Garry T. Bard, B.A., LL.B., TEP
Barrister, Solicitor & Notary Public
EST8PLNR LAW FIRM

As with any estate planning concern there is usually a problem, an issue, and an opportunity. Essentially, there are two basic problems with the inheritance of cottage properties: capital gains tax on death - who pays and with what funds; and maintaining the cottage with minimal disputes. This article will deal with the first problem of keeping the family cottage in the family, as opposed to possibly selling it to pay Canada Revenue Agency’s capital gains tax.

As a Wills and Estates lawyer, I have witnessed many situations where clients may have dealt with the disposition of the family cottage in their Wills at death but failed to put any funding in place to pay the resulting capital gains tax and allow their wishes to be realized. Let’s look at a few ways we can minimize or even eliminate these problems by examining the capital gains issue and considering various estate planning and funding options to pay the tax.

Capital gains tax can arise on the actual sale of a cottage or at the death of the cottage owner-- When an individual dies, under our Income Tax Act, he or she is deemed to dispose of all of his/ her capital property at what is known as “fair market value”, even if the cottage has been left in a Will to the children. This can include cottages, boats, rental properties…the list goes on.

Where the fair market value exceeds the adjusted cost base, or “ACB” (the original purchase price plus the cost of any improvements to the property), the owner’s estate realizes a capital gain. Under the most recent income tax rates, 1/2 of the gain is included in income. That amount is reported on the deceased’s terminal return (filed in the first year after death) and tax must be paid on that amount, usually in the highest tax bracket.

However, where the property is inherited by a spouse, or a spousal trust, the property “rolls” to the spouse or the spousal trust at the ACB price -- this merely defers the payment of tax until the death of the second spouse when the property is inherited by the kids.

Remember, if you do any renovations to the property -- e.g. winterize it -- those costs will bump up the ACB of the property and reduce the eventual tax payable. So don’t forget to keep your receipts!

Principal Residence Exemption from Capital Gains

Before 1982, it was possible to have each spouse own one property and claim it as his or her principal residence. However, the definition of principal residence was changed for the 1982 and subsequent taxation years such that a “family unit” -- defined as: a married couple together with their unmarried children under age l8 -- is now only entitled to a single principal residence. Gains realized on the disposition of other family residences (like the family cottage) are taxable.

Planning for and Funding the Capital Gains Tax Payable

When considering various planning and funding options, it is strongly advised that you consult with a qualified estate planning professional in order to review your own personal circumstances before proceeding with any of the following strategies:

1. Sell or “gift” the cottage to the kids now, either in total (while maintaining something called a “life interest”), in joint tenancy, as tenants-in-common. These strategies can provide considerable relief from current and future capital gains, as well as avoid Estate Administration Tax or “EAT” (formerly known as “probate fees”), and limit or even eliminate Land Transfer Tax, in the hands of your children, as purchasers.

2. Transfer the cottage to an “alter ego trust”, to avoid capital gains at the time of transfer, as well as EAT (probate) at death.

3. Establish the cottage as a non-profit organization, which is usually only suitable for those with a large cottage property to be shared by an extended close-knit family but enables future generations of family to use the cottage without incurring capital gains tax or EAT.

4. Otherwise, the estate could sell off some other assets to pay the tax, if there is no cash in the estate. But at what sacrificed price?

5. Or, the kids could pay the tax from own funds; but will they have enough money quickly enough to satisfy Canada Revenue Agency?

6. Borrow the funds – but who will borrow? The estate? Only if it is an ongoing estate. What about the kids? Should they mortgage the cottage? Who’s going to repay? A $70,000 loan for example over 20 years at 8% = $7000/year. What happens if kids disagree later on about the loan repayment and their respective shares of that repayment? That is where a “Cottage Maintenance Trust” would come in handy – but that’s a topic for another day.

7. Sell the actual cottage to pay the tax – this really defeats any plan to pass it on to one’s heirs and has its own inherent problems of establishing fair market value, finding a buyer, and selling the cottage in enough time to pay the capital gains at a profitable price. Unfortunately, this happens all too frequently, without proper estate planning in place.

8. Consider purchasing permanent life insurance, where health is not an issue. Proceeds from a beneficiary-designated life insurance policy are allowed to accumulate in a tax-deferred manner similar to an RRSP (but without the monetary upper limit) and these proceeds are payable tax-free as a death benefit. This strategy would provide the necessary funding to pay any resulting capital gains tax and avoid the cottage having to be sold.

9. Consider starting a “sinking fund” as soon as possible by investing a regular deposit for the sole purpose of capital gains tax payment. The major disadvantage here is that this money will be taxable every year if it is in an unregistered account. This can severely affect the amount you had planned on funding the eventual capital gains liability.

10. Finally, to start limiting capital gains liability now you may want to look at switching the designation of your “principal residence” from the house in the city to the cottage in the country. This is an effective way of limiting future capital gains, especially with the escalating values of recreation properties, although it doesn’t solve the problem of funding existing tax liability.

As a Wills and Estates lawyer, I have witnessed time and time again the benefits of proper planning to ensure that capital assets, such as cottages, boats, or rental properties, pass smoothly to the intended heirs. This article provides general information on the problem and some possible solutions. Every cottage owner is advised to seek assistance for his or her own particular situation by contacting a professional advisor with expertise in this area. Every cottage owner needs a cottage succession strategy – including the appropriate language contained in your Will and a plan that is properly carried out in the most tax-efficient manner, following a comprehensive review of your current situation with a qualified estate planning professional.

Garry T. Bard, B.A., LL.B., TEP is an estate planning lawyer and principal of EST8PLNR LAW FIRM. He can be contacted at (705) 431-6211 or gbard@est8plnr.com . Visit Garry’s website today at www.est8plnr.com !