There are rules in the Income Tax Act that deal specifically with gifts and non-arm’s length transfers of property. We summarize them below.
If you give property to someone, you are deemed to dispose of the property for “fair market value” proceeds of disposition. This means you may have a capital gain or loss, depending on your adjusted cost base of the property (which is your original cost, with possible adjustments).
“Fair market value” normally means the highest price someone would pay on the open market in an arm’s length transaction with full information.
The person who receives the gift is in turn deemed to have an adjusted cost base of the property, for capital gain / loss purposes, equal to its fair market value.
I give property to my son. My adjusted cost base of the property is $10,000 and its fair market value is $50,000.
I will have a capital gain of $40,000, one half of which will be included in my income as a taxable capital gain (if I have any allowable capital losses, that inclusion will be reduced).
My son gets an adjusted cost base of the property of $50,000. So, if he later sells it for, say $60,000, he will have a capital gain of $10,000 and half of that will be included in his income.
The gift rule applies not only to gifts to individuals, but also to gifts to other entities. For example, if the above gift was made to a charity, I would still report the same taxable capital gain. However, I could claim the charitable tax credit for the fair market value of $50,000.
In general terms, the federal charitable tax credit is 15% of the first $200 of gifts in the year, plus the provincial credit which depends of the province, and typically brings up the percentage to around 20%. After that, if you are in the highest income tax bracket which for 2022 applies to taxable income over $221,708, you are eligible for a federal credit of 33% plus the applicable provincial rate, which can bring that up to around 50% or more, for gifts over $200 to the extent of your taxable income in the top tax bracket. If there is any remaining amount of gift, you get a federal credit of 29% plus the applicable provincial rate. If your taxable income is not subject to the highest tax bracket, the rate for donations over $200 remains at 29% plus the provincial rate.
Example of charitable gift
Assume you made the $50,000 gift from the above example to a charity. You would still have a capital gain of $40,000 and a taxable capital gain of one-half of that amount included in your income (subject to the rule explained further below about publicly-traded shares or other securities).
You have taxable income in 2022 of $241,708, which is $20,000 over the top marginal tax rate threshold.
You will get a federal credit of 15% of $200 plus the provincial credit. You will get the maximum federal credit of 33% on $19,800 plus the provincial credit. For the remaining $30,000 of the gift, you will get a 29% credit plus the provincial credit.
There is an additional tax benefit if your gift to the charity is a publicly listed security. In such case you still get the charitable tax credit as noted above, but you will have no capital gain, which obviously will save you even more tax.
Furthermore, there is no capital gain or loss if you give cash, since the adjusted cost base of the cash will equal its fair market value. An exception occurs if you give foreign currency, since that may fluctuate relative to the Canadian dollar; this is an exception that we will discuss in a future letter.
Non-arm’s length transfers that are not pure gifts
These rules can be quite punitive.
They can apply to transfers between non arm’s length persons, which include related persons as defined in the Income Tax Act. Related persons include you and your spouse or common-law partner (although there is a special rule for transfers to them, as discussed below), your siblings, your children, parents, grandchildren, and in-laws, among others. Related persons also include you and a corporation that you control or another related person controls. Interestingly, related persons do not include your cousins, nieces and nephews, and aunts and uncles.
The first rule can apply where you sell property to a non-arm’s length person for proceeds that are less than the property’s fair market value. In this case, you are deemed to have sold the property for fair market value. The apparent rationale for the rule is to prevent you from shifting accrued capital gains to a lower-taxed non-arm’s length person. However, the rule is one sided, in that the purchasing person gets an adjusted cost base equal to what they actually paid, and not the fair market value. As illustrated in the example below, this can lead to double taxation.
I sell property to my son for $10,000. My adjusted cost base of the property is $10,000 and its fair market value is $50,000 at the time of the sale.
I will have deemed proceeds of $50,000 and therefore a capital gain of $40,000 ($50,000 deemed proceeds less my adjusted cost base of $10,000).
But my son’s adjusted cost base of the property will remain the $10,000 that he paid for the property. So, for example, if he turned around and sold the property to a third party for $50,000, he would also have a capital gain of $40,000. Double taxation occurs.
The second rule can apply if you purchase property from a non-arm’s length person for more than its fair market value. In this case, your adjusted cost base is ground down to the fair market value even though you paid more than that. But again, this rule is one-sided, in that the non-arm’s length person’s proceeds of disposition are whatever you actually paid. As the example below illustrates, this rule can also result in double taxation.
My son sells me property for $50,000. His adjusted cost base of the property and its fair market value are both $10,000.
I have a deemed adjusted cost base of $10,000. However, my son’s proceeds of disposition equal the $50,000 that I actually paid for the property, which means he will have a $40,000 capital gain.
If I later sell the property for more than $10,000, I will also have a capital gain. So again, this rule can result in double taxation.
Exception for transfers to spouse or common-law partner
If you sell or give property to your spouse or common-law partner, a tax-free “rollover” is allowed so that the above rules do not apply. Basically, you are deemed to have sold or given the property for proceeds equal to your adjusted cost base, and your spouse or partner picks up the same adjusted cost base.
However, you have the option to elect out of the rollover, in which case the above rules do apply. There are various reasons you might do this – for example, if you have unused capital losses, you could apply them to offset any resulting capital gain, while providing your spouse or partner with a stepped-up adjusted cost base.
I give property to my spouse. My adjusted cost base in the property is $10,000 and its fair market value is $50,000.
With the rollover, I have deemed proceeds of $10,000 and therefore no capital gain. My spouse then has the same $10,000 adjusted cost base.
However, say I have unused capital losses that I could use to offset a capital gain. If I elect out of the rollover, I will have deemed proceeds of $50,000 and a resulting capital gain of $40,000, which could be offset by my capital losses, thus resulting in a nil or low net taxable capital gain. My spouse would benefit from an increased adjusted cost basis of $50,000, which would decrease any capital gain (or increase any capital loss) when they eventually sell the property. Note however that the future capital gain or loss may be attributed back to me under the income attribution rules.
Unfortunately, you cannot get a capital loss by electing out of the rollover. This results from the superficial loss rules, discussed below.