As we noted in our last blog on the many emotional aspects of owning a family cottage, issues such as property usage or joint ownership need to be carefully managed to prevent your dream getaway from turning into a source of inter-family squabbles. But what about the tax and legal implications of owning a vacation home?
These are potentially touchy topics that many Canadian cottage owners prefer to avoid. After all, their idyllic Muskoka or Cabot Trail hideaway is about relaxing and forgetting life’s stresses, not worrying about the minutiae of tax planning and legal structuring. But sidestepping these potentially complex issues only adds to the eventual succession challenges for cottage-owning families. Better to tackle them head on, develop a coherent strategy and take action to mitigate associated risks—from legal challenges over property access to whopping capital gains tax liabilities.
The caveat, of course, is that no two cottage succession strategies are the same. Yours should be tailored to your family’s specific financial circumstances. Always work with your advisory team—which might include a chartered professional accountant, a lawyer with experience in tax and estate planning, an insurance professional and your personal financial planner, among others—before making important strategic decisions.
With that in mind, here are the high-level points you should consider when developing your cottage succession plan:
Make a will—and include the cottage
A properly-drafted will is the cornerstone of estate planning in Canada. It’s especially important if you have several children and a cottage in the family.
Recent surveys have shown that many Canadians lack a recently updated will. The percentage of those with a vacation home is unclear, but there are surely some cottage owners who haven’t taken steps to protect their property and ensure that it passes on to the next generation in an efficient manner.
There are some basic cottage-related considerations to cover in a will: Who in your family should be a beneficiary of the cottage? If ownership of the property is split amongst your children or other family members, how should that ownership be divided? How do you want the cottage to be managed after your passing?
You may decide that the property is best liquidated as part of your estate, or you may choose to sell it during your living years. Selling is a preferred option if a parent thinks their children could bicker over use or ownership of the cottage. Put simply, some beneficiaries will want the property, while others may prefer to take their share of the equity and use it to cover other lifestyle expenditures. These sorts of financial conflicts are far more common than many cottage owners would like to admit.
Whatever your wishes, they must be clearly stated in a legally valid will. And don’t leave it too late. There are many cottage owners who fail to sign off on a will before they pass away or before they become mentally or physically incapacitated and can no longer make estate-planning decisions on their own.
Drafting a will proactively will also mitigate the risk of it being contested or having family members make undue claims. ‘Mom and dad wanted me to have the cottage,’ is the kind of statement all too familiar to beneficiaries that have been left to unravel a poorly-drafted (or non-existent) will. Leaving it to the kids to determine how such an emotional asset will be divided or shared after a parent’s death is both disruptive and divisive—and it’s easily avoided.
Managing access to your property
As we noted in our last blog, a cottage plan can help set the rules around the use of a cottage if the property is passed on to multiple children, or is shared by several owners. It’s an important document that sets the ground rules. In most cases, it should also be drafted with a lawyer’s assistance.
While having all cottage stakeholders sign off on a cottage plan or sharing agreement by no means guarantees that it will be followed to the letter, structuring and notarizing the document with proper legal advice helps avoid ambiguities. Being able to refer to this contract is one way to help de-escalate family conflicts and clarify who will have ongoing rights to the property.
What to know about cottages and tax planning
Perhaps the most significant financial consideration of owning a cottage—beyond mortgage payments and ongoing upkeep—are the potential tax implications.
Unless the cottage is the owner’s principal residence, when it’s eventually sold, gifted or when the owner dies (assuming it’s not rolled over to a spouse or common-law partner), it will generate a capital gains tax liability that must be covered by the estate. Specifically, that tax will apply to half of the proceeds of the deemed disposition of the property—which in Canada is the increase in value beyond the adjusted cost base (or the cost to purchase the home plus qualifying expenses such as major renovations).
For example, if a cottage was purchased for $500,000 and appreciated in value to $1 million by the time the owner passed away, half of that increase (or $250,000) would be subject to capital gains tax.
At a time when vacation homes across Canada are skyrocketing in value—driven largely by COVID-19 remote work trends and restrictions that have curtailed international travel—that tax liability could present a major financial burden for cottage-owning families. In addition, many pundits have speculated that Ottawa could hike the capital gains inclusion rate in a future federal budget as a tool to help pay for massive pandemic-related deficit spending. If that’s the case, the cottage ownership equation will change dramatically. Many families could face the difficult decision of whether to keep their second property and find other sources of funding to pay for the tax bill, or sell to cover that liability.
Probate fees are another cottage succession cost to keep in mind. Every province (except Quebec) levies probate fees on the value of assets in an estate. In Ontario, for example, the probate fee is $15 per for every $1,000 of the value of the estate over $50,000. If an estate was worth $100,000, for example, the Estate Administration Tax would be $750. Vacation properties are typically considered part of an individual’s estate and will be subject to these fees.
Choosing the right tax-mitigation strategy for your needs
There are a number of strategies that cottage owners use to mitigate tax and probate fee liabilities.
One is to leverage the Principal Residence Exemption (PRE) and declare the family cottage your primary home to shield it from capital gains tax. This tactic can make sense if the gain in value on your vacation property is greater than that of your non-vacation home—which is unlikely in most Canadian cities (and even some towns) as residential home prices continue to surge in the wake of COVID-19—or if the future increase in the value of the vacation property is likely to exceed that of the home where you spend the bulk of your time. But be careful: The Income Tax Act includes a series of provisions designed to prevent PRE abuse. Careful planning and professional advice are needed to determine how to use the PRE in your circumstances and avoid running afoul of Canada Revenue Agency rules.
Some cottage owners will form a joint tenancy relationship with their children or other heirs to avoid probate fees, registering title of the property in all of their names and allowing it to transfer from a deceased joint owner to a surviving joint owner(s) without passing through the former’s estate. This approach is far from seamless and has been challenged by provincial and federal tax agencies as an aggressive tax-avoidance technique. In other words, joint ownership can create more problems than it solves and (like the PRE) should only be employed with professional advice.
Trusts are another estate and financial planning tool used to help mitigate capital gains liabilities. These structures are typically best suited for tax deferral rather than mitigation because simply transferring a property into a trust can trigger capital gains; in some cases, they can be used to defer a tax liability for years. But the bottom line is that trusts are complicated and potentially cumbersome. They should be used in very specific situations.
Paying for tax liabilities with life insurance
To cover the cost of future capital gains liabilities upon death, many cottage owners will consider purchasing a life insurance policy. This strategy is best explored when the owner is relatively young and free from major health issues. Life insurance gets very expensive for older policy holders, while many elderly applicants won’t qualify for coverage at all—especially if they have significant pre-existing conditions.
In the end, the best tax-planning strategy is the one that’s customized to you and your family and takes your overall financial well-being into account. Leverage the advice and services of your personal financial team to develop a plan that addresses the many legal and tax considerations that could complicate ownership of your cottage—then sit back on the dock and relax.
Because there’s nothing like enjoying the peace of mind that comes with having your estate planning and cottage succession bases fully covered.
The Bridgewell Team
Contact a member of the Bridgewell team for assistance in preparing your cottage succession plan.