Jonathan Chevreau, Financial Post · Mar. 10, 2011 | Last Updated: Mar. 11, 2011 2:21 PM ET
Many Baby Boomers have paid-for homes, while their grown children are contemplating entering the housing market. Instead of letting them rent during their first foray after leaving the nest, it’s tempting to buy a second “investment” property with Junior as the main tenant.
Fully 10% of Canadian parents are considering this, according to TD Canada Trust, but you need to be aware of the full tax and estate-planning consequences.
There are at least four options, according to chartered accountants Kathy Munro and Caryn Walt, who wrote an insightful analysis in the Winter 2011 edition of PricewaterhouseCoopers’ Wealth and Tax Matters.
Using the example of a $250,000 condo, Option 1 is buying the condo in your own name and having the child pay you rent. Assume the parents are in the top 46% tax bracket. But if they already have a principal residence for tax purposes, any capital gains on the second property — the one being rented by the child — will not be tax-free for the parent/owners.
You and your spouse are considered one family unit, which gets only one principal residence. So if the condo rises to $450,000 at your death (or sale) the capital gains tax will be $46,000 (half the $200,000 gain x 46%). The condo will also be subject to probate fees as high as 1.5% in Ontario or 1.523% in Nova Scotia.
Option 2 is gifting cash of $250,000 to the child, who buys the condo in their own name. This has no immediate tax consequences but can create problems with siblings who may naturally desire an equal portion of the ultimate inheritance. Tax-wise, though, this condo becomes the child’s principal residence, which means tax-free capital gains if it rises in value over the years. And because the parents don’t own it, there will be no probate fees upon their death. The downside comes if the child gets married then divorces. Under equalization laws, he or she may lose half the value of the condo to the departing spouse.
Instead of providing an outright gift, Option 3 is to set up a mortgage so the child buys the home and pays you back through a normal amortization schedule. The loan is interest-free because any interest paid by the child is taxable in your hands and the child can’t deduct the interest on his or her own tax returns. The child can pay back the principal or the mortgage can be left outstanding, providing better protection if a divorce occurs while owning the condo. There may be probate fees but as with Option 2, the child takes advantage of the principal residence exemption. This is the most popular option, Ms. Munro says.
Option 4 is creating a discretionary intervivos family trust to acquire the condo on behalf of the child. Since parents act as trustees, they retain legal control over properties set aside for their beneficiaries: the children. The child cannot designate another property as a principal residence during the years the trust owns the condo. This option is more complex and costs a few thousand dollars to set up but provides more flexibility for the changing needs of the child — the beneficiary who ultimately receives the condo or the proceeds from its sale can be determined by trustees in the future.
Jamie Golombek, managing director, tax, with CIBC Private Wealth Management, favours a zero-interest mortgage, which is “easy, tax-effective and guarantees mom and dad can get their money back should they wish.”
Alternatively, you could waive principal repayments during the course of the mortgage; ultimately, the parents forgive the debt entirely, essentially gifting the loaned funds to the child.
Real estate author Don Campbell says outright gifting doesn’t teach kids anything, so parents often lend them the funds to buy a home in the child’s name.
They may not charge interest but want their principal back, especially if retirement is looming.
He suggests making the arrangement a “teachable moment” by formalizing a joint venture between parent and child in writing. You can download a template free from his website at http://myreinspace.com.
That way, “we give the kids a hand up and get our money back.”