High Cottage Values Mean Succession Challenges
David Christianson, CFP, R.F.P., TEP
Most cottage owners are now aware that there will be a tax hit when they sell the cottage or when they die.
In past generations, it was much less challenging to pass the cottage on to the kids. Until 1972, there was no tax on capital gains and before 1982 the principal residence exemption could be claimed by both spouses. This meant that a couple could actually have two principal residences eligible for tax-free gains on a sale or gift.
Now, a married or common-law couple is only allowed one principal residence exemption. Therefore, if both residences are sold, the gain on one sale or transfer may be tax free, but the gain on the other will attract tax, if it has increased in value.
Remember that 50% of the gain on a capital asset must be included in income in the year of sale, or in the year of death if there’s no surviving spouse. The taxable portion is taxed at the taxpayer’s marginal tax rate.
In Manitoba, this marginal tax rate can range from zero (if no income), to 28% on taxable incomes from $10,000 to $38,000, and as high as to 46.4% on taxable income in excess of $125,000. (These are approximations of the bracket thresholds.)
If you gift the cottage to a family member, this is still a deemed disposition for tax purposes, as the family member is not dealing with you “at arm’s length.” The same holds true if you transfer it to a trust for the benefit of your family or to a corporation that you control.
By the way, if you are ever gifting away a property, make sure your lawyer does NOT transfer it for a dollar, or that one dollar becomes the cost base for the next sale. Make sure it is a gift and not a sale for a dollar. (As long as it is a gift for zero consideration, then the person who receives it can use the fair market value at time of gift as the cost base to calculate future gifts.)
If you sell to a third party for full value, though, the tax on the gain is covered by the proceeds of the sale. However, gifts do not generate cash, but there still may be tax to pay. You need to have that cash on hand to pay the taxes.
Solutions?
The first step is to determine who in the family really wants the cottage, can afford to keep it up and will play well with others, if sharing among siblings. I leave that up to you for now. The family cabin can have a lot of sentimental value for family members, so this may be tough.
If you expect some siblings to want the camp property and not others, you can put a clause in your Will that allows any to use some of their other inheritance to purchase a portion of the cottage, or to decline that option. Ownership of the property may be divided into as many parts as siblings who want it. The others could take cash.
Also think now about how the usage and upkeep responsibilities will be determined.
On the tax side, be creative in how you use that principal residence exemption. It does not have to apply to your house in the city. On the death of the second spouse (or a sale of both properties), both residences are deemed to be sold. The executors can decide after the fact which one is treated as the principal residence. Obviously, pick the one that has gained the most in value since purchase.
When calculating the gain, obviously, include all allowable capital expenditures - things like new dock, erosion protection, cottage additions, new driveway - in the cost base, to minimize the net gain that must be claimed.
If you have been fortunate enough to have had both properties increase in value, then you should make arrangements now to have the cash available for the future tax, when that time comes. The best way to have guaranteed cash available upon death is a life insurance policy. In this case, a joint and last-to-die term-to-100 or universal life is probably the ideal type of contract, although whole life also works. Last-to-die polices are cheaper, as the rates are based on the spouse with the longer life expectancy.
The death benefit is tax free and will enhance the estate, making sure the liquid cash is there for the taxes.
An alternative is to take action now and transfer the cottage into the children’s name, or into the name of a corporation or trust for their benefit. However, half of any gain to the date of transfer will be taxable.
The advantage of these more complicated arrangements is that the corporation or trust does not die. The cottage can be held into future generations without a disposition of the property. However, you must plan ahead for the transfer of the shares or the trust interests.
Think about it now – spring is always just around the corner!
Post questions and comments.
* * *
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.