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Life Interests and the Family Home – Probate vs. Taxes

Does your parent want to give you title to their home while still living in it?  A “life interest” is the legal approach often used by parents to do this.  The deed of the property is transferred but the parent keeps a contractual agreement allowing them to live in it for the rest of their lives.  Parents may do this to simplify the settlement of their affairs upon death, but may also do it to avoid payment of probate fees.  This can create some significant income tax issues, and your lawyer may not be aware of this.  In fact, many tax preparers are unlikely to (a) be aware of the life interest, or (b) if they are, may not know the tax issues.  Hence, this long complicated article.

Are you trying to avoid probate? What is probate?  Probate is the process by which the government approves your Last Will and Testament.  Effectively, this is getting legal approval that this is, indeed, the “last” Will.  It allows your executor to settle your final affairs. If your Will is not probated, the executor does not have the protection of the law to distribute your assets to your beneficiaries.  For small estates, or where all of your assets are held in joint name and/or distributed by way of beneficiary designations (e.g., life insurance, RRSPs, TFSAs, segregated funds), probate may not be necessary.  However, probate is important for protection of those involved in asset distribution.  For example, assume that your executor gave the $50,000 in your bank account to your friend, Joe, as stated in your Will.  However, a month later, another Will was located that was more recent, and you had changed your mind in that newer version.  You now intended the money to be given to your friend, Sam.  If Joe is unable or unwilling to repay the money, Sam could sue the executor for this money.  In fact, if the bank distributed the money without seeing proof that the Will was probated, the bank could likely be held responsible also.  This is the importance of probate.

The government charges a fee for probate which varies by jurisdiction, but is typically a percentage of the value of all assets held at death that will be distributed according to the Will.  The home is often a valuable asset, and probate fees can be expensive, so parents may wish to transfer the home to their family before death to avoid these fees.  Sometimes it is done because the parents are fearful of losing the home if they move to an assisted living or long-term care home.  This is, most often, a needless fear, and discussions with the lawyer and professional financial planner is warranted if this is a concern.  In PEI, see my article titled, Nursing Home Financial Assistance In PEI.  Regardless of the reason, use of a life interest means a person can transfer home ownership while still being allowed to live in the home.  However, it can have some serious tax consequences, which may outweigh the probate savings.

Principal Residence Exemption Impact

As long as they live in the home and retain full ownership, the home and up to one-half hectare of land will be eligible for the principal residence exemption at the time of death (or when the property is sold or given to the family, if earlier).  Assume a parent has a home valued at $400,000 and gives it to their children today, retaining a life interest.  After today, they no longer own the home.  As required by tax law, they will report the disposal of their property on their tax return for that year, and claim the principal residence exemption if it qualifies as such for every year of ownership.  They will pay no taxes on it.

Now, assume they (not the children) live in the home for another 10 years, the house increases in value to $500,000, and the last surviving parent dies.  The family then decide to sell the home.  The $100,000 increase in the value of the home will be taxable because the home does not qualify as a principal residence from the time it was gifted to the children.  This is because none of the children lived there, and their parent did not own the home for the final 10 years.  Even if the children do not sell it, this type of a gain could also occur if the family converts it to a rental property, or if one child buys the home from their other siblings.

Assuming that the children are in a 35% tax bracket and one half of the capital gain is taxable (based on tax rules at the time this article was written), there would be $17,500 of taxes owing on the $100,000 gain noted above.  If the parents had not transferred the home to the children, this sale would have been tax-free, but probate fees would have applied on death.  With probate fees of 1.5% as they are in some provinces, total fees would be $7,500, much less than the taxes.  In fact, probate fees are lower than 1.5% in a number of provinces.

This would not be an issue if there is only one child, and that child lives with the parent.  In such a case, the home would also be a principal residence for the child receiving ownership (assuming they have no other home).  In such a case, this life interest transfer scenario may make sense, even more so if the parent owns a cottage as well as a primary home.  In that situation, after the transfer, the parent could still claim the other property as a principal residence if they spend some time living there each year.

Immediate Tax Impact

There will be immediate tax costs if property transferred is not a principal residence, and/or the acreage exceeds the maximum allowed for the principal residence exemption (usually 1/2 hectare, or 1.24 acres).  Any capital gains triggered will be taxable, and note that whether or not part of the gain is a tax-free disposal of a principal residence, all real estate transfers should be reported on the tax return, whether transferred by sale, gift, death or transfer to joint name.  Note that sales should never be done between family members at a price other than fair value because of related tax penalties.

Valuation of the Life Interest and Remainder Interest

There are further complexities with life interests as well.  At the time the life interest is created, the value of the home is split into two parts for tax reasons.  One portion is the value of the “life interest”, and the balance is the value of the “remainder interest.”  For tax purposes, the parent is treated as having sold their whole property at its resale value.  Then, they are deemed to buy back the life interest at its share of the value, while the children receive the value of the remainder interest.  These values become their costs for future transactions related to the property.  Both parts have a value, but first, the total value of the property must be determined at the date of transfer for reporting it on the parent’s tax return.  An appraisal may be necessary.

