In my last column, I discussed the two most basic elements of estate planning — wills and powers of attorney — and how they affect the intergenerational transfer of wealth that your clients must eventually deal with. Now let’s look at one of the more common intergenerational asset transfers — the family cottage.
Many of your existing clients probably own cottage properties and the numbers are likely to grow. These clients, particularly older baby boomer clients, will want to be informed about the basic tax issues affecting the transfer of these assets.
Consider the example of a well-to-do family that has owned an extensive cottage property since the late 19th century. The vast old stone cottage — a mansion really — that once dominated this storied property was torn down long ago. The property has since been subdivided into four smaller lots with more modest cottages. These are currently owned by two brothers and two sisters, each with children who are starting families themselves. Further subdivision of the property is not possible. Nor does the family want to see any or all of the properties sold to outsiders.
What will this family need to know to engineer a tax-cost-effective transfer of their property to the next generation? I’ll focus on the basic tax questions they’ll need to answer.
When property is transferred to succeeding generations, there are two primary tax issues to resolve: the calculation of capital gains as the property changes hands; and the potential for probate costs.
Coping with capital gains
When a cottage property is transferred to someone other than a spouse, it generally has a deemed disposition at its fair market value. When this creates a capital gain, a tax liability is usually created as well. (When a transfer of a cottage property creates a capital loss, for tax purposes, the loss cannot be deducted or used to offset capital gains, since there are special tax rules that apply to ‘personal use properties’ which include cottages and vacation properties.)
Like any other investment, we calculate the capital gain by taking the deemed proceeds (or fair market value) of the property and subtracting the adjusted cost base (ACB). The resulting number is the capital gain, 50% of which is taxable.
Your client will want to document the fair market value of the property. This can be a bigger challenge than first anticipated, since even on the same lake, cottage values can vary dramatically. It is usually worth the effort and cost of obtaining a formal valuation from a real estate expert in the area.
Simply put, the ACB is the original price paid for the property, plus the cost of capital improvements that have been made since. Remember that boathouse that was built in the summer of ’74? What about the deck that was put in back in ’88? Are the bills for those improvements still around? Immediately, you can see how complicated this calculation can become for a property with years, possibly decades of renovations and upgrades put into it.
There are some other important factors that could help reduce the capital gains burden:
- The cottage’s value on V-Day: Before 1972, there was no capital gains tax in Canada. For tax purposes, December 31, 1971, was fixed as the Valuation Day for previously acquired assets that might eventually be sold or transferred, creating tax consequences in the process.
- The capital gains exemption on a principal residence: This applies regardless of a designated property’s appreciation in value or if the property is only used on a seasonal basis. An important date to remember on this point is January 1, 1982. Prior to that time, each family member was allowed to designate an eligible property as a principal residence. Afterwards, the designation was limited to each family unit. Nevertheless, it is still possible to eliminate capital gains made prior to 1982 so long as one spouse is able to designate the property as a principal residence.
- The special election under the old $100,000 lifetime capital gains exemption: Ottawa eliminated the lifetime capital gains exemption in February 1994, but in doing so, it gave individuals an opportunity to make a special election in their 1994 tax filings to “crystallize” unrealized gains on capital property such as a cottage. Individuals who did so would be able to increase the ACB or tax cost of a cottage by the amount elected at that time, thereby reducing the ultimate capital gain on the property.
Reducing probate costs
Probate is the process by which a court legitimizes a will, thereby allowing the executors the legal right to distribute an estate’s assets. Probate fees, also known as administration taxes, vary from province to province, ranging from a flat fee $65 in Quebec to open-ended fees that are based on a percentage value of an estate’s assets. Ontario is the most expensive, imposing fees of $5 per $1,000 for the first $50,000 of an estate’s value and $15 per $1,000 above this amount. An estate worth $1 million in Ontario would generate probate fees of $14,500.
Naturally, cottage owners like the extended family mentioned above will want to avoid paying probate fees if possible. There are ways to do that, but each has complications that can cause tax or other complications:
- Gifting a cottage: Cottage owners can gift their property to relatives or others. This will eliminate probate fees upon death since ownership has been transferred. However, when the gift is made to someone other than a spouse, a disposition is triggered at market value, possibly resulting in a capital gain for tax purposes. The change in ownership could also generate a land transfer tax liability, not to mention legal and other professional fees. Before deciding to make a gift of the family cottage, it’s best to do a cost benefit analysis to see if the effort will be worthwhile.
- Changing title: Cottage owners can also avoid future probate fees by changing title on the property to joint tenancy with right of survivorship (JTWRS). When the original owner dies, the property will pass to the other owners who were added to the title. The deceased’s estate would no longer have any interest in the property. So if original owner A added B and C to the title, once A dies B and C will own the property while A’s beneficiaries are left with nothing. The drawback to changing title to JTWRS is that it triggers a disposition at market value at the time of title transfer. However, the gain realized on transfer is pro-rated to reflect the portion of the property that was actually transferred. This may be preferable to gifting, which triggers a disposition of the entire property.
- Establishing a living trust: A living trust is another popular way to avoid probate fees (i.e. since the original owner does not possess the cottage on death, there’s no probate). However, if the trust is set up for the benefit of someone other than a spouse, the transfer will trigger a deemed disposition with capital gain implications. Also, every 21 years, a trust is deemed to have disposed of its assets, including cottages, at fair market value. Tax would then be owed on any capital gains accrued in the period. If the cottage owner is over 65, then an alter ego or joint partner trust could be used to avoid triggering a capital gain until the original owner’s death. Trusts also have to be well structured to allow flexibility. They can, and should, include guidelines on the use of a cottage, the terms of funding and doing maintenance, and the ways beneficiaries’ interests will be treated in the event of death. Professional advice is essential when setting one up.
Next time, I’ll discuss some useful strategies for extended families sharing a cottage property.