Cottages: Merriment, Death and Taxes
Written by: Nicole Ewing, B.A. (Hons.), LL.B.
Cottage season is mercifully just around the corner now. But as your clients will inevitably discover, owning a cottage is not all bonfires and frolics in the lake. It also requires thoughtful planning to avoid future anxiety and disappointment. This brief article lists some issues that should be considered now to protect your clients and their families in the future.
Wonderful—that cottage your client purchased a few decades back has experienced an astronomical increase in value! So big in fact, it may now prevent the beloved family cottage from being passed to the next generation. A cottage is capital property, and with capital property comes capital gains tax. If the cottage owner is planning to leave the property to the next generation via his or her Will, and he or she has not planned for the taxes that will become due when the property is transferred (i.e. on death), beneficiaries are often required to sell the property just to pay the tax bill. This can be particularly devastating for family relations where one child receives the cottage and the accompanying tax bill, and another receives an equalization payment for the value of the cottage without the tax bill. Here are a couple of ways the taxes might be lowered and harmony maintained:
Make the Most of the Principal Residence Exemption
A family unit’s principal residence is sheltered from capital gains tax. If the cottage has experienced a larger gain than the family home it would be beneficial to designate the cottage as the principal residence. Even where a cottage is used occasionally or only during a certain period of the year, the Income Tax Act may permit for it to be considered the family’s principal residence. For the years of ownership before 1982 special attention is required—prior to then, each spouse, not just each family unit, was permitted to obtain an exemption. If title to the properties is held separately there may be a tax minimization opportunity here; however, joint ownership is more advantageous for probate planning, so an analysis of the collective benefit is required.
Minimizing Capital Gains by Maximizing the Adjusted Cost Base (ACB)
If the cottage is not the principal residence, the appreciated value is taxable on disposition. The capital gain is determined by subtracting the adjusted cost base (ACB) from the sale price—therefore, increasing the ACB will reduce the gain. Cottage owners should be made aware that the cost of additions and improvements to the property may be added to the original purchase price when determining the ACB. Using a dedicated bank account for cottage related purchases, as well as keeping a file with invoices, receipts and cancelled cheques, will make future dealings with CRA much more manageable.
The Transfer: Now or Later?
This is not an easy decision. Either method has its inherent risks and rewards, which must be weighed carefully within the unique (or perhaps all too common) circumstances of each family. The following are a few considerations:
Transferring During Life
Adding children as joint owners of the property: While providing rights of survivorship, thus avoiding capital gains taxes and probate fees upon the parents’ deaths, this method will trigger an immediate partial deemed disposition and taxable capital gain.
Gifting to children during life: Again, this method avoids probate fees; however, it also results in an immediate deemed disposition and taxable capital gain. It also shifts the liability for any future appreciation into the hands of the children.
Selling to children during life: As with any sale, the seller will incur a capital gain, on which tax will be payable, and the purchaser will assume the liability for any future increase in value. The danger lies, however, in the temptation to “sell” the property for less than fair market value, say, I don’t know, for $1. Nay says the CRA; regardless of the actual purchase price, the parents will be deemed to have sold the property for fair market value and will owe tax accordingly. Worse yet, the purchaser-children will still acquire the property at the purchase price and, upon disposition, will be liable for tax on the entire value over and above the actual purchase price. Yes, the parents and the children will, in effect, pay tax on the same appreciated value.
Other legal considerations include the property becoming vulnerable to the creditor or family law claims of the children. And, of course, the parents will lose control of the property—including when and how often they will have access. To maintain control, the parents could utilize an Inter-vivos Trust. While not often an appealing option because of the immediate tax consequences and the fact many owners don’t fancy they will die in the next 21 years, this may be an appropriate strategy where there is little capital gain on the property or the principal residence exemption is available, and the owners are of an advanced age. It will defer tax on any increase in value between the date the trust is created and the death of the last surviving spouse until the 21stanniversary of the trust. Where the parents are over age 65, an alter-ego or joint partner trust may be an option as well.
Transferring at Death
Leaving the cottage outright: As mentioned earlier, upon the death of the cottage owner there will be a deemed disposition triggering a capital gain. The estate will be liable for the capital gain and each beneficiary’s proportionate share of the estate will be reduced by the tax payable. If one of the children does not want the cottage, his or her portion will nonetheless be reduced. Unhappiness ensues.
Testamentary trust: This allows the testator to set out a detailed regime for the use and management of the cottage—including decision making structures and creating a fund to finance maintenance and upkeep. The trust will, however, be subject to the 21-year deemed disposition rule: the cottage must either be rolled out to the beneficiaries prior to the 21st anniversary of the trust, or the trust will owe tax on the accrued capital gain.
Provide that it be sold with an option to purchase to the children: Where there are multiple beneficiaries and potential for discord, this option ensures that any shared ownership and responsibilities are discussed, understood and accepted by each child.
Some Final Thoughts
While legal costs sometimes negate any potential benefit of a double Will created solely to save on probate fees (roughly 1.5% of the value of the estate), the benefits of a double Will should be considered where the cottage is owned outright and has a significant capital gain.
As well, given our proximity to Quebec, the location of the family cottage is important. Where the family cottage is located inQuebec and the owners are considering taking up residence in the province, the estate plan should reflect the fact that Quebecdoes not have probate fees and the requirements for Wills are different—if the property will be transferred at death, an up-to-date and valid Will is imperative.