A visitor to Canadian Tax Resource recently wrote in with some questions on what to do with a large accrued capital gain and an intent to pass along assets to his heirs in an efficient manner. Following is our response.
Based on the facts provided, you are 70 years old with a portfolio with an accrued capital gain of $800,000. None of the assets had been acquired before 1972. You are a resident of Ontario.
You intend to preserve capital for your heirs but realize that the portfolio may need more diversification and re-balancing.
At your income level your marginal tax rates are 43.41% up to 123,000 and 46.41% over $123,000. The tax on capital gains is ½ of these marginal rates. The estimated tax liability on the portfolio is approximately $185,000 and your “estimated” probate fees on these assets would be $15,000.
Probate may be easily avoided through the use of segregated funds or a trust but the accrued tax liability cannot. It would not make a significant difference from a tax perspective if you were to liquidate your portfolio fully to crystallize your gains all at one or in small portions over time. That being said, the more funds that remain invested and not eroded by taxes on crystallized gains the better you will be in the long run.
The strategy suggested would involve taking out an investment loan with the existing assets as collateral. The invested amount would increase by the amount of the loan and interest on the will be deductible for tax purposes.
If we assume a loan of $750,000 at 5% per year, the interest payments would be $37,500 which could be deducted from any gains realized. To fully use the interest deduction you could sell approximately $93,750 per year and incur little tax. You may need to sell an additional $50,000 to cover the interest expense.
There are risks to using leverage:
- There is a cash flow risk because the interest must be paid and usually monthly.
- If there is a decline in market value in the short term the loan value does not change. If securities are purchased on margin, you may be subjected to a margin call and may be forced to liquidate to cover the call.
- The interest rates on investment loans, if margin or a line of credit is used, is subject to market fluctuation.
Despite your wealth and given your age it is typically not recommended unless you have a high risk tolerance and long time horizon.
Segregated funds are an insurance product that looks very similar to a mutual fund except that segregated funds are insurance contracts that offer a capital protection guarantee. Segregated funds also can be distributed to the beneficiaries directly upon proof of death and bypass probate and the associated fees.
Like mutual funds segregated funds allocate income and capital gains to the investor and these allocations retain their original characteristics (interest, dividends, and capital gains). Segregated funds however, can allocate capital losses to its holders while mutual funds may only allocate net capital gains. Taxes are due on the income and gains but no cash payments will be distributed. Thus there is a tax liability with no cash in flow and units may need to be redeemed to cover the tax liability. The redemption of the units removes funds from their exposure to the market. Despite this segregated funds are tax efficient but the tax does erode the invested capital.
Be aware that because of the capital protection feature, segregated funds typically have a much higher management expense ratio (MER) than a traditional mutual fund. This MER is an expense of the fund for professional management and reduces the annual performance of the fund.
Segregated funds are normally suitable for creditor protection, preservation of capital and probate avoidance.
Establish A Trust
A trust is normally used when control of assets is an issue. For example, assume an adult child has a gambling problem, spends all their money on frivolous things, or simply cannot manage their money. If you were to give that child a large sum of money, it would probably be spent very quickly. By establishing a trust, the trustee would hold title to the assets for the benefit of the beneficiary. Income from the assets could be paid or a regular basis or at the discretion of the trustee. Thus control of the assets is retained by the trustee but the income paid to the beneficiary is taxed in the beneficiaries’ hands.
A trust may be established while you are living or out of your will after death. A trust established while you are alive is called an inter-vivos trust and any income retained in the trust that has not been paid out to the beneficiaries is taxed at the highest marginal tax rate in the province (46.41% on normal income in Ontario in 2008). The inter-vivos trust would avoid probate and the assets could be distributed based on any determining factor (age of the youngest beneficiary, 15 years after death of the settlor etc.). Note that when assets are transferred to an inter-vivos trust, a disposition is recorded for tax purposes and any taxes must be paid on gains up to the date of the transfer.
If the trust is established out of a will, the tax rates that are applied to income retained in the trust are the same as those applied to individuals except that the personal tax credits are not available. A trust established from a will could be used to split income with family members. Since this trust is established out of the will there is a deemed disposition at death and probate would be applied to the estate as the assets would form part of the estate. However, the subsequent trust may be distributed or dissolved at a future event without being subjected to probate.
If a trust is an option you will need to find a reliable and suitable trustee. You may use a family member or a corporate trustee (i.e. a trust company). Using a trust company has costs that can be somewhat high but not prohibitive for a trust of $1 million. There are also legal costs to draft either a trust deed or a will that establishes a trust deed.
If control is not an issue and the assets are no longer required, you may simply give the assets to your adult heirs before death. The gift would result in a disposition for tax purposes and again any taxes due must be paid but you would effectively avoid probate.
Hopefully the above provides you with some clarification of the different options available. If you have a similar situation and are looking for advice or support, I offer a range of estate services through my professional tax firm.
I can assist you with estate planning, tax planning and business succession planning services. In addition, I also have executor support services, to support an executor in the administration of an estate.