After the total value is determined, the portion of the total value that is related to only the life interest may be required.  Whether this calculation is needed will depend on whether the house is sold while the parent is living of after their death.  How should it be valued?  One method I have seen used is to assume that the parent is renting the property until their death, and estimate the current lump-sum value of future rent.  Life expectancy, rental value, and an interest rate for present value discounting must be determined to use this method.

To explain further, I will continue with the example above.  Assume the life interest portion of the $400,000 total value is calculated to be $150,000, which means that the remainder interest is worth $250,000.  At that time, the children are deemed to have paid $250,000 for the home, and the parents are deemed to have paid $150,000 for their life interest.  This is based on subsection 43.1(1) of the Income Tax Act.  These amounts become the costs for future tax calculations.

Instead of being transferred directly to the children, some times the house is transferred to a trust, with all of the children being the beneficiaries.  If this is the case, the tax rules for the parent will be the same as explained earlier.  However, the trust will be required to file a T3 tax return each year, resulting in additional costs for tax preparation fees,and a different tax reporting scenario upon eventual sale of the property.

Future Property Disposal at Death of Parent

Let us assume that the parent lives in the home until their death.  When they die, the children will inherit the full property, and the parent’s cost of $150,000 for the life interest will be added to the children’s cost of $250,000 for the remainder interest.  This is based on paragraph 43.1(2)(b) of the Income Tax Act.  Consequently, when the property is sold for $500,000, the children’s cost will be $400,000 ($150,000 + $250,000), resulting in the $100,000 gain discussed above.

Income Tax Act paragraph 43.1(2)(b) only applies if the owner of the life interest is related to the owner of the remainder interest, and the parent has died before the property is sold.  What happens if the parent had kept a life interest but deeded the property’s remainder interest as a gift to to an unrelated friend. The tax situation would be worse.  The cost of the life interest of $150,000 would not be added to the friend’s cost base and the capital gain on sale of property would be higher by $150,000.  Granted, it would be unusual for a person to bequeath their family home to other than a family member, but it could happen if there are no other family members.

Future Property Disposal while Parent is still Living

What happens if the property is sold prior to death of the parent, such as when the parent moves out of the home to live in an assisted-living residence or a nursing home? In that case, the above noted tax rule in paragraph 43.1(2)(b) does not apply.  Think about how this sale would need to occur.  First, the parent would need to transfer their life interest to the children; otherwise the children could not sell the property.  This would be done by gift or fair market sale.  If not a gift, sale by the parent at an amount less than fair market value could mean additional tax costs, and this should not be done (for any property).  If you want to give the children a break, sell them the property at full cost, and give them a gift of cash later, or speak to a lawyer about doing a combination of part by way of sale and part by way of a deed by gift (documented). The value of the life interest at the time of this transfer to the children must be determined; let us assume it is $125,000.  There will be a difference in value between the life interest transferred to the children compared to when it was created by the parent at the time of the initial property transfer.  This will result in a capital gain or a capital loss.  It will usually be a capital loss ($25,000 in my example) because the parent would be older, and hence, it will be worth less.  However, such a loss is a capital loss on personal property, and not tax deductible.  The children will now add this later life interest value of $125,000 to the cost of their remainder interest ($250,000).  The selling price of $500,000 minus the total cost of both the life and remainder interests (e.g., $375,000) is used to calculate their capital gain (or loss) on the sale of the whole property.  In my example, if the parent had died, the total cost would have been $400,000, not $375,000  – a $25,000 difference.  In summary, sale of the property before death of the parent will result in a higher tax cost under normal circumstances because of the decrease in the value of the life interest as the parent ages.

My conclusion is that parents should not transfer their home to their children (with or without a life interest) unless they understand the full income tax consequences.  If they are worried about losing the home because of future occurrences, they should obtain professional advice, both legal and tax, to determine if their worries are justified.  And, if the property is transferred and a life interest retained, the family should obtain tax advice before selling the property if their parents are still living.

Finally, be aware that, with rare exceptions, all real estate transactions should be reported on a tax return whether sold, gifted, placed in joint name or transferred at death.  If property is sold to a family member, it should be sold at its full fair market value, and not less, to avoid double taxation in the future.  Obtain tax advice if you are considering such a transaction.  If you are concerned about marriage breakdown issues for your children when transferring property to them by sale or gift, seek the advice of a family law lawyer on how to protect the property.  And, finally, before putting a property in joint name, seek the advice of legal counsel and a professional financial planner on the risks.  You may also wish to read by web site article titled, Joint Ownership – Understand the Risks and Benefits.

Blair Corkum, CPA, CA, R.F.P., CFP, CFDS, CLU, CHS holds his Chartered Professional Accountant, Chartered Accountant, Registered Financial Planner, Chartered Financial Divorce Specialist as well as several other financial planning related designations. Blair offers hourly based fee-only personal financial planning, holds no investment or insurance licenses, and receives no commissions or referral fees. This publication should not be construed as legal or investment advice. It is neither a definitive analysis of the law nor a substitute for professional advice which you should obtain before acting on information in this article. Information may change as a result of legislation or regulations issued after this article was written.©Blair Corkum