More answers on cottage succession
David Christianson, CFP, R.F.P., TEP
Whether calling it the cottage, the cabin, the camp or the chalet, recreational property owners and their families have shown they are very concerned about the issues of succession and taxation.
When I wrote a newspaper column on this, I received e-mails from all over the country asking for more information. So, here is a follow-up, with some specific examples and answers to some of the questions posed.
First, the bottom line - in spite of the recent soaring values of cottages, most owners find that when they do the calculation, the tax burden on a sale is lower than they feared. The actual tax rate is always less than 23% of the gain and the cost base is often higher than they thought.
Remember, the tax calculation is:
- fair market value (in the event of a gift to a non-arm’s length family member) or sale price; minus,
- adjusted cost base (original purchase price, plus all capital improvements over the years; equals,
- gross gain.
Half of that gain is taxable income, multiplied by the cottage owner’s marginal tax rate (likely between 27% and 46%) to determine the actual tax payable on the sale or gift.
Passing the cottage on to the family (either by gift or by passing away) is a little more challenging than an actual sale for cash, as no money is received. Not everyone – and not all estates - will have adequate cash to pay the taxes.
A bigger challenge might be for the family to decide how to share the time, maintenance and upkeep on the cottage, once Mom and Dad are gone.
Do we give away the cottage to the kids now, or just wait until we die?
According to several accountants I have worked with, like Dave Loewen of PricewaterhouseCoopers, and my own experience, the vast majority of owners who look at their actual numbers and their options choose to do nothing now. Some will purchase permanent life insurance – a guaranteed way to provide cash for the taxes - but most do not transfer now to the kids, or to a trust or a corporation for the benefit of the kids and grandkids, all of which would trigger tax now.
Let’s look at an extreme example, a cottage that has been owned for 50 years by Mom and Dad. We will assume it was worth $10,000 in the spring of 1972, when capital gains became taxable. This “valuation day” price sets the original cost base.
In 1994, the $100,000 capital gains exemption was eliminated. However, the government allowed property owners to raise their cost base to as much as $100,000 without paying federal tax. Mom and Dad’s cottage was then worth $80,000, so they declared this value as the new cost base under the capital gains election provision. (If they had missed this voluntary opportunity, then the cost base would have remained at $10,000.)
As the grandkids proliferated, more room was needed, so additions were built, totalling $50,000 of capital improvements (not repairs and regular maintenance). Since they kept track of all receipts, this raised the cost base for tax purposes to $130,000, or $60,000 if they had failed to file the election in 1994.
The neighbour’s comparable cottage just sold for $400,000, after commissions and costs. Let’s use that figure to illustrate the taxes on a sale, a transfer for free to the kids or a trust, or in the event of the second spouse owner dying.
The proceeds are $400,000 and the cost base is $130,000 (or $60,000), so the gross gain is $270,000 (or $340,000). Half of this is taxable – either $135,000 or $170,000. The maximum tax in Manitoba would be 46.4% of this, either $62,640 or $78,880, and less than this if Mom and Dad’s incomes were below $115,000 each before the sale.
On a cash sale, that isn’t too bad, as you would have the money in hand to pay the tax. However, on a gift to the kids or transfer to a trust for their benefit, someone has to come up with that money. There’s the rub.
Now, what if you instead want to add your kids to the cottage title, to make your estate settlement simpler – what is the tax effect?
It depends on your actual intention. If you are not transferring beneficial ownership (that is, you continue to be the sole actual owner, notwithstanding the addition of your kids to the title), then there is no disposition and no tax. If that’s your intention, then clearly document this intention. That makes sure no tax is payable at this time. The tax will still be payable by your estate when you die, or by you when you sell.
On the other hand, if you are actually gifting part of the cottage to the kids, then there is a disposition of the portion you gifted and tax must be paid if there is a taxable gain.
In all cases, the principal residence exemption can be used to make the sale or transfer tax-free, but only if it has not been used during this time on the sale of another house. The exemption might still be intact even if you had sold houses, but had no profits. If Mom is in a personal care home and sold her house 10 years ago, the exemption on her cottage would apply for 10 years divided by the number of years of ownership since 1972, times half the gain.
Most properties will not have as large an increase as we have shown, and many cottages are sold for cash rather than passed to the next generation.
If you are in this situation, get some good professional advice, look at the actual numbers and explore your options before doing anything.
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David Christianson is a fee-for-service financial planner and portfolio manager, whose team at Wellington West Total Wealth Management Inc. provides comprehensive financial advice and management. You can e-mail him at dchristianson@wellwest.ca or visit his website at www.davidchristianson.com.