Real Estate Taxation and Funding 

Real estate has created vast wealth for Canadians. Certain regions and cities have shown considerable appreciation in value. Canadians and foreign investors have been buying real estate in the most desirable locations, such as Toronto/GTA and Vancouver. Canadians have accumulated millions of dollars in real estate investments. The appriciation in real estate values has created a vast amount of wealth.

Unfortunately very few real estate owners have implemented any estate, tax and succession planning for their real estate investments. Life insurance is used to fund capital gains tax, land transfer tax and estate administration tax. These taxes will become payable when the property is inherited by their children.

All assets in the deceased's estate are subject to estate administration tax (formerly known as probate fees) in Ontario. In addition there is also the cost of probating a will.

In Ontario Estate and Administration Tax is as follows: 

• First $50,000 of assets, estate administration tax payable is $5.00 per thousand

• Balance over $50,000 of assets, estate administration tax payable is $15.00 per thousand

Capital Gains Taxation of Personally Owned Real Estate:

• Principal Residence – Exempt from Capital Gains Tax

• Recreational Property (Cottage) – Half of the amount of Capital Gains is Taxable 

• Investment Property – Subject to Capital Gains Tax

Capital Gains Taxation of Corporate Owned Real Estate:

The type of capital property dealt with by executors most often is real estate. If real estate is held by a privately-owned corporation it is also capital property. On deemed disposition the estate is taxed on the shares of the corporation.

The tax payable and any capital gains exemptions available is determined by a variety of factors. We would advise clients to consult an accountant or tax lawyer. Stone-Hedge Financial Group Inc. can refer one to you or work with your existing accountants and tax lawyers. 

Regardless of what exemptions are available to minimize the tax burden for your children, there will always be some form of tax payable and expenses incurred on deemed disposition of shares in privately owned corporations. Privately owned corporations can be either operating companies or holding companies.

Funding for Estate Tax Liabilities and other Fees:

Stone-Hedge Financial Group Inc. respects accountants and lawyers and their expertise. Accountants and lawyers charge fees for financial and legal advice. Accountants and lawyers cannot provide a life insurance policy to pay for future tax liabilities. When probating a will the estate will incur additional expenses, including additional accounting and legal fees. The most important component of any estate plan is to fund the future tax liabilities, if there is no funding then the estate plan is incomplete.  

Your tax lawyers and accountants cannot predict the value of your property at time of death, how long you will live, and any changes in the income tax act or other legislation the provincial or federal government will change or implement. These factors combined always leave a degree of uncontrollable and unforeseen risk. The only certainty one has is death and taxes and the ability to make funding provisions for these predetermined unavoidable events during one’s lifetime.

Capital Cost Allowance of Rental Property Taxation:

What is it?

If you own rental property such as an industrial unit or building, commercial unit or building, residential condominium, house or rental building, your accountant has probably elected to account for depreciation of the property at a rate of 4%. Depreciation is not actual money spent to maintain the property but to account for future expenses. The property will require maintenance in the future and eventually will have to be replaced. When the owner of the property deceases all their assets are taxed as if they are sold at fair market value. The depreciation that was expensed over the years is recaptured and taxed. The recaptured depreciation payable is in addition to capital gains tax and estate administration tax. 

Who has to pay the tax?

If you willed your property to your children, your children are the ones that have to pay these taxes. If they are unable to come up with the funds they will have to sell the property.

How much tax will they have to pay?

This is the million dollar question. On average Canadian real estate has appreciated at a rate of 6% per year, however desirable locations have shown considerably higher rates of appreciation. Since no one knows exactly when they are going to die, and the market value of their real estate at time of death, the tax payable is unknown. All one can do is make informed assumptions. 

What options do I have to fund the future tax liability:

1. You can let your kids pay for it if they have the money. This is usually not an option. The kids have their own financial obligations such as paying of their mortgage, paying for their children's education or simply don't have the funds.

2. Start a sinking fund – This is simply putting money aside and investing it in a savings account or GIC’s. Interest is fully taxable without any preferential tax treatment. The current low interest rate environment will result in after tax returns of anywhere form .5% to 2%. The reason why people invested in real estate is to get a better return on their money. Funding tax liabilities with low returns is not an attractive option.

