A popular strategy to avoid probate fees on non-registered accounts and real estate is using joint tenancy with a right of survivorship. This allows the asset to bypass the estate and transfer to the surviving joint owner directly. Although the strategy may help your client save on estate administration taxes, income tax and estate consequences are often overlooked and can disrupt your client’s estate plan.
Under the income tax rules, each joint owner with a right of survivorship is presumed to have an equal interest/ownership in the asset. When your client adds a spouse or common-law partner on title, the default rules state that the transfer occurs at the adjusted cost base (ACB). When your client adds another individual on title, such as a child, there is a deemed disposition of a proportionate share in the asset at fair market value (FMV). These changes in ownership, whether during the client’s lifetime or due to a joint owner’s death, can cause unintended consequences as illustrated in the hypothetical example below.
Keeping the cottage in the family
Amit (age 68) is married to Sonam (67), and they have two children, Raj (35) and Riya (31). Raj is married with two young children and Riya is single with no kids. Amit purchased a cottage in 2001 for $300,000, currently valued at $1.1 million, and he is the sole owner of the property. He and Sonam would like to ensure that their estate is divided equally between their children and that the cottage stays in the family. To avoid probate fees on the cottage, Amit decides to add Sonam, Raj and Riya as joint tenants with a right of survivorship, and he documents his intention of creating a true joint tenancy that provides both legal and beneficial interest to all joint owners.
For income tax purposes, Amit will be deemed to have disposed of 75% of his interest in the cottage when Sonam, Raj and Riya are added as joint owners. The 25% interest transferred to Sonam will not result in any immediate capital gains taxation due to the tax-deferred rollover between spouses. The remaining 50% interest transferred to Raj and Riya will trigger capital gains of $400,000 for Amit at the time of transfer [(50% × $1,100,000) – (50% × $300,000)].
Assuming a 45% tax rate, this transfer would result in an immediate tax liability of $90,000 for Amit ($400,000 × 50% inclusion rate × 45%) that will have to be paid using other assets. He may be able to reduce this tax liability using the principal residence exemption or other strategies such as the capital gains reserve.
After the changes in title, the FMV and ACB for each owner are as shown in the table below.
Table 1: FMV and ACB for joint cottage owners after title change
|Amit (25%)||Sonam (25%)||Raj (25%)||Riya (25%)|
|FMV of interest||$275,000||$275,000||$275,000||$275,000|
|ACB of interest||$75,000||$75,000||$275,000||$275,000|
Let’s fast forward 10 years. The cottage is now worth $1.8 million, so each owner’s proportionate interest is $450,000.
Raj passes away in an unfortunate accident, resulting in a deemed disposition of his interest in the cottage, which will be distributed equally among the surviving joint owners.
Assuming a 50% tax rate, Raj’s estate would owe $43,750 in income taxes [(FMV of $450,000 – ACB of $275,000) × 50% inclusion rate × 50%] on the deemed disposition of his interest in the cottage without ever inheriting any assets from Amit and Sonam. This not only reduces Raj’s residual estate available for his spouse and children but also inadvertently disinherits Raj’s family from the cottage due to the survivorship rights of the other joint owners. This is contrary to Amit and Sonam’s desire to ensure both Raj (and now his surviving spouse and children) and Riya are treated equally.
These adverse consequences could have been avoided if, instead of using a true joint tenancy, Raj and Riya had been added as joint tenants with a gift of right of survivorship. This type of ownership does not provide beneficial interest to Raj and Riya until the survivor of Amit and Sonam passes away, which means there would not be a taxable event when Raj predeceases Amit and Sonam.
At this time, as the ownership cannot be changed retroactively, Amit and Sonam may consider revising their estate plan to provide a greater share of their estate to Raj’s family, especially to account for the income taxes paid by Raj’s estate for the asset he never inherited.
After Raj’s death, the FMV and ACB for each owner are shown in the table below.
Table 2: FMV and ACB for remaining joint cottage owners after son’s death
|Amit (33.33%)||Sonam (33.33%)||Riya (33.33%)|
|FMV of interest||$600,000||$600,000||$600,000|
|ACB of interest||$225,000||$225,000||$425,000|
The FMV of Raj’s $450,000 interest is divided equally among the surviving joint owners ($150,000 each), which increases the ACB of their interests accordingly.
When Amit and Sonam pass away, Riya will receive 100% ownership in the cottage as the sole surviving owner. The tax liability on the deemed disposition of 66.66% interest in the cottage will be paid using Amit and Sonam’s estate assets, which will further reduce the residual assets available for their beneficiaries, including Raj’s family.
To equalize their estate between Riya and Raj’s family, Amit and Sonam may consider adjusting Riya’s share for the potential tax liability on the cottage that will be paid from their estate, while Riya inherits the cottage free and clear of the tax liability.
Besides the income tax consequences discussed, it is important to keep in mind that adding a family member as a joint owner can expose the asset to claims from the family member’s creditors and result in loss of control over the asset.
For all these reasons, it’s important for your clients to obtain tax and legal advice before using joint tenancy with a right of survivorship to save probate fees.
Vivek Bansal, CPA, CA, is director of tax and estate planning at Mackenzie Investments. He can be reached at email@example.com.