The article “Should You Sell Your Home To Your Kids?” was originally published on MoneySense on October 13, 2020.

Graham is considering a creative strategy to access his home equity with the help of his grown children. The end goal: to build a vacation property for the whole family.

Q. A scenario we are thinking of is “selling” our principal residence to our three adult children. We would use the proceeds to build a vacation home that they will eventually inherit. When they buy our home, it will not be a principal residence for any of the children, as they all have homes. Instead, it will become an investment for them, while their mother and I rent from them until the vacation home is built and beyond.

The house is worth just over $600,000. We need $450,000 to $500,000 at most to build, and would be willing to sell the principal residence to all three of our kids for that price. Does this sound workable? Can we choose this lower price without any tax implications?

A. First off, Graham, kudos to you for creativity. This is an interesting proposal and an opportunity for your family.

Assuming you have not owned another home during the years you have owned your principal residence, the sale—whether to your children or otherwise—should qualify for the principal residence exemption. There are limitations on acreage, so that a home with more than ½ hectare (1.24 acres) of land may not fully qualify unless you can demonstrate that the extra acreage is necessary to use and enjoy your home. A common example of this situation may be if you live in a municipality that has a minimum lot size of more than ½ hectare.

According to the Canada Revenue Agency, “if you sell property to someone with whom you do not deal at arm’s length and the selling price is less than its fair market value, your selling price is considered to be the fair market value. Similarly, if you buy property from someone with whom you do not deal at arm’s length, and the purchase price is more than the fair market value, your purchase price is considered to be the fair market value.”

Selling the house to your kids at an artificially low price would not be beneficial given the sale proceeds are presumably tax-free to you, Graham. The kids would actually benefit from the price being higher, to reduce their future capital gains tax given the rental property would not qualify as a principal residence when they eventually sell it. But, as CRA notes, the purchase price will be considered to be the fair market value regardless of the price you use.

Consider alternatives to “selling low”

There is nothing to stop you from selling it for the $600,000 fair market value and gifting your kids $100,000 to $150,000 to accomplish the same thing as you’ve proposed. However, I would encourage you to be sure that you do not need that money to fund your retirement and could comfortably afford to give it to them.

Another alternative would be to sell your house to your kids for $600,000 and lend the $100,000 to $150,000 to them. They may need a down payment of 20%, or $120,000, to buy the property from you, and could finance the rest with a mortgage from a bank.

If you charged interest on the loan to your kids, they could deduct the interest on their tax returns, as they will have borrowed the money for investment purposes. You would have to report the interest income on your own tax returns. If you charge no interest, that is OK in this instance as well, Graham.

In order for your kids to treat the property as a rental property to deduct their mortgage interest and the other associated property costs on their tax returns, the rent you pay them must be equal to fair market rent. In other words, you cannot choose an artificially low rent to reduce their net rental income or increase their net rental loss.

Besides that, if you want to pitch your kids on this being an investment for them, the rent they are earning should be reasonably competitive.

I think your idea here has merit and is a great example of an alternative to a reverse mortgage. Seniors can do this without involving their kids, as well, potentially listing their home for sale with the condition that they want to remain as long-term tenants. It may limit the potential buyers for the home, but an investor may appreciate the opportunity to buy a home with a tenant who has money (from the house sale), who will treat the property well (having been the previous owner) and who may stay for a number of years (providing stable rental income). A real estate agent could help develop the proper listing details for the home and prepare a residential tenancy or lease agreement to sign at the same time as the agreement of purchase and sale is completed.

Real estate should be a complement, not a replacement, to other long-term investments

That said, there are a couple things I will question about this proposal, Graham. The result, from the sounds of it, is that you and each of your children will end up owning two real estate properties. Home ownership can be good for a lot of reasons and rental real estate can be a good way to invest. But whenever I talk to someone who is going out of their way to own multiple properties, I encourage them to consider whether that is the best approach.

Real estate has appreciated significantly in many Canadian cities, including Vancouver, Toronto and Montreal, in recent years. However, prices have decreased in other cities, particularly in Alberta. Rental real estate is likely to provide a comparable rate of return over the long run to a balanced investment portfolio. But real estate has significantly higher acquisition and sale costs (land transfer tax, real estate commissions, legal fees, etc.). As long as someone has a long-term time horizon and is not expecting real estate to make them significantly wealthier than stocks and bonds, especially given the already high prices in many Canadian cities, that is important to consider.

Your kids may have other opportunities, like Registered Retirement Savings Plan (RRSP) or Registered Pension Plan (RPP) tax deductions, which they forgo to buy this home from you. Or opportunities for tax-free growth in their Tax Free Savings Accounts (TFSA). If they have children — your grandchildren — and may forgo contributions to Registered Education Savings Plans (RESPs). They should be sure the one-third rental property ownership is a complement to their other long-term investment and financial goals, and not a replacement.

Calculate the opportunity cost

Finally, let’s say you build a vacation property for $500,000, as planned. If you sell your home and then have the choice to invest the proceeds in stocks and bonds, or build the property, there is an opportunity cost from not investing the proceeds, and building instead.

Let’s say you could have otherwise earned a 3% after-tax return on investing the money. A 3% “cost” to you on not investing that $500,000 is $15,000 per year.

Now what about property tax, insurance, utilities and maintenance? These could vary depending on the property, but let’s assume another 3% per year. We are up to 6%, or $30,000 in costs. But the property will grow in value, right? Over the long run, real estate has historically grown at slightly more than inflation, despite the growth we have seen in some big cities in recent years. So, call it 3% growth, or $15,000 per year. A 6% cost of $30,000 less 3% growth, or $15,000, is 3 per cent or $15,000; that’s the net cost for your notional $500,000 property. Are you going to get $15,000 of use out of the property? If you were only going to use it a month or two each year, what could you rent for the same $15,000 that owning would cost you?

If you were going to use it six months a year, that is different. Now we are up to 26 weeks and $15,000 divided by 26 weeks is only $577 per week. If you thought your usage was going to be that much, buying may be better than renting.

If you did not think you were going to use the vacation property that much but were open to offering it up for short-term rental, you might still be able to justify owning from a financial perspective. That extra income would help cover the costs.

This is not to say that financial considerations should drive all your decisions, but if you would not use your notional vacation home much, consider renting a vacation property.

As I said from the start, you have come up with an interesting proposal and opportunity for your family. I am neither for nor against it, and have tried to raise some questions to help you make a good decision. I hope my input has been helpful.

Jason Heath is a fee-only, advice-only Certified Financial Planner (CFP) at Objective Financial Partners Inc. in Toronto. He does not sell any financial products whatsoever.