3. Life Insurance – Life insurance is the most tax efficient way to fund tax liabilities. The life insurance policies Stone-Hedge Financial Group Inc. sells are fully guaranteed it is pure insurance you know up front how much you have to pay, how long you have to pay for, and the amount of the tax free death benefit. Depending on health and age you may be able to get returns on your money or anywhere from 5% to 8% after tax based on mortality. Mortality is an assumption used for calculating the return. The Canadian Government uses mortality tables for the Canada Pension Plan (CPP), to make funding provisions based on the average life expectancy of Canadians.

If you elected the third option as your preferred way to pay your tax liability using Life Insurance you get additional benefits which are as follows:

1. There is no risk that you won’t have enough money saved up to pay for the future tax liability. With a sinking fund it would take years to save up enough money and if you died prematurely there would be a shortfall.

2. When people buy property they also take out a mortgage. The lender wants security on the mortgage and requires the borrower to buy mortgage insurance. Mortage insurance is also called creditor insurance for investment properties. The lender is named as the beneficiary on all or part of the life insurance policy. A portion or all of the life insurance premiums paid is a tax deductible expence for investment properties. Once the mortgage is paid off you can still own your policy and change the beneficiary to your children. You can have more than one beneficiary if the face amount of life insurance policy exceeds the amount borrowed from the lender.

What happens if you do nothing or procrastinate?

1. Time is money when it comes to insurance, with older ages even a one year difference in age can amount to tens of thousands of dollars in additional premium.

2. Health can deteriorate rapidly, insurance premiums are higher for those with poor health. One can also become uninsurable if they have certain illnesses or medical conditions. If one is uninsurable the sinking fund option would be the only option to fund future tax liabilities.

3. If you or your children don’t have the money to pay the tax liability you can sell your real estate property during your lifetime. The proceed from the sale of your real estate property can be used to pay for capital gains tax. Either way you still have to pay capital gains tax, however you would avoid estate administration tax and land transfer tax.

4. You can will your real estate property to your children and let them worry about paying the taxes. The cost of probating your will and other assets subject to taxation may leave a shortrall in the estate. Your children may not have any other option other than to sell your real estate investments.  

What your children will face if they have to sell your real estate investments?

Generally your children will face two risks liquidity risk and market risk. There are also additional risks associated with certain types of properties, such as environmental assessment risk to clean up the property.

Liquidity Risk

Unlike investments in segregated funds, mutual funds, stocks, bonds and GIC’s, real estate is not a liquid asset. It may take months if not years to sell your real estate at a fair price. If there is a tax that has to be paid, your real estate may have to be sold at a substantial discount to fair market value. 

Market Risk

Just like any investment real estate has its cycles. The current bull cycle in real estate started back in 1996 and is one of the longest in recent history. Locations such as Vancouver and Toronto/GTA have shown above average returns for real estate investors. The appreciation in real estate values has also increased one’s future tax liability. Estate tax inherently is an inflationary tax. By virtue of ownership of real estate property that appreciates you increase your tax liability. Real estate markets do and will correct, just as they have in the past in the 1980’s and early 1990’s. The mild correction in 2008 was just a pause in a bull cycle. A severe downturn in real estate can last for a decade or longer. The last thing a real estate investor wants their children to do is sell their real estate investments into a market that has experienced a severe downturn. Unfortunately market conditions are unpredictable, it is impossible to predict the real estate market conditions at time of death.

Environmental Assessment

Governments can and will pass legislation that has financial implications to real estate investors.  Environmental assessment is now mandatory when one buys or sells certain types of real estate like industrial property, commercial property or undeveloped land. A simple oil spill can run $20,000 to clean up, for propeties used for heavy industrial the costs can be staggering. Without an environmental assessment it may not be possible to sell your real estate property. Lenders require an environmental assesment as a precondition for a mortgage. In extreme cases if your real estate property has been used for automotive, scrap yards, heavy industrial, or has been contaminated the cleanup costs can exceed the value of the property.   

Stone-Hedge Financial Group Inc. has extensive expertise in real estate taxation and funding our clients include builders, developers and individual investors.

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The information provided on this web site is intended for general information only. It should not be construed as legal, accounting, tax or specific insurance and investment advice. Clients should consult a professional advisor concerning their situations and any specific insurance and investment matters. While reasonable steps have been taken to ensure that this information was accurate as of the date hereof, Stone-Hedge Financial Group Inc. and its affiliates make no representation or warranty as to the accuracy of this information and assume no responsibility for reliance upon it.