What’s Your Tax Issue? – Renting Out Your Home

The Tax Issue:

I live in Ontario and own a house.  I’m thinking about renting out the house (to supplement my income).  I bought the house in 1986 with my then-husband for $85,000, both of our names were on the deed.  We separated in 2006 with me remaining in the house; then divorced in 2008 at which time I ‘bought him out’ of the house resulting in the house being solely in my name.  The house is currently valued at approx. $260,000.  If I move out, rent it out, then decide to sell it within 1-5 years, how do I calculate the tax I would owe re capital gains?

The Answer:

Your question actually has three “tax events” happening so it’s a good exercise for a 2nd year tax student like me (as I was at the turn of the century 🙂 ).

First, you bought out your husband at the time of your divorce. I’m not sure about the circumstances, but the general rule here is that regardless of the actual price you paid, your husband’s share of the original cost became your cost for tax purposes unless, at the time, you both elected on your tax returns to apply the actual price you paid.

Second, at the time you decide to move out and rent the property, there is “change of use”, which would normally result in a deemed disposition at fair market value. Since the house is your principal residence, your gain is tax-exempt.

Third, once the change of use has occurred, any future increase in value might be taxable when you sell the house. There is a special election you can make under section 45(2) of the Income Tax Act that will allow you to avoid the change in use rules and treat the property as your principal residence for up to 4 years. In order to benefit from this concession, you cannot claim depreciation during the time you rent the property. If you sell the house within the 4-year limit after making the election, then the full amount of the gain will be exempt as a principal residence. However, if you sell after the four years, then the full amount of the increase in value from the time you moved out will be taxable as a capital gain.

Rollover of RRSP’s and RRIF’s on Death – Don’t Take It For Granted

If you are the executor of an estate, or you are perhaps advising your client on his will, you should be aware of the rules regarding RRSP’s and RRIF’s on death.

I’m surprised at the number of people, executors and plan administrators alike, who work on the often erroneous assumption that these plans simply roll over tax-free when the surviving spouse is named as the beneficiary.

In fact, the opposite is true. While capital property automatically rolls over tax-free to a spouse on death, a RRSP/RRIF does not. The general rule is that it is taxable in the hands of the deceased annuitant. From there, a number of possibilities can occur.

If the spouse is named as the “successor annuitant”, then the capital in the plan is not paid out. The plan simply continues and the spouse replaces the deceased as the annuitant. There is no tax to the estate and no reporting is required. The successor annuitant can be named in the plan itself or in the will. The successor annuitant can also be established in other cases if the executor and the plan administrator agree.

If there is no successor annuitant, then the proceeds of the plan are realized and they are taxed either in the hands of the surviving spouse or the estate, depending on the circumstances. If the spouse is designated as the plan beneficiary in the contract, the payment of funds is made to the spouse upon death of the annuitant, and the spouse adds the amount to income. The spouse then has until 60 days after the end of the year to transfer the funds to his or her own RRSP/RRIF to obtain an offsetting deduction.

If the spouse is named as a beneficiary in the will alone (which will likely be the case in Quebec), then the payment of funds is made to the estate. The executor and the spouse must then agree and file an election (form T2019 for RRSP’s  or T1090 for RRIF’s) to have the proceeds added to the spouse’s income, and be eligible for rollover into his or her plan.

What if the spouse refuses to sign the election?

Take the case where a deceased man is survived by his second wife, has children from a former marriage and the leaves a RRIF to the spouse in the will, with no clear instructions regarding the taxes. The residue from the estate goes to the children. The executor must receive the funds from the RRIF and pay them to the spouse under the terms of the will. No taxes are deducted from this amount. The spouse can then choose not to make the election. She will receive the entire amount of untaxed capital from the RRIF and she will not have to roll it into her own plan, thus avoiding future taxes on withdrawal. The taxes will be borne by the deceased, and be taken from the residue of the estate, thus providing a possible unintended benefit to the spouse, and most likely some very disgruntled children.

Friends in Low Places

CRA prescribed interest rates were announced this week and, for the third quarter in a row, they have been pegged at a very slim 1%. What better time to pull out a couple of tried and true income splitting strategies designed to take advantage of these rates.

Strategy #1 – Loan To Spouse

Whenever prescribed rates dip, tax planners suggest this strategy, but with rates this low, I’m not just suggesting, I’m urging. If you have investments earning income on which you are paying tax at high marginal rates, and your spouse pays tax at lower rates, this strategy is for you. Making a gift of funds to your spouse to have him earn the investment income might sound like a good idea, but, of course, this would trigger the income attribution rules. Essentially, the income earned by your spouse would be attributed back to you and taxed in your hands.

A bona fide loan to your spouse would not create the same attribution problem; but it is subject to other restrictions. Essentially, you must charge interest on a loan to your spouse at the prescribed rate in effect at the time the loan was made. Any income earned by your spouse over and above this rate will be taxed at his lower rate.

With prescribed interest  rates at 1%, and equity investments moving up, this strategy has never been more attractive.

Strategy #2 – Corporate Freeze

If you are a business owner and you’ve been contemplating allotting shares of the business to your spouse or minor child, the time is now.

If you shares have a value, you cannot simply issue new shares to your family members without triggering tax. The normal course of action would be to freeze the value of your shares and issuing new common shares in the desired proportions. This will generally trigger the “corporate attribution” rules. Essentially, the company would have to pay you an annual dividend based on the value of your shares at the time of the freeze. What’s the rate of the dividend? That’s right – the prescribed rate. So a corporate estate freeze should now be considered for anyone who has a company with value and wants to bring family members into the fold.