How best to structure property sale to your kids

Some people inherit things the rest of us can only dream of. A friend of mine had a father who was a collector of all things weird. When his dad passed away, my friend inherited a cannon that was once used in a circus act to shoot a woman across a tent. His brother inherited the 25-foot catapult that his father used to keep trespassers off his property (he'd shoot chicken dung that he collected from the farm across the road).

The rest of us can only dream about such things. Rather than making generous gifts, some parents prefer to sell their assets to their children. Consider the following situation that appeared in a recent Canada Revenue Agency (CRA) technical interpretation (document 2007-0244941E5).

THE STORY

This is the story of a father - call him Hal - who owned a rental property. On Jan. 1, 2007, his daughter - call her Cindy - moved into the place (the taxpayers' real names aren't disclosed by CRA). Hal's intention was that this would be a "rent-to-own" arrangement whereby Cindy would pay her father an amount each month for 10 months, and then Cindy would purchase the property from Hal for its fair market value, say, $250,000. The monthly payments would be considered a down payment.

Hal had two questions. First, could he continue to deduct rental expenses for that 10-month period that Cindy lived in it before she bought it? Second, will Hal have to report the 10 monthly payments as proceeds of disposition when selling the place to Cindy?

CRA's answers to these questions raise a potential double-tax problem that can be avoided if structured properly.

THE DOUBLE TAX

CRA said that Hal could continue to deduct expenses provided that the monthly payments received from Cindy were considered to be rental income. Not rental income? Then no deduction for expenses. And whether Cindy's payments should be rental income is a question of fact.

Where the monthly payments from Cindy were intended to be for use of the property, represented fair market value rent, and were not refundable to Cindy (i.e., if she chose not to purchase the property in the fall, would Hal have refunded those monthly payments to her?), then the monthly payments are likely rent, and Hal can deduct expenses.

On the other hand, if the payments were considered refundable deposits which would be given back to Cindy, those payments would not generally be considered rent, and Hal would not be able to deduct expenses.

Is there a difference to Hal whether he structures the monthly payments as rent, or refundable deposits? Absolutely. If the monthly payments are considered rent, Hal could end up paying tax twice on part of that "rent." This is a double-tax problem.

Consider Scenario 1. Suppose Hal collects, say, $20,000 from Cindy over the 10 months, and considers the amounts to be refundable deposits to be given back when Cindy buys the place. In this case, Hal would not pay tax on the $20,000 (nor could he claim expenses). Cindy will then buy the place for $250,000, but Hal will give her $20,000 toward that price, so that she only has to come up with $230,000 on her own. Hal reports a selling price for tax purposes of $250,000, but he was not taxed on any of the payments received over the 10 months.

Now, consider Scenario 2. Hal instead considers the $20,000 collected to be rental income, and deducts expenses of, say, $12,000. In this case, Hal pays tax on net rental income of $8,000. Then, Hal sells the place to Cindy. Assuming Hal wants to credit Cindy for the $20,000 she paid to him, he'll set the selling price at $230,000, but Hal will still have to report a selling price of $250,000 since Canadian tax law will deem him to have received fair market value for the property, even if he collects just $230,000 from Cindy. In this case, then, Hal reports a selling price for tax purposes of $250,000, and he also pays tax on $8,000 of payments received over the 10 months. This is more taxable income than under Scenario 1.

THE MORAL

If you were Hal, which way would you structure the arrangement?

As a general rule, when selling property to your children, and receiving payments that you'll eventually apply to the selling price, you'll likely be better off calling those payments refundable deposits rather than rent against which you deduct expenses.

Be sure to document your intention, so that your argument can be supported if CRA ever challenges your tax treatment.

(prepared by Globe & Mail)