Canada: Income tax considerations in structuring real estate transactions with life interest
19 August 2014
Posted by: Author: Ranjan Thiruchelvam
Author: Ranjan Thiruchelvam (Collins Barrow National Cooperative Inc.)
A life interest in real estate provides an exclusive right to use a property during the lifetime of the holder of the interest. Often, an individual will incorporate a life interest on a transfer of a property by way of gift to a relative in order to ensure that the individual has use of the property during their lifetime, to know for certain who will own the property when they die, and to avoid probate fees upon death. Historically, life interests were used to avoid income tax on a deemed disposition at death, but section 43.1 of the Income Tax Act was introduced in 1992 to prevent such tax planning opportunities. Nevertheless, the strategy remains popular, and there are many issues to address in order to structure real estate transactions with a life interest in a tax-effective manner.
Although a life interest may be used in many situations, we will consider the example of a mother transferring her principal residence to her daughter and retaining the life interest. At the time of the transfer, the mother will be deemed to have disposed the property at its fair market value (FMV). The mother's tax liability on the capital gain arising as a consequence of the deemed disposition will be offset by the principal residence exemption, provided the property qualifies as the mother's principal residence. From the mother's perspective, the tax implications are the same if she gives the property outright or gives it to her daughter while retaining a life interest.
Valuation of life interest
In order to determine the daughter's adjusted cost base (ACB), the total FMV of the property at the time of transfer from mother to daughter must be allocated between the "life interest" and the "remainder interest." The mother will be deemed to have reacquired the life interest at its FMV. The daughter will be deemed to have acquired the remainder interest – the right to full ownership of the property after the termination of the life lease – at its FMV. The critical issue is the valuation of these interests. In a recent case from the Tax Court of Canada, the court calculated the value of a life interest by capitalizing the rent that could be expected over the taxpayer's life. The court considered the actuarial life expectancy of the taxpayer as well as the projected rent for the property. The FMV in excess of the life interest would be allocated to the remainder interest.
Termination of life interest
Assume that the FMV of the mother's property at the time of the transfer is $100,000, and that the life interest is valued at $40,000 and the remainder interest at $60,000. Upon the mother's death, there will be a deemed disposition of her life interest at its ACB of $40,000. Thus there will be no tax consequences to the mother at death. The tax implications for the daughter, however, are more complex. The value of the mother's life interest of $40,000 will be added to the ACB of the remainder interest held by the daughter upon the mother's death. The daughter will then own the property outright with an ACB of $100,000. If the daughter sells the property immediately for $150,000, she will have a capital gain of $50,000. The principal residence exemption will not be available because the mother had lived in the property up to her death; the daughter owned the property but did not ordinarily reside in it. Consequently, the daughter will be responsible for the income tax on the entire gain of $50,000.
A situation may also arise where the property must be sold during the mother's lifetime (perhaps because she moves to a seniors' home). Prior to the sale, the daughter may pay her mother to remove the life interest or the mother may gift it to her. When a life interest is transferred at a time other than death, the FMV of the life interest must be determined and this amount will be added to the ACB of the remainder interest. If the mother is elderly, the life interest may have little value. As a result, the daughter's ACB may only be the original $60,000. If the house is sold for $150,000, a $90,000 capital gain will occur, which again is unlikely to be offset by the daughter's principal residence exemption. In this case, had the mother retained ownership of the home completely until the sale, it often would qualify as her principal residence exemption and no tax will be payable.
There are many potential issues with life interests, like the loss of tax basis, loss of principal residence exemption, and other risks to the holder of the remainder interest (the property could be lost to creditors of such holder, for example). Careful planning is required where, for example, the family intends to keep the property for a long time after the parent's death and the property is not the parent's principal residence. Additionally, complications can arise on the transfer of farm or fishing properties or the transfer of a property to a charity. Look for discussion of these matters in other issues of Tax Alert.
One must consider all aspects of such planning prior to implementing changes in ownership of property. Probate fees are often a small price to pay compared to the other potential costs of changing ownership of real estate, particularly one's home, without professional advice. Your Collins Barrow tax specialist can help you to structure your real estate transactions in the most tax-effective manner.
This article first appeared on mondaq.com.