Getting ready to close the cottage? If 2020 has taught us anything, it is how fortunate we are to have one. Now, how do we keep it in the family?
Create a lasting legacy with a smooth transfer of ownership.
A family cottage is a place of cherished memories, where children, and maybe even grandchildren, have grown, swum and played under the stars. As owners grow older, they may begin to think about handing it down to their loved ones. Early planning can help avoid conflict, reduce taxes and ensure the cottage remains in the family for the next generation – and possibly for generations to come.
Begin the dialogue
There’s a special kind of lifestyle that goes with owning a cottage. S’mores, swimming and lounging on the deck go hand in hand with bugs, mice and never-ending repairs. There are costs for maintenance and taxes, and family schedules to consider. You might assume that your children would love to take over the cottage one day, but it’s important to ensure they actually do. If you have more than one child, would they all want to share it? And if so, can they get along and handle the joint responsibility? These questions should all be raised early on, before any assets change hands.
The capital gains issue
Over the years, many cottages and vacation homes have increased significantly in value and are now worth substantially more than their purchase price. At death, 50 per cent of this increase in value, minus the cost of improvements (such as additions or decks) is subject to tax if the cottage is transferred to anyone other than your spouse – this is capital gains tax. An asset like a house qualifies as a principal residence and is exempt from this tax, but generally cottages are not. If your estate does not have enough funds, it may be forced to sell the cottage to pay the tax.
Sara and Charlie purchased a cottage in 1975 for $60,000. Over the years, they invested $100,000 in improvements to the property. Today the cottage is worth $500,000. Charlie passed away last year, leaving Sara the sole owner of the property. She wants to pass on the cottage to her two children after she dies. Assuming the cottage is not her principal residence, the transfer will result in a capital gain of $340,000, of which $170,000 is taxable at Sara’s marginal tax rate.
- Original cost $60,000
- Capital improvements $100,000
- Total investment $160,000
- Market value today $500,000
- Capital gain ($500,000 – $160,000) $340,000
- 50% of capital gain taxable $170,000
For illustration purposes only.
There are several strategies to consider that can help reduce taxes and support a smooth cottage transfer.
Sell the cottage to the kids now
By selling the cottage to your children today instead of transferring it at death, you can limit the tax liability and pass the responsibility for any future capital gains on to your children. In addition, because the cottage is transferred outside of your estate, the time and costs associated with settling the estate are reduced, and the cottage is protected against potential claims from creditors or other parties.
If you decide to go this route, set the sale price at least equal to the fair market value of your cottage, not a reduced or nominal price. The Canada Revenue Agency will consider the cottage to have sold at the fair market value, so reducing the price will not reduce the capital gains tax. Also, when your children eventually sell or pass on the cottage, they will be required to report the reduced purchase price as their cost base, resulting in double taxation.
The sale will trigger a capital gain tax liability, but you can structure the sale and the tax payment over five years if you take a mortgage back from your kids. You may also consider forgiving the mortgage in your will so that your kids will receive the cottage free of any debt.
Selling the cottage today can also provide you with a source of income. You’ll want to ensure the additional yearly income doesn’t push you into a higher tax bracket and reduce any government benefits such as Old Age Security.
One possible drawback to consider with this solution is that the children become the owners of the cottage. They could sell it, or it could become an asset at risk in the event of a marriage breakdown.
Leave the cottage for children in the will
If you choose to pass on the property after your death, there are two ways to do it: you can name the heirs in your will and they will become co-owners of the cottage, or you can create a trust that owns the cottage and give each heir a portion of the trust.
A trust allows you more control over what happens to the cottage. You can allocate funds for maintenance, taxes and bills. A trust also protects against marriage breakdown or bankruptcy. Keep in mind that trusts cost money – a fee of about one or two per cent of the cottage’s value every year.
Use life insurance to cover capital gains
Life insurance can be a cost-effective way to help pay capital gains tax. Consider purchasing a policy that pays out after both you and your spouse pass on. You can also choose a plan where the death benefit increases over time to match the growing tax liability. If cost is an issue, your children could pay a share of the premiums.
Sell the cottage and pass the proceeds to your children
You may opt to put the cottage on the market now or specify that it be sold after your death. After paying taxes and transaction costs, any remaining proceeds will pass to your kids. They can then use the money however they want, including buying their own cottage. The downside to this option is that the cottage doesn’t remain in the family, but it may be a reasonable solution to avoid potential conflict.
Get professional advice
However you decide to transfer ownership of your cottage, proper planning can help ease the way and reduce the tax burden for you and your loved ones. Speak to your advisor and a legal and tax professional to determine your best course of action.
A cottage-sharing agreement can help co-owners manage expectations and avoid conflict around many issues. Some things that should be discussed and put into writing include:
- Maintaining a cottage budget, including paying for utilities, taxes and insurance
- Retaining the cottage ownership within the group
- Opening and closing the cottage, cleaning, and performing maintenance and repairs
- Deciding on large renovations and purchases and how these should be financed
- Rules around pets, guests and renting out the cottage
- Schedule for usage
Keep your receipts
You can reduce taxable capital gains by keeping financial records for any improvements you make to the property – for example, additions, bunkies, decks, landscaping, septic systems and boathouses.
Did you know?
Capital gains tax came into effect December 31, 1971. Even if you owned the cottage before that date, you need to calculate the increase in value only since then.
© 2020 Manulife. The persons and situations depicted are fictional and their resemblance to anyone living or dead is purely coincidental. This media is for information purposes only and is not intended to provide specific financial, tax, legal, accounting or other advice and should not be relied upon in that regard. Many of the issues discussed will vary by province. Individuals should seek the advice of professionals to ensure that any action taken with respect to this information is appropriate to their specific situation. E & O E. Commissions, trailing commissions, management fees and expenses all may be associated with mutual fund investments. Please read the prospectus before investing. Mutual funds are not guaranteed, their values change frequently and past performance may not be repeated. Any amount that is allocated to a segregated fund is invested at the risk of the contractholder and may increase or decrease in value.