The cottage is a source of joy for many families, and is often
viewed as 'common property' within generations. Like many people,
you are perhaps considering leaving the cottage to your heirs so it
can be enjoyed by generations to come. Whether you are in this
situation, or considering purchasing a cottage for the first time,
there are certain financial implications you may want to consider.
They might influence how you intend to pass on the cottage to your
heirs be it through a will, a sale or perhaps through a trust. And
they may also influence how you structure the purchase of a new
property today.
When transferring any property, you should first consider the
cost impact of the transaction. If you have owned a property for
several years its value has likely increased, creating what could
potentially be a significant capital gain assuming the transfer
takes place after October 17, 2000. If this is the case, 50% of the
appreciated value of a cottage is considered taxable income in the
year it is sold or transferred. A major downside of a capital gains
tax is that in most cases it is not deferrable - the amount owing
must be paid immediately. (Note, the sale or transfer of a
principal residence is excepted.)
Example:
Elizabeth has decided to give the cottage to her
only son. When she purchased the cottage, the property had a value
of $50,000. Over time, it has appreciated in value to $150,000. Of
the $100,000 in appreciated value, $50,000 ($100,000 x 50%) will be
considered taxable income in the year of the transfer. Clearly this
could have a significant effect on her tax situation and could
impact her Old Age Security benefit.1
While the prospects for an easy transfer of the cottage to a
family member might seem grim, with proper care and planning you
can keep the property within your family for the next generation
without creating a significant tax burden.
Transfer the cottage today
While this would appear to be the simplest
solution, the above example shows one of the major pitfalls - the
immediate capital gains tax. If you transfer the cottage into your
child's name today, you will immediately trigger capital gains
resulting in an additional tax burden for yourself. Even if you
sell the cottage at a 'bargain' price the government will consider
the property to have been sold at fair market value, so you will
not be reducing the capital gains tax payable by you. Your children
however, will be required to report the "bargain"
purchase price as their cost base, creating a larger capital gain
for them when they pass away or choose to sell the cottage some
time in the future. It is important to be sure of your decision
before transferring the cottage as you are not only giving up
ownership but also control over its use.
Leave the cottage to your children in your will
This strategy should involve planning by
both you and your children, and should be done with the assistance
of a will specialist (i.e., a lawyer). If there are multiple heirs,
you may want to formulate guidelines for usage and maintenance
costs associated with the cottage and set them out in writing.
Remember, upon your death your estate will be liable for the
capital gains tax on the disposition of the cottage and therefore
if any of the children do not want the cottage, their share of the
estate will still be responsible for a proportional amount of the
tax on the capital gains. If you know now that a child(ren) is not
interested in owning the cottage, you might consider stipulating
some other form of compensation for them. An insurance policy could
be purchased to help offset the tax, and if the children purchase
the policy, the premiums could be divided among those who will be
sharing the cottage after you pass on.
Sell the Cottage to your Child and Hold a Demand Mortgage
While there is no way to defer taxes
forever, by selling the cottage to your children and taking back a
demand mortgage with deferred payments, you are permitted to spread
the tax payable on the capital gains over five years. At the time
of your passing, you can forgive the mortgage in your will and the
cottage will be left to your child with no debt or taxes
payable.
Trust Options
-
Inter Vivos Trust (Living Trust)
A trust created and taking effect during
your lifetime is called an inter vivos trust. By moving the cottage
asset into a trust now you will be deemed to have disposed of the
asset at fair market value and you will be required to pay the tax
as the transfer is subject to capital gains. Since the capital
gains tax will be paid in the year of transfer, the children will
not face a capital gains tax bill when you pass away. To
potentially avoid this large tax liability, you may want to
consider setting up the trust immediately upon purchase of the
cottage or at a time when property values are low. You are able to
hold the property, in trust, for 21 years without triggering any
capital gains in the trust. You may want to consult with a tax
specialist to consider additional strategies for deferring the
capital gains.
Example:
Bill has owned a cottage for eight years and is
now doing some early estate planning. Having paid $50,000 for the
cottage, the value steadily appreciated to $75,000 last year. A
sudden shock in the real estate market has knocked the value of the
cottage down to $60,000. After speaking with his tax specialist,
Bill seizes this opportunity to roll the cottage into a trust,
paying capital gains tax on the $10,000 ($60,000 - $50,000) of
appreciated value, and avoiding any further capital gains in the
trust for 21 years.
-
Testamentary Trust
This trust takes effect upon your death,
and while there are few capital gains advantages (your estate is
liable for all capital gains upon your passing), it gives you the
ability to define issues like the sharing of the asset. As an
example, you can stipulate who has the cottage at what point in the
year, or create a first right of refusal option in case of any
disputes over a sale of the cottage down the road.
These are just a few of the options available to you, and they
are designed primarily to show you that with proper planning you
can pass on the cottage without passing on a significant tax burden
as well.
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