There are specific rules under the Income Tax Act that apply to transfers of property between persons who do not deal at arm’s length, which include persons who are related for income tax purposes. When the rules apply, there may be deemed proceeds on the sale, or a deemed cost on the purchase, that differs from the actual proceeds or cost.
Related persons for these purposes include most individuals that you consider your close relatives in a colloquial sense – for example, your children and grandchildren, your parents and grandparents, your siblings, spouses and common-law partners of all of the above, and your in-laws. Interestingly, related persons do not include aunts, uncles, nieces, nephews and cousins.
In terms of corporations, you are related to a corporation if you or a related person control the corporation, or you or a related person are part of a related group that controls the corporation. Control generally means owning more than 50% of the voting shares of the corporation.
As illustrated below, at least two of the rules involving transfers between related persons can be quite onerous.
Rule 1: If you sell property to a related person for proceeds less than fair market value, you will have a deemed disposition at fair market value. However, this rule is one-sided, in that the related person’s cost of the property is not bumped up to fair market value.
You sell property to your son for $4,000. The fair market value of the property is $10,000 and your cost of the property was $4,000.
You will have deemed proceeds of $10,000, resulting in a $6,000 capital gain, half of which will be included in your income as a taxable capital gain. However, your son’s cost will remain $4,000. Therefore, if he sells the property to a third party for the same $10,000, there will be double taxation, since both you and your son will have been taxed on the same $6,000 gain.
Rule 2: If you buy property from a related person and pay more than fair market value, you will have a deemed cost of fair market value. However, similar to the first rule, this rule is one-sided, in that the related person’s proceeds of disposition of the property is not ground down to fair market value.
You buy property from your son for $10,000. The fair market value of the property is $4,000 and his cost of the property was $4,000.
You will have a deemed cost of the property of $4,000, even though you paid $10,000 for the property. However, your son’s proceeds will remain $10,000. Therefore, he will have a capital gain of $6,000 and taxable capital gain of $3,000. And if you subsequently sell the property for more than $4,000, you will also have a capital gain.
Rule 3: If you make a gift of property to any person, whether related or not, you will have a deemed disposition at fair market value. The person will have a deemed cost of the property equal to its fair market value.
You give property to your son. The fair market value of the property is $10,000 and your cost of the property was $4,000.
You will have deemed proceeds of $10,000, resulting in a $6,000 capital gain, half of which will be included in your income as a taxable capital gain. However, in contrast to the first rule, your son’s cost will equal $10,000. So if he turns around and sells the property for $10,000, there will be no double taxation.
As you can see, making a gift of property is much better than selling it to relative for a nominal price.
Transfers to Spouse
An exception to the above rules applies where you transfer property to your spouse (or common-law partner). In such case, there is an automatic “rollover”, which means you have a deemed disposition at your tax cost of the property and your spouse inherits the same cost of the property.
However, if you wish, you can elect out of the rollover, in which case the above rules may apply where applicable.
You give property to your spouse. The fair market value of the property is $10,000 and your cost of the property was $4,000.
Under the rollover, your proceeds will automatically be $4,000 and you will have no gain to report. Your spouse’s cost of the property will be $4,000.
If you elect out of the rollover, you will have deemed proceeds of $10,000, resulting in a $6,000 capital gain. You might consider this election, say, if you had unused capital losses that could offset the gain, so that you would not pay any actual tax on the gain. The upside would be that your spouse’s cost of the property would be bumped up to $10,000.
Note that the election out of the rollover cannot normally trigger a loss. That is, when you sell property to your spouse at a loss, the “superficial loss” rules under the Income Tax Act normally apply, meaning that your loss will be denied.
Transfer of income-earning property
The above rules apply equally to personal property as well as income-earning property. However, as discussed in our May 2018 Tax Letter, for income-earning property, the income attribution rules may apply after you transfer the property (in the case of a transfer to your spouse or minor child). For example, if you simply give property to your spouse or minor child, any subsequent income from the property will normally be attributed back and included in your income.
Transfer by tax debtor
Finally, if you are considering transferring property for less than its fair market value to a family member (whether by sale or gift), make sure you don’t have any debts to the CRA, from the past or the current year, that you’ll be unable to pay. If you have such debts, the CRA can assess your relative to collect the net value you transferred to them, to pay your tax debt. This rule, under section 160 of the Income Tax Act, was discussed in detail in our September 2016 letter.