Robert Ciprick, CGA
The following information is provided as a guide only. It is designed to show possible alternatives that are available if you are currently or will be in the future planning the succession of your cottage. The material is not to be relied on solely without contacting your professional accountant as all possible strategies are not provided in an in-depth manner in this report.
Owners of recreation properties will one day face one of their most difficult and challenging task when they sit down to plan the succession of their cottage.
Given today’s valuations of cottages, one certainly should expect that there will be a substantial capital gain tax payable upon the transfer of their cottage ownership. This tax burden could prevent future generations from being able to afford the cottage that is being transferred to them. Proper succession planning is a way to assist the owners of these properties to make the transition as smooth and tax efficient as possible.
Cottage owners usually wish to maintain their cottage for the enjoyment of their families. Generally, they hope that their children will enjoy and create their own precious memories of time spent at the cottage as they have done.
A very important step in achieving this outcome is to sit down and to have a frank discussion with the family members of how succession can be done.
The offspring usually have their own views of the way the cottage should be used and operated when the parents are no longer around. Very often, the siblings’ views will not coincide with each other.
To add to the difficulty of planning a succession, the present or at the time of passing the cottage on, the financial needs of the sons and daughters will have to be considered and this certainly will have an effect on how the siblings will perceive the value of inheriting a cottage.
There are a few very important questions to be answered.
When you hand down the family cottage how will you do it?
By bequeathed, or
By a sale?
How will ownership of the cottage be structured?
Joint title, or tenants in common,
Through a trust, or a corporation?
Capital gains and deemed capital gains
Let’s start with a first a few words regarding capital gains.
Regardless of how the cottage is dealt with, at one point or another there will be a capital gains tax to pay. There is a possible exception though.
The exception is to elect the cottage as your principal residence during the period that you have owned it. This will result in no capital gains on the cottage’s disposition.
Of course, this will allocate the capital gains to any other residential properties that you own upon its sale which you have inhabited for the same period of time that the cottage was designated as your principle residence.
At the time of sale it is wise to contact a professional to compare your properties to understand which property should be deemed as your principal residence to be able to limit the capital gains tax as much as the income tax act allows.
Dates to consider.
To ensure that any capital gains are as low as allowed there are a couple of past dates to keep in mind. These dates will help you to make sure you have the correct ACB of your cottage at time of disposition.
First date is December 31st, 1971. This is what is known as valuation day. Capital gains first came into effect January 1st, 1972. Prior to that date there was no capital gain tax. If you owned your cottage at the end of 1971, valuation day, the FMV of your property at that time became your ACB.
Then in 1981 there was the change from the ability of both you and your spouse being able to designate a property as their principal place of resident and avoid capital gains on both places upon sale of the properties.
Now the income tax act states that only one place is eligible for principal residency exemption and any other personal use property such as a cottage or your home will be subject to a capital gain inclusion of 50% the net proceeds of disposition.
Another date that needs to be considered was 1994. If you owned the cottage at that time you could increase your ACB by using the $100,000.00 capital gain exemption that was available back then. That date is when the Government cancelled that exemption.
A tax professional can help you to determine the value of your property and to which property you should claim the principal residence on that will provide the most tax-savings to you.
Selling the cottage:
Selling the cottage outright is probably the simplest and easiest way one can deal with a cottage succession. More than likely though, that is not what you had hoped to do for your family.
Selling during your lifetime or upon your death could leave cash to be divvy up upon your death which could make it much simpler instead of trying to be fair with who gets the cottage. Remember all of your offspring might not be in the position to use the cottage.
You could also give family members the first right of refusal to purchase the cottage either now or upon your death before selling it outside the family. A problem with this method would lie when one of your offspring is financially better off than their siblings but more than one offspring is interested in purchasing your cottage.
When selling the cottage it is prudent to ensure that you have the correct adjusted cost base of your property, including the cost of all capital improvements (whether or not you have receipts)and don’t forget about any election you might have had available in prior years. The elections were covered under the heading title “Capital Gains”.
If selling your cottage to a family member during your lifetime, you must sell it at FMV.
A method to reduce the immediate tax liability would be for you to take back a five year promissory notes rather than cash. The notes can become due on demand starting January 1st in each of the following five years. This will allow you to spread your tax liability on the capital gain over a five year period. You could even go a step further by not actually collecting on these promissory notes. You can simply leave the notes outstanding and forgive them upon your death. There would be no tax consequences to forgiving these notes upon death.
This strategy has the same effect as a gift to a family member, but you will be able to spread your tax bill over five years.
You must ensure the promissory notes are drafted correctly to avoid losing the capital gains reserve.
Remember though; never sell the cottage to a family member at less than FMV. If you do, you will still have to pay tax on the FMV of the cottage and the family member will only have an ACB of what they paid as the sale price. This results in double taxation.
Gifting the cottage:
The benefit of gifting the cottage now, is that the future growth in value of the cottage will accumulate in the hands of the heirs who have received the gift.
At the time of gifting, the parent(s) could choose to maintain the use of the cottage by taking back a life interest in the cottage. This will allow the parent(s) to still have full use and control over the cottage. Although, technically they do not own the cottage, they will still be required to pay the taxes and the maintenance fees under their “right to use” agreement.
