

Many parents want to transfer their cottage to their children while they are alive, however, any gift or sale to their children will result in a deemed capital gain equal to the fair market value (“FMV”) of the cottage less the original cost of the cottage, plus any renovations to the cottage. Consequently, a transfer while the owner-parent(s) is/ are alive will create an income tax liability where there is an unrealized capital gain.

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

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

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

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