A source of many happy and lasting memories, family cottages are often passed down from one generation to the next. Ensuring a successful transition however, depends in large part, on how important tax and legal issues are addressed.
When ownership in a cottage is transferred to anyone other than a spouse (e.g. an adult child), capital gains (calculated as the total market value less the total cost) are immediately triggered. As 50 per cent of the capital gain is included in the taxable income of the transferring parent(s) (along with the potential for the claw back of government benefits such as OAS), concerns over the tax bill often result in a delay in the transfer of the cottage until both parents have passed away. Depending on how much the property has appreciated in value since 1972 (the year the federal government first introduced capital gains taxes), the taxes payable (including probate fees) may be considerable and could even result in its sale (if there is insufficient cash in the estate to pay the taxes due).
A number of planning strategies may be employed to reduce or defer the tax liability on the cottage. One simple yet effective strategy is to document (i.e. keep receipts) for all capital improvements (e.g. replacing the roof, installing a new well, etc.) that have been made to the cottage. These improvements increase the total cost base (for tax purposes) of the cottage, and in doing so reduce future capital gains. In addition, verifying that an application for the $100,000 lifetime general capital gains exemption was made in the 1994 tax year is recommended, as it will reduce future capital gains on the cottage by increasing (or "bumping up") its cost base.
Designating the family cottage as your "Principal Residence" (provided it is not used for income generating purposes) will avoid all capital gains upon its sale or disposition. Once used, it will no longer be available for any other properties owned by either spouse. It is important to note that for years prior to 1982, each individual taxpayer was able to designate one principal residence, specifically, if a couple had owned both a home and a cottage, the principal residence exemption was available for both properties (provided that the home was owned solely by one spouse and the cottage was owned solely by the other spouse).
Adding an adult child as a joint owner on the cottage is often used as a means to bypass probate while ensuring that the parents can continue to enjoy the cottage. However, it is important to understand the risks in doing so. Not only does this change in ownership trigger a capital gain (50 per cent of which must be added to the income of the parents) on the property, the cottage may also become subject to the claims of the child's creditors (or ex-spouse). In addition there is also the potential for future legal ownership challenges by other siblings, if the intention of the parent(s) (i.e. did the change in ownership constitute a gift?) were not made clear.
Parents who choose to sell the family cottage at a discounted or token value (i.e. what their children can afford to pay) need to be aware of the tax problems this can cause. Not only does this trigger a capital gain in the year of sale, it also gives rise to the potential for double taxation.
For example, consider what happens when a cottage worth $500,000 (originally purchased by the parents for $100,000) is sold to the children at the discounted price of $100,000. Section 69 of the Income Tax Act deems the cottage to be sold for its true market value of $500,000 (triggering a $400,000 capital gain ($500,000 market value - $100,000 sale price) taxable at a rate of 50 per cent to the parents in the year of sale. Unfortunately, the children will assume the cottage (for tax purposes) at a value of $100,000 which is what they actually paid.
This means that if the children were to sell the property for its fair market value of $500,000 they would pay tax on a $400,000 (i.e. the $500,000 market value less the $100,000 purchase price) capital gain. This is a double tax problem, because the parents already paid tax on the $400,000 gain in value (from $100,000 to $500,000).
A more tax efficient alternative is to sell the cottage to the children for its full market value, with payment in the form of cash (whatever the children can afford to pay) with promissory notes being taken back for the remainder of the purchase price. This strategy both ensures that the children will assume the property (for tax purposes) at its current market value of $500,000 (no potential for double taxation when they sell) and allows the parent(s) to spread the $400,000 capital gain over a period as long as five years (versus being taxed on the full gain in a single year at the highest rate) when the sale proceeds are not fully collected in the first year. If the intention is to gift the cottage to the children, these notes can be forgiven upon death (through provisions made in the parents' Will) with no negative tax consequences (i.e. the cost base of the property will not be lowered by the amount forgiven).
To maintain harmony among the new owners, a written cottage agreement is recommended. This agreement should include a schedule for the use of the cottage, clarification as to who can be an owner, and the financial contributions required from each owner (to ensure the cottage is properly maintained and bills are paid). Provisions as to how financial decisions are to be made and disputes are to be resolved should also be set out in the agreement.
As a last resort, the cottage could be sold with the (after tax) proceeds distributed to the children.
With professional advice and advance planning, the necessary tax and estate planning issues can be resolved and the family cottage preserved so that future generations can continue to create happy family memories.
Darryl Prociuk CFP, R.F.P., TEP is a Registered Financial Planner and may be contacted at [email protected]
