Protecting the family cottage when the tax bill comes in

The longer you’ve owned the property, the larger the tax when you die. Would-be heirs could be the losers.

Today, many Canadian families own more than one home, the second property usually being a cottage. Though some cottage owners do not realize it, this second property can create significant tax liabilities for their estate upon their death. Unlike your primary residence, the cottage will be taxable.

Most real estate acquisitions tend to grow in value in the fullness of time. Generally speaking, the longer you’ve owned the property, the greater its value. Just as predictable as this growth in wealth, however, is the eventual incidence of death and taxes. We cannot escape either of them. When you depart this life, Canada Revenue Agency will be standing by, calculating the appreciation on the cottage and determining your capital gain and corresponding tax bill.

If you don’t have sufficient cash available in your estate to cover your tax bill, the cottage and any other estate assets may need to be liquidated to generate the cash. Thankfully, there are several other solutions to the problem worth your consideration. Below, briefly, are a few of the more common alternatives.

  1. You could transfer or sell the cottage to your children while you are alive. This strategy is used fairly commonly but has its pitfalls. Sale of the cottage will attract a capital gains tax on 50 per cent of the appreciated value at the time of the transfer of ownership. Capital gains result when the fair market value exceeds the adjusted cost base of the property. Your children may also have to pay provincial land transfer taxes on the fair market value of the property. If you transfer or sell the cottage to your children for a price below fair market value, CRA will adjust the figure to reflect the fair market value and tax you accordingly.

When your children transfer or sell the cottage down the road, their cost base will be equal to the selling price you used when the cottage was transferred or sold to them. The lower the purchase price used in the transfer, the higher the potential capital gain down the road for your children when they sell the property.

  1. You could make the cottage your principal residence. If your cottage has appreciated more than your home, this can make good sense. CRA has ruled that if you own more than one property at the time of disposition either during your lifetime or when an estate is settled, you can elect either property as your principal residence and pay the capital gains tax on the other. Property must meet certain criteria to qualify as a principal residence, and this should be reviewed with your accountant or lawyer before you make your election.
  2. You could ensure funding is available to cover the final taxes on the cottage. You can either put aside money to cover the future tax bill or acquire an insurance policy for the amount of the estimated capital gains tax. The cottage would be left to the children and the insurance benefit would be paid to them, providing the cash needed to pay the tax. For couples, a joint and last-to-die policy will ensure the benefit is paid on the second death, when the capital gains tax is due.

You will likely want to ensure that your family cottage remains in the family. Whatever your plans for this, you will need to consult your lawyer, your accountant and your financial advisor to determine the best way of achieving your goals.

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