When two siblings share an inheritance, their best intentions to redistribute the property can backfire and trigger unnecessarily high taxable capital gains.
When their mother died, Troy and Karl were joint beneficiaries of her will and inherited the lakeside cottage she’d lived in for the past 30 years.
Troy lives out of province and would rather not be saddled with the responsibility for the house, so the brothers decide that Troy will sell his portion to Karl for about half of what it’s worth, who plans to keep it in the family while his kids are young as a vacation home.
However, if Troy does sell the house to Karl, he may be triggering a higher tax bill in the future if and when Karl sells the cottage. The reason is that the low sale price will trigger a high taxable capital gain for Karl. The irony is that if he just gave the house to Karl, the problem could be avoided.
The capital gain you eventually get taxed on is calculated as the Proceeds of disposition (POD, i.e., the price for which you sell the property) minus the Adjusted Cost Base (ACB, i.e. the price for which you are deemed to have acquired the property).
To minimize capital gains, you want to keep these two numbers, POD and ACB, as close together as possible. The smaller the difference between them, the smaller the capital gain.
When you acquire a property via a purchase, the ACB is considered to be the lesser of the fair market value of the property (FMV), or the price you paid.
In the case of Karl and Troy, selling for below market value makes the ACB lower, which means that if Karl sells the house at a profit, that profit will be higher for tax purposes than it would have been if he’d purchased Troy’s half at its FMV.
So does that mean Troy should sell the house to Karl for the full FMV, even though he doesn’t really care about the money? No. He should give it to him.
Gifts, like inheritances, are non-taxable. However, any increase in value of an inherited asset such as a cottage during the period in which the inheritor possesses it, is taxable. So while Karl doesn’t pay tax on property he inherits at the time he inherits it, from that point on all the gains are his (tax) responsibility.
But how do you calculate the ACB of something you received as a gift? Since you obtained it for zero dollars, shouldn’t the ACB be $0? And doesn’t that mean an even bigger gain?
No. For tax purposes, when you receive a gift from a non-arms’-length person, e.g. a sibling, parent or spouse, the ACB for the recipient is considered to be the fair market value (FMV) even though the recipient paid nothing.
In other words, if Troy just gives his half of the cottage to Karl, when Karl goes to sell he can use as his Adjusted Cost Base the full FMV of the property, instead of the artificially low FMV that would be used in the case of a sale at below market value.
Example: Assume the cottage has a fair market value of $300,000 at the time Karl and Troy jointly inherit it. Ten years later, Karl will sell it for $500,000.
Case 1: If Troy sells his half, worth $150,000, to Karl for just $75,000, Karl’s capital gain is as follows:
Adjusted Cost Base (ACB): $225,000 (Karl’s inherited half at $150,000, plus the $75,000 for the other half)
Capital Gain = $500,000 – $225,000 = $275,000
Case 2: If Troy gives his half to Karl, Karl’s capital gain is as follows:
ACB: $300,000 (the FMV of the cottage)
Capital gain = $500,000 – $300,000 = $200,000
Capital gains are 50% taxable, so in the second scenario Karl pays tax on $37,500 less (half of $275,000 – $200,000) income.
Note that there’s nothing stopping from Karl making a ‘gift’ of $75,000 to his brother, after Troy makes a gift of his half of the cottage.
If you’re contemplating a significant transfer of assets and need some insight as to the tax implications, contact us for a free consultation.