Q: My wife and I are in our 60s and we own and live in our own home. We also own a house that we’ve rented out to my father (who is 86) since just before we got married 16 yrs ago. If this rental house were to sell, it would trigger payment of capital gains tax. That worries my wife and I; what would happen if my wife and I were to both die while on vacation.
We have made a will and this allows my father to stay in the house until he chooses to leave, but is there any way he can defer capital gains tax owed on the house until he actually moves and sells? I should point out he is not on the deed to the property. So far all the articles I have seen relate to children inheriting parents homes, not the other way around.
Answer from Romana King, senior editor at MoneySense:
Yes, it can get quite confusing when trying to negotiate through all the advice on how to minimize taxes when leaving your estate to loved ones. Keep in mind that any information given here is also just a start. I am not an accountant or legal expert. For specific and precise information, you will need to pay for professional advice.
Still, I can offer some insight.
If you died before your wife, the rental property (and all other assets in your estate) would pass to her without triggering tax (there are a few exceptions but a tax specialist will alert you if and when these apply). Then, when she dies, the sum of the estate—which are all the assets that were accumulated over the course of your life—would transfer ownership to the next beneficiary. In this case, your dad.
From the Canada Revenue Agency perspective, any time an asset passes from one person to another, like when you leave the house to your father in your will, the CRA considers this a deemed disposition—a type of sale where, either, there was a change in use in the asset or a change in ownership. This “sale” is how the CRA determines what tax is owed.
For that reason alone, your father would not be able to defer the payment of capital gains tax; it’s the transfer from your estate to him that’s triggered the capital gains tax, not his sale of the property (either immediately or sometime in the future). The reason is that the capital gains tax that was triggered is not actually owed by your dad, but by your estate. Since this rental home was not your primary residence, your estate would be responsible for paying capital gains tax on this transfer of ownership.
To help you appreciate how capital gains tax is calculated, consider this simple example: If you purchased the house as a rental property for $120,000 and in the year that both you and your wife died the home had a fair market value of $160,000, your estate would owe capital gains tax on $40,000. But a benefit of capital gains tax is that you only pay your marginal tax rate on 50% of the capital gain (the profit made between the purchase price and the sale price).
Now, if this marginal rate was based on your father’s income tax bracket, there wouldn’t be much tax owed (assuming he lives in Ontario and has an income that’s less than $41, 536). But it isn’t. It’s based on your marginal tax rate, as calculated by your estate on your last tax return (also known as your terminal tax return). This last return will have to consider all assets that are part of the estate as income. All your RRSP money, all your RRIF money, any TFSA gains that accrued from the time you died to the time your beneficiaries liquidated the funds, along with your pension—all of it will be considered “liquidated” by the CRA and the taxman will require you to pay tax on that total sum.
For a simple example, let’s assume you managed to save up a $500,000 nest egg and then died. This $500,000 of total income on your terminal tax return would push you well past the lowest marginal tax brackets and right into the largest tax bracket. That would mean the capital gains on the house left to your father would be charged tax at the highest marginal tax rate. If you live in Ontario, your beneficiary would end up paying just over 53% on roughly half of your estate to the taxman. Worse, it’s this terminal tax return marginal tax rate that would be used to calculate the capital gains tax owed on the house your dad just inherited—somewhere between $8,800 and $10,600 to the CRA, based on our example.
Now, here’s the kicker: This applies regardless of who inherits the property. (The only time you can defer tax on inherited assets is when a spouse inherits the assets.) So, whether you leave the home to your father, your brother or a friend, your estate would be responsible for paying the capital gains tax on the home. Once paid, the beneficiary (in this case, your father) would then own the house. This, then, becomes his primary residence and any additional price gains could be sheltered under his principal residence exemption.
Of course, there are ways to mitigate this estate tax burden, but you’ll need to talk to a tax specialist.
Romana King is the senior editor and real estate specialist at MoneySense. She is also a licensed real estate sales agent. Follow her on Twitter (@RKHomeowner) or on Facebook. If you have real estate concerns or questions, please email Romana directly at [email protected] or call her on her direct line at 416-764-1382.