At the time of the gift, the cottage will be valued at FMV and there will be taxes to be paid on 50% of the capital gain. The gain will be the difference between the FMV and the ACB of the cottage. The ACB is the original purchase price of the cottage along with any costs associated with any capital improvements, selling fees, etc., during the lifetime of the gifters’ ownership.
The gifting of the property could be done in a year when their overall income allows them to be in a lower tax bracket than a bracket they might expect to be in, in future years.
Gifts of real property to family members do not attract land transfer tax.
A strategy that may help in this scenario and in the selling the cottage scenario to an offspring is to transfer the cottage in stages, rather than all at once. If you transfer say, 20 per cent each year for five years, (the percentage used is an example) the capital gains taxes in each year (does not necessarily need to be consecutive years) will be much less. Of course, this would require you to have a FMV valuation each of the years of transfer. Also, the value of the cottage could rise each year resulting in a higher capital gain for the percentage of the cottage being transferred. The goal is to defer and to be able to handle the tax liability without hardship to the new owners. The danger here is: now someone else owns a piece of the cottage and could choose to sell it. Or if they predecease you their share of the cottage could be willed to their offspring or someone else.
Bequeathing a property:
When a cottage owner passes away the property more than likely will flow through to his/her spouse at the ACB of the property and the capital gains will be deferred until the last spouse passes.
If the property is willed to heirs or others then there will be a deemed disposition of the property at FMV. The estate of the deceased will be liable for the taxes that are owed from the deemed capital gain.
If the estate is unable to pay the tax liability then the estate will either have to sell some of the assets to cover the taxes or the heirs will have to pay the taxes if they wish to keep the cottage.
A nuance in settling estates upon death is if there is a capital loss on the FMV between the time of death and when the cottage is sold then the capital loss is available to be carried back to offset capital gains in the estate. This is allowed through subsection 164(6) of the ITA as long as the capital loss is realized in the first year of the taxpayer’s death. Another condition is that the cottage must not have been lived in since death. In the event of this happening the property would then be a personal use property and no carry back of capital loss from the property would be allowed.
Cottages could be lost here if proper planning was not taken to cover these taxes.
One type of planning that many tax payers use is to have enough life insurance coverage for the owner(s) of the cottage to be able to pay the taxes upon death. If insurance is not purchased earlier, then the cost of the insurance could be prohibitive in doing this step as part of the plan. The payment of the insurance coverage could be covered by the heirs since they will be the ones benefitting in the end.
Another opportunity to look into is whether the cottage property is large enough to divide into separate plots to leave each family member their own lot to build on?
There certainly will be costs involved when a cottage is passed on through a will. Probate fees, capital gain tax and land transfer tax.
Holding a cottage in a trust:
If you are thinking of gifting the cottage, a trust might be a better way to transfer the cottage to heirs, especially if there is more than one heir. This can be done now into an inter vivos trust or when you pass away it is called a testamentary trust.
The main differences between the two trusts are the tax rates.
One could also leave cash in the trust to help with the maintenance or capital costs of the cottage.
A trust will help to protect the cottage from potential creditors of your heirs.
Transferring the cottage into a trust will create a deemed disposition which will more than likely create a capital gain unless the principal residence rule is acted upon. The advantage is now any gain will accumulate inside the trust. A deemed disposition will occur at the trust’s end of life which is 21 years. Capital gains will have to be paid at that point but the cottage may stay in the trust for another 21 years and so on. There are other items to consider with a trust and discussing this with a tax pro in this field is a must.
Establish a corporation: either for-profit or a non-profit corporation to own the cottage:
There are benefits to both types of corporations. Here is a quick look.
The property can be held in a separate legal entity.
Asset would be protected from personal creditor debt.
It can enter into contracts and incur debts.
The cottage can be rollover into a corporation at cost without incurring any capital gains at that time.
There are other costs though
Directors of the corporation have to maintain the minute book, hold annual meetings, and
File annual returns.
Shareholders of a business corporation could also be deemed a taxable benefit when they use the corporation assets (the cottage) for their own personal use.
Setting up a shareholders agreement is advisable.
One of the shareholders could possibly sell their shares of the corporation at any time and to anyone. Or will it to whom they choose.
Non-share Corporation (not-for-profit)
Advantages are similar to being a business corporation.
This is more suited to families who expect to keep their cottage in their family for several generations.
Family members would become due-paying members of the organization.
Board of directors would be established to set out bylaws, rules for dues, maintenance and usage.
There are fees associated with this type of vehicle: fees to set-up the corporation, ongoing fees to administer to look after the annual items, returns, meetings, and reports.
Family law in your province could be problematic.
A couple other points to consider:
To avoid future problems with ‘family issues’ such as sons or daughters possible divorce settlements, one would need to write exemptions into any transfer agreement or into the will if the cottage is to be transferred after death.
A prenuptial agreement could protect the cottage ownership if this type of agreement has the legal strength in your province of residency.
If you own a cottage make sure both spouses names are on title in order to avoid probate fees if one of the spouses should pass away. No doubt the property will be passed onto the other spouse unless it is expressed differently in the decease’s will. Probate fees would apply to the estate solely owned by the deceased.