Keeping the family cottage in the family

Those planning to pass on the cottage to their children may not realize the potential tax bomb that awaits. Many cottages have increased significantly in value over their purchase price, which can lead to a large capital gain at death. If not planned for, your estate may be forced to sell the cottage to pay the associated tax instead of transferring it to your children.

An in-depth look at the issues

For many individuals, it’s important that the cottage stays in the family so that their children (and grandchildren) can continue to enjoy it.

When you die, assets can be transferred to your spouse¹ tax free, but a transfer to your children (or other heirs) may trigger a capital gains tax that must be paid before the children can enjoy them. Canadian households can only protect one property from tax on capital gains by using the principal residence exemption (PRE). This often means that transferring your family cottage to your children may not be exempt from tax.

Over the years, many cottages and other vacation properties have increased significantly in value and are now worth substantially more than their original purchase price. At death, a portion of this increase in value is subject to taxation. For individuals², 50% of the first $250,000 of realized capital gains in a year is taxable and 66⅔% of the amount above $250,000 is taxable. This could trigger a significant tax liability for your estate. If your estate doesn’t have sufficient assets, it may be forced to sell the cottage to pay the tax, which means the cottage wouldn’t stay in the family. Many people are simply unaware of this ticking tax time bomb.

Consider selling the family cottage to your kids now

By selling the cottage to your children today instead of transferring it at death, you can cap the tax liability and pass the responsibility for any future capital gains to your children. In addition, because the cottage is transferred outside of your estate, it can avoid the time and costs associated with the settling of an estate (including probate, where applicable), as well as avoid potential claims against your estate from creditors or other interested parties.

While selling the cottage today may trigger a taxable capital gain, you can spread the capital gain out over 5 years if you take a mortgage or promissory note back from your kids. However, for this strategy to work, you can’t receive or be entitled to receive more than 20% of the sale proceeds each year for the first 5 years. If you’re feeling generous, you can make the mortgage or promissory note interest free, waive payments, and/or forgive any remaining balance in your will so that your children will eventually own the cottage with no debt payable.

However, there’s an important detail you want to be aware of: Don’t try and reduce your capital gain by selling the cottage for a nominal price! The Canada Revenue Agency will calculate your capital gain based on the fair market value (FMV). What this means is that when your kids sell the cottage further down the road, their cost base will equal the nominal price, resulting in double taxation.

Selling your cottage today can also provide you with a much-needed source of income. Not only do the costs of maintaining the cottage disappear, but you can also use the mortgage payments to fund your retirement, pay for that dream vacation, or retire earlier.

Example

Sara, a 65-year-old widow, owns the family cottage and wants to make sure that it goes to her children. She is, however, concerned about the impact of the potential tax liability at death.

If Sara were to sell the cottage today, she’d trigger tax payable of $101,250 on the $400,000 capital gain. Half ($125,000) of the first $250,000 and 66⅔% ($100,000) of the remaining $150,000 is taxable at the assumed 45% tax rate. If the payments were spread over 5 years, the capital gain could also be spread over that time, reducing the annual capital gain to $80,000 ($400,000 / 5 years). Since her capital gain each year is well under the $250,000 threshold, she can reduce her annual tax liability to $18,000 ($80,000 x 50% x 45%) by benefitting from the 50% inclusion rate on the entire gain. This reduces her total tax from $101,250 to $90,000 ($18,000 x 5 years) and doesn’t take into consideration any additional potential savings as a result of the smaller annual capital gain, putting her in a lower tax bracket. In addition, the mortgage payments could be used to pay the tax for the first 5 years and then, fund her retirement.

Conversely, if Sara’s cottage was transferred to her children 20 years from now at her death, it would result in an assumed tax liability of $498,534. This is due to the capital gain being significantly larger ($1,724,281) and a larger portion would be included in her income at the 66⅔% inclusion rate. Also, the option of spreading the capital gain over 5 years isn’t available at death, eliminating this valuable tax planning strategy. Finally, if her estate has insufficient assets to pay the tax, it may be forced to sell the cottage instead of transferring it to her children as she had intended.

So, paying some tax now could save Sara’s estate a lot of taxes at her death—a fact that may decide whether the cottage stays in the family.

Ideal Candidates

Individuals with a home and a cottage:

• who want to pass the cottage on to the next generation
• who would like to cap their tax liability on the cottage
• who could use some extra retirement income

Take Action

If this strategy is right for you, you should:

• set the sale price at least equal to the FMV of your cottage
• consider taking back a mortgage from your children with payments structured over at least 5 years
• consider forgiving the mortgage in your will so that your kids will eventually own the cottage free of any debt

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1 Includes a spouse or common-law partner as defined by the Income Tax Act (Canada)

2 This article assumes that the federal government’s proposed changes to the capital gains inclusion rate become law. Under these rules, individuals includes graduated rate estates (GREs) and qualified disability trusts (QDTs). Corporations and all other trusts are subject to a 66⅔% inclusion rate on all realized capital gains.