Tim Cestnick is managing director at WaterStreet Family Wealth Counsel and author of 101 Tax Secrets for Canadians.
My youngest son, Michael, is starting to figure out the value of money. Two years ago, he would have preferred keeping a bag of pennies to having a $10 bill in his pocket. Well, things have changed. Last weekend, Michael tried to trade five of his quarters for a toonie of his grandfather's. Michael now knows that a swap can actually leave him better off financially. The same is true in tax planning. You could save tax by swapping assets with a family member. Here's how:
INCOME SPLITTING
You might want to swap assets with a family member to shift taxable income from your hands to the hands of someone else in the family who will pay tax at a lower rate. If you can move an income producing asset to a family member with a lower income, the income generated on that asset could be taxed at a lower rate. The tax savings annually could be as high as $18,360 if you live in Ontario - the highest potential tax savings from splitting income in the country (the nationwide average is $15,990, but varies by province). For income splitting to work, the transferor should have a higher marginal tax rate than the transferee.
Now, you have to be aware of the attribution rules in our tax law, which are designed to attribute certain income earned by family members back to you where you've transferred assets to those family members.
SWAPPING ASSETS
One method to sidestep the attribution rules is to transfer investment assets to a family member in exchange for assets of equal value.
In other words, a fair market value swap can work to accomplish income splitting. Consider Steve's story.
Steve is in the highest marginal tax bracket while his wife, Michelle, is in a lower tax bracket. Steve has $200,000 of investments that he would like to transfer to Michelle so that she can pay the tax on the income earned on those investments instead. Simply giving Michelle the $200,000 won't accomplish this because of the attribution rules. But what if Michelle transferred to Steve an asset of equal value? I'm talking about her half of the family home, which is worth $400,000. This story, however, doesn't end here. There are some other issues to be aware of.
THE FINE PRINT
Disposition at fair market value: When swapping assets, each family member will be disposing of their assets at fair market value, which could trigger a taxable capital gain, but perhaps not if your investment values are worth less today than what you paid. Still, even paying a little tax today could be worthwhile if future income will be taxed at a much lower rate. In the case of Steve and Michelle, she's transferring her half of a principal residence to Steve, so the principal residence exemption can protect her from tax. Keep in mind, if you're transferring investments to your lower income spouse, any capital loss will be denied under the superficial loss rules. Not so with your children; you'll be able to claim a capital loss when swapping assets with a child.
Election should be filed: To avoid the attribution rules, a swap must take place at fair market value. When swapping with your spouse, it's necessary to make sure that subsection 73(1) of the Income Tax Act not apply to the transfer of assets. This is done by both spouses filing an election (a written paragraph) with your tax returns for the year of the transfer.
That provision causes transfers between spouses to automatically take place at your cost amount, not fair market value, which you don't want. This election is filed by attaching a statement to each spouse's tax return and is necessary only where it's your spouse involved in the swap.
Ownership matters: Make sure that the asset you take back from your family member was truly acquired by him or her, and not by you. In the case of Steve and Michelle, the swap would not have worked if Michelle's half of the home had actually been purchased with Steve's money.
Take back non-income-producing assets: If you're the family member with a higher income, make sure that the asset you take back does not produce income, otherwise you won't accomplish the income splitting you're looking for.
Get help: Don't try this stunt at home on your own. You wouldn't give yourself a kidney transplant, so don't try an asset transplant - or swap - without help either. This is particularly true if you're thinking of swapping assets with your spouse.
