Whether you’ve had it for a number of years now or if you’ve just recently purchased it, cottage succession planning is important if a family wishes to keep its cottage for several generations. You want to ensure that it remains in the family for succeeding generations to enjoy. 

There are many things to consider in any succession plan, but perhaps the most important financial obstacle is the capital gains tax liability. The cottage is considered a capital asset and in order for it to be rolled over to your spouse upon death, it must it be jointly held with right of survivorship (JTWROS), with the other joint owner being the spouse. Otherwise, if it is not jointly owned, then the Will dictates what happens.

Depending on the details in the Will, the cottage could be deemed to have been disposed of at fair market value and taxes will be payable – specifically Capital Gains Tax. This often creates a final tax bill so over-whelming that many cottages must be sold just to pay the tax liability.

To calculate the Capital Gain, you need to determine the current Fair Market Value (FMV), and deduct the Adjusted Cost Base (ACB). Tax is payable on 50% of the Total Capital Gain.

There are a number of ways to reduce the tax bite so that the cottage can be passed on to heirs without bankrupting the estate. Below is an overview of a few options to consider. For additional details or even other options, consult your Financial Advisor.  

Ways to Reduce Taxes When Passing on a Cottage to Heirs:

• The cottage can be transferred to a spouse with no taxation.
  
  
• Transfer the property as a gift – in this case, the property is viewed to have been disposed of at the Fair Market Value and taxes are calculated accordingly. A reminder here is that capital gains taxes are applicable at FMV, so there is no benefit of transferring the property through a sale at less than market value.
  
  
• If you include the cottage in your Will, the law considers it to have been disposed of as a result of death. The property can be transferred between spouses without tax if it is jointly held with right of survivorship and the other joint owner is the spouse. Then the property passes on to the other owner, and Capital Gains tax would be payable upon the death of the second spouse.
  
  Directing inheritance of the cottage to your children will subject them to capital gains taxes. However, taxes can be paid from sources other than your estate. A life insurance policy on the owner’s life to cover taxes at death is another option to consider. Establish the policy with the insurance amount at least equal to the projected tax payable at life expectancy. 
  
  The intention here is to provide tax-free insurance proceeds to offset the cottage capital gains tax and to possibly provide additional estate assets. Estate beneficiaries can even pay the insurance premiums.
   
• Principal residence exemption is something else to be considered in planning cottage succession. A principal residence is not subject to capital gains tax, irrespective of how much it appreciates in value. Determine which has more value, the house or the cottage. If it’s the cottage, one option to consider is to make the cottage your principal residence, providing you an opportunity to reduce taxes on the cottage.
  
  Don’t forget that implementing this type of strategy will eliminate the exemption on your home, for which capital gains taxes will now be applicable.
  
  
• Transfer to Family held non-profit organization. This makes everyone equal dues-paying members of a club. The capital gain is crystallized on initial transfer and land transfer tax may be payable. Although this is beneficial for future generations, it requires specialized advice and may not be suitable for everyone. 
  
  
• Alternatively, you may want to consider establishing a trust, such as an Alter-Ego Trust. No immediate capitals gains would be applicable, but rather they would be triggered by your death and every 21 years thereafter.   

In summary, there are a number of strategies available for you to consider when looking at your cottage succession planning. Discuss the situation with your family. Be sure your will is current.

The most important thing to do is to see a qualified advisor before deciding on any course of action, and then choose the one that best suits your needs.

Article Glossary & Example

Fair Market Value

Adjusted Cost Base

The Adjusted Cost Base (ACB) is calculated as the original price paid for the property plus the cost of any capital improvements you have made since the property was acquired. Remember that year you put in the new dock? 

Don’t forget that new roof you put on 4 years ago. If it was acquired before 1971, then the value at December 31st, 1971 applies. If the Capital Gains tax exemption was taken advantage of in 1994, then the ACB indicated on the receipt of that year may be used.  Now add the cost base and the total capital improvements and you have your Adjusted Cost Base.

Total Capital Gain

Example:

Raymond and Sylvia purchased their cottage on a small quiet lake in 1975 at a price of $15,000. They had the property appraised 5 years later in 1980, and were given an appraisal for the cottage of $20,000. They have estimated that in the intervening years they have spent $32,000 on various improvements and additions, including the addition of a fireplace, replacing a most of the windows, roof repairs and installing a dock and boat lift. 

In today’s market, the value has been appraised at $245,000. If the cottage were disposed of today (through sale or the death of the owner) the capital gain would be $198,000 ($245,000 - ($15,000 + $32,000)). Tax would be payable on half of that - given current law - equal to $99,000 and at a 50% marginal rate that would result in approximately $49,500 of additional taxes owing.