Written by Karen Yull, CA, MBA
A Companion Advisor article

Your cottage has been a source of enjoyment for you and your family for years and one day you'd like it to belong to your children. And, since you bought it, its value has gone higher and higher. But, while it's nice to see your investment increase in value, can your kids afford to inherit the family cottage?

It's an important question and not a thought that people often consider when they "selflessly" leave property for others.

For example, assume you purchased a cottage in Muskoka in 1976 for $50,000. In today's market, it is now valued at $500,000. You also own a home in the city that you purchased for $150,000 in 1980, which is now worth about $350,000.

If you transfer the cottage to your children now, you are deemed to have disposed of the property at its current fair market value of $500,000, resulting in an immediate capital gain. However, in determining the gain, make sure you have properly calculated the cost of the property for tax purposes. It may be higher than you think! The cost will be increased by any capital improvements you have made to the cottage over the years. It may also be higher as a result of electing to use up your $100,000 capital gains deduction back in 1994.

Principal residence designation

This may not be as bad as it sounds, since all or part of the gain can be sheltered by the principal residence exemption. If you and your spouse own two residences, a home in the city and a cottage, only one of the properties can be designated as your family's principal residence each year. Before 1982, each spouse could designate a separate property as a principal residence for a particular year, provided the property was not jointly owned.

The amount of taxable gain is based upon a formula that examines the number of years you owned the property, and the number of years it has been designated as your principal residence. In the above example, you may decide to designate the cottage property as your principal residence for the majority of years you owned it. In making this designation, you will have to consider the relative appreciation of each property and the expected timing of any sale or transfer.

Based on the above, if you own a cottage property and sell your home in the city, you should not automatically assume that the gain on the city home is free of tax. Careful consideration will have to be given as to which property should be designated as your principal residence for each year.

Other issues

Based on your objectives, there are several different tax and estate planning strategies you can use to avoid or minimize the tax hit when you sell or transfer the family cottage. The key strategies are to make optimum use of the principal residence exemption and to shift any future growth in the value of the property to other family members. One of the advantages of transferring the cottage to your children now is that your tax liability is based on the cottage's current value. If you expect it to appreciate significantly in value, a transfer now may be worth considering. One of the disadvantages is that the capital gains tax must also be paid now, rather than at some point in the future. The one exception is where you choose to use your principal residence exemption to shelter the gain from tax.

You may also be reluctant to transfer the direct ownership of the cottage to your children. You may not want to lose the legal control over the property, as well as the legal right to use it. If this is the case, consider using a family trust to hold the vacation property. There is still a deemed disposition at fair market value when the property is transferred to the trust, so all of the above principal residence issues still need to be addressed.

Transfer now versus on death?

Rather than transferring the property now, you may intend to let your children inherit the property after the death of both you and your spouse. In this situation, the capital gain will be based on the fair market value of the property at that time. This will leave your children with a tax bill that will have to be paid with cash which may be difficult without selling the property or other assets. One possible solution is to purchase a "joint-and-last-to-die insurance policy" equal to the amount of capital gains tax that is likely to result. It can also be arranged to have your children pay for the premiums on a shared basis, since they will ultimately become the main beneficiaries.

Estate planning issues become more difficult where your intention is to only have some, or just one of your children, inherit the family cottage. Dealing equitably with all of your children based on unknown future values can be a daunting task. No parent wants the family cottage to become a future source of conflict. A family discussion to determine the best outcome may help prevent problems further down the road.

One of the most important financial decisions facing cottage owners today is the potential tax if the cottage is transferred to other family members. Regardless of when this occurs, this liability will arise. Obviously, there is no clear-cut answer regarding the best course of action to take. In all cases, it's recommended you seek professional tax and legal counsel to get advice tailored to your individual situation.

Karen Yull, CA, MBA is a chartered accountant and tax specialist dealing with individuals, businesses and not-for-profit organizations with Grant Thornton LLP.

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