Last summer, we discussed the case of Todd and Joanne Winchester, two siblings from British Columbia who had vacation properties. See that article here. We looked at many things, including estate protection to ensure the properties could be enjoyed by the next generation. However, I glossed over the technical details on estate protection. This month, we’ll more closely examine Todd’s cabin property outside of Nelson, B.C.
Todd is in his mid 50s and is an avid hiker, fly fisherman and skier. He and his new wife, Teresa, have had a second home for three years now. They want to ensure that the cabin is in their control during their lives and that it becomes a family legacy for Todd’s children from a previous marriage.
Their advisor has suggested that they only have a couple options:
- deferring taxes owing until the death of a surviving spouse (probably Teresa, as she is 15 years younger than Todd)
- transferring or selling ownership to the children now and pay any taxes owing
As with any choice in life, there are benefits and drawbacks to both options.
To defer taxes until Teresa’s death, there could be 40 years of growth in the value of the cottage, resulting in a large and difficult-to-project bill for capital gains tax owing. Unless there was sufficient liquidity in the estate to pay the taxes, Todd’s children could end up unable to find the dollars to pay taxes, and selling the cottage.
To transfer ownership to Todd’s children today, or sell the cottage outright to the children today results in a couple of potentially unfavourable scenarios. First, there may be taxes owing today on the cabin, though probably not significant taxes, as they’ve only had the cabin for three years. Second, the children may not have the funds to purchase the cottage right now, as both are in their 20s and only beginning their careers. The third problem is that Todd and Teresa would be giving up control of the asset to the children, which is contrary to one of their stated goals above.
For these reasons, they decide to defer taxes until second death, and gift the cottage to the children upon second passing. (Note: for simplicity’s sake we will assume that there is no concern with Teresa and the children having a falling out after Todd’s passing, negating any need for spousal trusts or other post-mortem control mechanisms).
Now comes the task of determining how to minimize the tax bill, and how to ultimately pay the inevitable capital gains taxes owing. Upon death, Todd’s cabin might qualify as a primary residence and be exempt from any capital gains tax. However, that exemption would be limited to the number of years that the Nelson property was actually the principal residence. Also, since the land surrounding the cabin is limited to half a hectare (about 1.2 acres), the excess is deemed not to have contributed to the use and enjoyment of the housing unit as a residence unless the taxpayer can provide evidence that the excess land is necessary for such use and enjoyment.
Another consideration is that any additions to the cottage that qualify for an addition to the adjusted cost base could be used to reduce the capital gains exposure, as the taxes owing are a function of the excess of value above the total ACB of the asset. In any case, there will probably be some capital gains tax payable to the estate due to the amount of time that the cottage was not the principal residence.
This is where life insurance comes in. Todd and Teresa’s advisors recommend they purchase low cost, joint, last-to-die coverage so they may pre-fund the tax bill with liquidity from insurance proceeds. As non-smokers aged 55 and 40, they could purchase $1 million of coverage from a number of different joint and survivor permanent Term 100–type plans for $3,500 to $4,500 per year. To invest those same premiums in another guaranteed vehicle would require an after-tax rate of return in excess of 7% over 40 years. Even after 60 years, assuming Teresa lives to age 100, they would need to make over 4% guaranteed, after tax. For whatever the ultimate tax bill is, permanent insurance is the lowest cost method of creating capital when the liquidity is needed most.
Chris Paterson has over 14 years of experience marketing various insurance products.