Last time, we discussed the factors clients should consider when transitioning the family cottage or vacation property. These factors included personal, family, tax and family law issues.
Once those are considered, it’s time to look at how to structure the transition. Several planning options are available. However, the viability and desirability of each option depends on each individual owner’s circumstances.
Options for succession
Joint ownership with right of survivorship can be a simple and effective method of property succession. However, it does not allow for sophisticated tax planning such as holding the property in a trust on the first spouse’s death. In addition, this type of joint ownership is not usually advisable for U.S. vacation properties owned by Canadians who are not U.S. citizens. This is due to the two countries’ tax systems and how they treat the property on death.
A transfer into joint ownership or by outright gift during the owner’s lifetime can be used for succession planning with family members. However, such gifts can trigger immediate capital gains tax consequences if the vacation property is not designated as the donor’s principal residence (see “The principal residence exemption”). Finally, joint ownership can expose the property to claims by the joint or new owner’s personal or business creditors, as well as to matrimonial claims.
Sale to beneficiary
Another option is to sell the vacation home to the intended beneficiary and take back a private mortgage. The mortgage can be forgiven in the mortgage holder’s will and other assets left to other beneficiaries to equalize the estate’s distribution. This transaction would trigger a capital gain or loss based on the fair market value of the property (no matter what price the home sells for). With the use of a take-back mortgage, the taxes payable on this gain could be spread over five years instead of one.
One of the biggest disadvantages of an immediate transfer, via sale or joint ownership, is the loss of control of the property by the original owner. However, the owner could still live in the home under a properly drafted occupancy agreement, or the owner could retain a partial or full lifetime interest. Nonetheless, some loss of control is necessarily a part of such planning.
Transfer by will
In a will, an owner can make an outright gift to one or more beneficiaries. A beneficiary can also be given the option to purchase the vacation home. Methods of valuation and payment terms can be provided.
A will can also include:
- tie-breaker provisions in case the beneficiaries reach an impasse with regard to ownership;
- a mandate or encouragement to draft a co-owners’ agreement to keep disputes to a minimum;
- funds in trust for payment of ongoing maintenance and repairs and other expenses.
Transfer by trust
Gifting the property by use of a trust is also popular, especially when dealing with intergenerational succession.
Trusts have other potential benefits in passing down a property, as they can:
- act as will substitutes;
- be used to plan for incapacity;
- allow for protection in case of creditor claims or marital breakdown; and
- protect against probate fees.
In Ontario, case law has shown that if a trust is used to pass a residence, including a vacation home, down to a child, it is not a matrimonial home and therefore is not subject to equalization with the child’s spouse. That’s because the residence is not owned directly by the child. A trust may also prevent possessory claims to a vacation home and other rights that may be available under family law legislation.
Trusts can be set up either during the owner’s lifetime (inter vivos) or in the owner’s will (testamentary). A trust can deal with succession to a vacation home, as well as providing a vehicle to administer funds to maintain it. Creative and sophisticated provisions can allow for successive control and ownership tailored to individual circumstances.
If a trust is used, consider future taxes. Most inter vivos and testamentary trusts are subject to the 21-year deemed disposition of a trust’s assets under Canadian income tax legislation. Since the beneficiaries must pay capital gains tax on the increase in value of the vacation home every 21 years, the rule should be planned for if the trust is expected to exist for longer.
Gifting through an inter vivos trust can allow the owner to retain control over the property and its use. Inter vivos trusts also allow for the property to pass outside the owner’s estate, bypassing the probate process.
For owners who are 65 or older, alter-ego or joint partner trusts can be attractive and tax-effective inter vivos trusts for a vacation home, as the 21-year rule does not apply (with certain exceptions). Further, the vacation home can be rolled into such trusts tax-free. As well, under new rules, alter-ego, joint partner and spousal trusts will continue to be eligible to claim the principal residence exemption.
U.S. vacation homes
Planning for succession of a U.S. vacation home presents additional challenges, and professional advice is required for each individual situation.
As discussed last time, estate tax credits may cover the U.S. estate tax liability, depending on the owner’s individual situation. (We acknowledge that the current U.S. estate tax regime is uncertain.)
As mentioned, joint tenancy may not be appropriate for U.S. estate tax planning purposes, because it can create significant estate and gift tax problems.
Clients could hold U.S. vacation homes in a specially designed inter vivos trust to avoid U.S. estate tax. In addition, if available, a non-recourse mortgage considering current low interest rates is another planning option to reduce exposure to U.S. estate tax.
Clients wishing to dispose of the property after death could donate the vacation home to a U.S. charity and receive a tax deduction.
Vacation homes outside Canada and the U.S.
As part of a worldwide succession plan, it’s important to consider how a vacation property should be dealt with by will, particularly if located in a civil law jurisdiction. It may be advantageous to draft a separate will to deal with property in the foreign jurisdiction, written in the local language and form. Many civil law jurisdictions have mandatory rules to pass property to spouses, children and other family members, and it may not be possible to simply pass a property outright to a spouse or to other desired beneficiaries.
Non-resident owners of Canadian vacation homes
Non-resident owners should consider the relative advantages of a separate Ontario will to deal with their Ontario-situs vacation home and related personal property (boats, furniture, etc.). This will should be prepared in conjunction with advice from estate planning advisors in their home jurisdiction, and should address how Canadian taxation interfaces with their local tax regime. For example, under tax treaty provisions, there are special opportunities available to ensure there is no double taxation on death in both Canada and the U.S.
The principal residence exemption
If an owner anticipates that a vacation property will significantly increase in value from the date of acquisition (or from January 1, 1972, if acquired before that date), he or she could treat the vacation property as a primary residence for tax purposes, thus exempting it from capital gains tax. Make sure clients remember to follow the new reporting and trust rules with regards to the exemption, certain of which are to be effective from October 4, 2016, and others from January 1, 2017.
Highlighted planning points
- Recommend an open discussion with intended beneficiaries to find out their interest in owning the vacation home. Discuss their ability to pay expenses and maintain the property, as well as how they’ll use it.
- Find out the estimated tax on the vacation home upon sale or deemed disposition. Consider how this liability will be paid. If there is a liquidity issue, consider available options, such as life insurance.
- If the owner wishes to gift the vacation home to family member(s), make sure they obtain legal and professional advice on how best to structure the gift. For example, a trust may protect a vacation home from possible future equalization claims under family law legislation.
- If bequeathing the home under a will, consider a flexible mechanism that would allow the beneficiaries to either purchase the vacation home or receive it as part of their share of the estate.
- Consider a co-ownership agreement for joint owners or beneficiaries of a vacation home.
- Recommend professional advice before a client purchases or passes on a vacation home located in another jurisdiction, particularly outside Canada.
Margaret O’Sullivan is founder of O’Sullivan Estate Lawyers LLP.