The Globe and Mail

Summer is the time for theatre festivals. Not long ago, at Scotland's Edinburgh Fringe Festival, the Sweet Productions company staged a play designed to stretch the definition of art. The plot is easy to remember, because there wasn't much to it.

The audience took their seats and then absolutely nothing happened on stage for the next hour. The lights then came up and any remaining audience members left. The funny thing was that some people who paid good money to see the play knew that absolutely nothing was going to happen.

I guess some people are content to do absolutely nothing. It's not my idea of an entertaining night out, but doing nothing – that is, refraining from certain transactions – can often make sense in tax planning. Let me share Ruth's story. Ruth is now 84. She owns a cottage that she rarely uses. Her children and grandchildren use the place all the time. The cottage is worth $500,000 today, while she paid just $50,000 for it back in 1975. She and her late husband had invested another $50,000 in the cottage over the years, so her adjusted cost base on the property is $100,000.

Ruth decided that she wants to give the cottage to her two children. The problem? If she gifts the cottage to the kids, she'll be deemed to have disposed of the property at fair market value. This could trigger a taxable capital gain and a potential tax bill of $92,820. She wasn't keen on paying that tax today; after all, she's not actually selling the cottage to the kids, so there won't be any sale proceeds available to pay the tax bill.

While it's possible that Ruth could designate her cottage as her principal residence and shelter the capital gain from tax, we did the math and figured that she's better to preserve that exemption for her city home, which has an even larger accrued capital gain.

And so what's Ruth to do?

Often, it makes sense to do nothing. That is, Ruth may be better off waiting until she dies to transfer the cottage to her kids. This will defer tax until that time. For Ruth, however, this was no option. She wants to transfer the property to her children today for sentimental reasons. She wants to see them enjoy ownership of the property while she's alive.

The idea

Given these constraints, Ruth is now considering a strategy that will allow her to spread her tax bill over a five-year period – payment terms she can manage – by taking advantage of the “capital gains reserve,” found in paragraph 40(1)(a) of Canadian tax law.

Ruth would “sell” the cottage (or any assets, for that matter) to her children for fair market value, but would take back promissory notes, not cash, in exchange. The notes will be worded such that Ruth will collect the proceeds over at least five years.

This will allow Ruth to pay tax on her capital gain over a five-year period.

In actual fact, Ruth does not intend to ever collect on the notes. That is, the children will never have to actually make a payment. Nevertheless, Ruth will still pay tax over five years. She will then forgive the promissory notes in her will, which will have no adverse tax consequences for anyone. As always, be sure to visit a tax pro if you hope to try this.