Last weekend my wife, Carolyn, and I were sorting through some boxes of paperwork in her mother’s basement. We stumbled across the last will and testament of Carolyn’s great, great, great-grandfather, Richard Clark. It was signed by him on June 11, 1903.
A few lines in his will stood out to me: “I give, devise and bequeath to my dear wife, Rachel, the brick part of the house in which we now live.” Grandma Clark didn’t inherit the whole house – just the brick part (their unmarried daughter inherited the rest of the house). And “my wife is to have, if she so desires, a cow, horse and pig, and proper food and shelter for the same.” Finally, he provided that “the four chickens that are owed to me by my son William I hereby forgive and are bequeathed to him.”
It was very kind of Grandpa Clark to forgive the chickens owned to him by his son. Although it’s common to see parents forgiving debts in their wills, the strategy should be considered even more often. Here’s a primer on the topic.
Our tax laws don’t always look favourably upon debt forgiveness. In fact, Section 80 of our tax law is designed, in certain situations, to include in your income the amount of any debts you might owe that are later forgiven by the lender. The debt-forgiveness rules apply where the debt is considered a “commercial debt obligation,” which includes a loan with interest where the borrower is able to deduct the interest costs.
I won’t spend time today detailing the very complex debt forgiveness rules, but will say that any debts forgiven upon the death of the lender come free of any negative tax consequences. So, if your kids owe you money, forgiving that debt in your will has no negative tax consequences.
Now, I realize that some want to track every penny loaned to their children so that an equalization can take place upon death. If, for example, you lend $10,000 to one child, but not the other, it might be considered fair to have that child pay back the $10,000 out of his or her inheritance so that the other children are not short-changed.
In other cases, parents simply want to forgive the amounts owing upon death. This approach is most common where the intention was always to give the child the amount, but perhaps it was established as a loan at the outset for good tax and financial planning reasons. Let me share with you three common scenarios where loans have been utilized and forgiven later.
1. Transferring real estate. Suppose you want to gift the cottage, or a rental property, to your kids. And you want to make the gift during your lifetime. If the property has appreciated in value, you will trigger a capital gain on the transfer, which could result in a tax bill. You can spread that tax bill over a period as long as five years (the maximum allowed under our tax law) by selling the property to your kids for a promissory note that is worded so that your right to collect the sale proceeds is spread over a period of five years. You don’t need to demand payment from your children for the note. You can forgive any notes in your will with no tax implications.
2. Help with a home purchase. Some parents want to help the kids buy a home. This is becoming more common as the price of homes rises in certain markets. While you could give money to your child, it often makes more sense to structure the amount as a mortgage on the property to give you the right to demand repayment. This makes even more sense when your child is already married. This way, you can protect that value from any marriage breakdown, or the attack of other creditors of your child. You can forgive the mortgage in your will if you don’t care to collect on it.
3. Lending money for business purposes. Perhaps you want to help your child get a business off the ground. You’d be wise to set this up as a loan with interest. This will ensure that, if the business fails, at a minimum you’ll be able to claim a capital loss. If you make the loan to a corporation established by your child, or invest the amount in the shares of your child’s corporation, you may be able to claim an allowable business investment loss later if the business becomes insolvent. You can forgive a loan in your will with no tax consequences. If you forgive an interest-bearing business loan during your lifetime, the debt forgiveness rules can kick in and may negatively affect your child.
Tim Cestnick, FCPA, FCA, CPA(IL), CFP, TEP, is an author, and co-founder and CEO of Our Family Office Inc. He can be reached at email@example.com.