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  • Christine Van Cauwenberghe

Cottage Planning

For many families, the cottage is a proud piece of heritage that holds fond memories and maintains family ties. Many would choose to preserve it more than any other family asset, and would find ways to keep its ownership within the family. But in leaving the cottage to their children, owners need to be aware of potential tax consequences and prepare ahead to ward off potential family disputes among their children once they are gone.

Tax Liability at the Time of Death

First, make sure that there are sufficient funds in your estate to pay for any potential tax liability at the time of your death. Many cottage owners do not realize that the increase in their property’s value since the time it was purchased could result to a tax liability because of the ‘deemed disposition’ of all of a person’s assets upon death. A deemed disposition means that all of your assets are deemed to be disposed of for fair market value (unless the assets are transferred to your spouse or common-law partner). Therefore, upon the death of the last spouse, your estate could owe tax before the assets can be transferred to the next generation. Without proper estate planning, you may need to sell some of the estate’s assets (including the cottage) in order to pay off the tax liability.

Principal Residence Exemption

To reduce the tax liability, you can designate the cottage as your principal residence, and exempt some, or all, of the capital gains tax from selling it. However, families can only designate one property as their principal residence for any given year. If you have owned more than one personal-use property during the same period of time, calculating the principal residence exemption can be quite complicated. For example, if you have owned the family cottage for the last 20 years, but have bought and sold several urban homes and exempted the gains from selling those homes during those 20 years, you will not be able to shelter the entire gain on your cottage.

Preserving the Adjusted Cost Base

Another option for minimizing the taxable capital gain is to ensure that all additions to the adjusted cost base (ACB) of the property are fully accounted for. This is important because capital gains are calculated by subtracting the ACB of the property from its fair market value, so the higher the ACB of the property, the lower the realized gains. Many people spend thousands of dollars for capital improvements into their cottages over the years, thereby increasing the ACB. However, the ACB only increases from out-of-pocket expenditures, so keep the receipts intact for all of your cottage improvements in order to justify these costs in case the Canada Revenue Agency or Revenu Québec audits you or your estate.

Planning with Insurance

If your estate has to pay a substantial capital gain tax upon your death and have no other way to minimize it, you’ll need to fund this liability. This may not be a problem if your estate has sufficient liquid assets; but sometimes there will not be enough to cover the tax liability, particularly if you incur significant long-term care costs.

To ensure sufficient funds for paying any potential tax liability, consider life insurance. Even if you can’t afford it, your children might be willing to pay the premiums to prevent a ‘fire sale’ of the family cottage at the time of your death. In any event, it is important to talk to your children about this sooner rather than later. Delaying the conversation could result in missing the life insurance option due to advanced age or poor health.

Gifting During Your Lifetime

Cottage owners sometimes make the mistake of transferring the property to their children during their lifetime, thinking that they can avoid paying taxes by transferring the cottage to their children now. Unfortunately, this is not true – the CRA and Revenu Québec will deem the property to have been sold for fair market value at the time it is transferred to the children, potentially triggering an immediate capital gain. If you do not transfer complete ownership of the cottage, but instead add a joint owner or owners, the following could occur:

  • If the intent is to make the children true joint owners of the property, there will be a disposition of a proportionate amount of the gain. For example, if a sole parent is currently the owner, and that parent adds two children as joint owners, then two-thirds of the gain is triggered now, with the remaining one-third triggered at the time of the parent’s death.

  • If the intent is to simply make the new joint owner a ‘trustee’ who does not have an ownership interest in the cottage, then there will be a disposition of the entire gain at the time of the last parent’s death.

It is important to note that by adding a joint owner of a cottage property, you will lose control over that asset. This can be problematic if your child suffers a marriage breakdown, or has creditor issues, so think carefully before giving up control of a major asset like your cottage. In many cases, adding children as joint owners of your vacation home is not recommended.

Succession Issues

If you are planning on leaving your vacation home as part of your estate, ask your children: Do they want the cottage, in the first place? They may be interested in coming to the cottage as long as you are there, but if they live in another province, or are not interested in maintaining the cottage, you may be surprised to learn that they do not want to keep it after you are gone. Discussing this issue with your children can help alleviate disagreements after the time of your death.

Equalizing the Estate with Insurance

If one or two of your children wants the cottage, but some do not, you may need to find a way to equalize the estate. If the cottage will form a large part of your estate, insurance may help fill the gap for the other children. Again, if you are not interested in paying the insurance premiums, do not rule out the possibility that your children may be willing to pay for them to help keep the property within the family. Buying additional insurance will also help ensure that there is sufficient liquidity in the estate, particularly if one child wants to buy the cottage using his or her inheritance money. It is usually recommended to leave the children equal portions of an estate, and a well-crafted estate plan will help ensure that those portions are enough to help each child keep the assets in the estate within the family.

Planning For Multiple Owners

If several children want the cottage, then they will need to enter into a written co-ownership agreement that will outline how the cottage will be used, who will pay for it, and who will be responsible for its upkeep. The co-ownership agreement should also specify how the parties can be bought out in case of disagreement and what happens when one of the siblings die – will it go to the grandchildren or to the surviving children only? Can it be transferred to a son- or daughter-in-law?

Passing on the family cottage to your children could be complicated, but it is best to resolve potential issues now rather than later. Speak with your financial, tax and legal advisors to help you draft a well-crafted cottage succession plan that will prevent family disputes or unexpected tax bills.

Christine Van Cauwenberghe Vice-President, Tax & Estate Planning Investors Group Financial Services Inc.

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