In our earlier blogs on developing a plan for the family cottage and the many legal considerations around cottage succession, we explored the emotional and financial sides of managing everyone’s favourite summertime (and in some cases four-season) family asset. But what about tax strategy?
Simply put, the capital gains tax implications of owning a second property such as a family cottage can be significant—especially with the pandemic-driven rise in property values in recent years. When a cottage is sold, it could be subject to capital gains tax that must either be paid in the owner’s lifetime or by their estate. For example, if a property is purchased for $1,000,000 and increases in value to $2,000,000 (assuming no capital improvements), the family or estate would be liable for taxes on that appreciated value.
That could result in a tax liability in the neighbourhood of $250,000 for the owner(s) or estate. As we noted earlier, any future increase in capital gains inclusion rates would drastically enhance that tax bill and could force some families to sell their property or shoulder an additional financial burden to cover the tax liability.
Fortunately, there are several approaches that cottage owners can employ to manage and/or mitigate that tax liability. Here are three to consider:
Leverage the Principal Residence Exemption (PRE)—If your cottage has increased in value more than your primary home, you can designate the former as your principal residence to avoid the eventual payment of capital gains tax when the cottage is sold or is deemed disposed upon the owner’s passing. Because the Income Tax Act has several provisions designed to prevent aggressive use of PRE provisions—which are actively enforced by the Canada Revenue Agency—always contact a tax professional before redesignating a cottage as your principal residence.
Trusts can also be used to mitigate capital gains tax liabilities but are most often used as a multi-year tax deferral tool. As with PRE designations, trust structuring is complex and requires help from qualified and experienced advisors such as accountants, lawyers and financial planners. Trusts should only be utilized in specific circumstances.
Consider life insurance—Another strategy—particularly if the intention is to will a property to family members—is to purchase a permanent life insurance policy to cover any future capital gains tax liabilities on the cottage (or a secondary property). This strategy delivers financial certainty to the family and can make cottage succession planning simpler. The challenge is that life insurance becomes more expensive to acquire as policy holders get older. They may even be ineligible for coverage in the face of pre-existing medical conditions. That’s why it’s important for cottage owners to purchase life insurance early when they’re healthy to avoid higher premiums or a rejected insurance application in future.
Be proactive—Beyond purchasing life insurance at the youngest possible age, it’s best to think proactively and conduct a financial planning exercise that weighs various tax scenarios, including when the property transfers to your heirs. One that comes up often: an adult child decides they don’t want to own the family cottage after their parents pass away, leaving their siblings in search of ways to buy them out. This is just one cottage estate planning challenge that can be addressed using tools such as life insurance. But it’s important to plan ahead and consider a wide range of potential outcomes, the eventual tax implications and how to address them.
Look to your personal financial team for tax planning guidance and be prepared to update your strategy as you and your children age and circumstances change.
The Bridgewell Team
Contact a member of the Bridgewell team for assistance in developing your customized cottage tax strategy.