Quick tips for cottage planning

Don’t bother trying to schedule an appointment with your clients just yet; they’re still at the cottage. When they get back though, if you get a chance to talk about it, there are a number of tips and easy suggestions you can discuss with your clients that will help them save money down the road.

Most technical suggestions focus on tax-planning strategies, as a lot of clients don’t realize that they’re on the hook to pay significant capital gains taxes regardless of whether they sell the property or give it away. But getting family discussions about the cottage started can be one of the most valuable services an advisor can provide in this area.

“Cottages generate the most acute estate-planning problems for clients [with] cottages and family businesses. It’s not the technical problems that seem to cause the rift in families, it’s the emotional ones,” says Sandy Cardy, senior vice-president, tax and estate planning, at Mackenzie Financial Corp. “Because it’s is such a repository of childhood memories, and the fact that people are so emotionally attached to the cottage, it is the most emotional landmine in any estate, that and the family business. It’s something that needs to be addressed and there needs to be a lot of communicating.”

The opportunity to open up this discussion and get clients thinking about how their cottages fit into their financial planning needs easily presents itself in small-talk about vacation time and the summer months. If clients mention that they spent weekends building a new boathouse or dock, start by recommending that they save receipts to prove what they spent on the improvements; although regular maintenance costs, such as paint or the occasional repair, can’t be claimed under the Income Tax Act, which doesn’t recognize “sweat equity,” money spent on materials and outside labour for renovations, additions, road improvements and other property improvements can all be added to the property’s adjusted cost base. Cardy then recommends advisors find out if clients used their $100,000 lifetime capital gains exemption to increase their cottage’s ACB before the exemption was repealed in 1994.

Knowing the appreciated value of the property can affect other real estate and tax planning decisions. If clients are selling their home, for example, but intend to eventually sell the cottage as well and the cottage property has appreciated more than the value of their residence, they might elect to save their principal residence exemption and pay the gains taxes on the house.

“The definition is really broad in the Income Tax Act and it will allow a seasonal residence to be considered a principal residence,” says Cardy. “So it may be possible if someone has a condo in the city and they have a big, lovely cottage in some expensive area, that’s where they should be focusing their principal residence exemption. You don’t need to make that decision until you sell one of them.”

An executor trying to minimize estate taxes after the fact can also decide at the time which property has the higher capital gain and designate that property as the principal residence. Families can also avoid paying tax on any property values that appreciated before 1982 by proving that one spouse owned the family home while the other spouse was sole owner of the family cottage.

Transfer strategies for estate planning and passing the cottage on to the next generation are well documented, but several points bear repeating, particularly given the relatively unknown tax liabilities.

“I think one of the biggest misconceptions is that parents think they can transfer the cottage to the children with no tax consequences,” says Dave Ablett, tax and retirement planning specialist at Investors Group. “A lot of people think it’s like a gift of cash. If I make a gift of cash in my will to the child, in effect the child receives that cash and there are no tax consequences. There are tax consequences though where the cottage is gifted to the child.”

“I think the one thing we recommend financial planners do when they talk to their clients is encourage the parents to start talking about which of the children wants to inherit the cottage.”

After making that decision, timing is the next point to consider. A gift or bequest through the will is a disposition of the cottage at its fair market value at death for tax purposes — the estate must pay the capital gains tax on the cottage before the remaining assets are divided and distributed to heirs. To be able to better equalize things for surviving family members, life insurance policies can be used to either pay the tax bill, or pay the children who are not inheriting the property.

Cottages passed on during the client’s lifetime are also fair game for tax collectors regardless of how much the property is sold for. In fact, selling the cottage for less than the property is worth will result in the family paying tax twice if they face an audit — clients will pay tax on the property’s fair market value at the time it was sold, plus the adjusted cost base will be set at the artificially low amount the new owners paid for the property.

“People can do what they want, but the black letter of the law is that when you pass anything down to the next generation it needs to be at fair market value,” says Cardy. “If you tried to play around with that and reduce the fair market value or reduce your tax impact, you could get penalized by the CRA.”

When selling or gifting the property outright, there are a couple of strategies available to help clients defer the tax bill.

Cardy recommends structuring the sale in such a way that parents take a zero-interest demand loan from the children so they can spread the related capital gains out over the course of five years rather than report the whole gain in one year, the way they would need to if they sold the property or gifted it outright.

“I really recommend it for a number of reasons. You’re not going to avoid any tax, you’re just deferring it, but whenever you can defer something, you can play around with marginal tax rates between husbands and wives. You can take advantage of lower tax brackets and there may be opportunity over five years to avoid some of the capital gains and losses that may be generated in someone’s investment portfolio,” she says. “There are more planning opportunities around spreading that gain over five years rather than having to report it all in one year.”

A demand loan, payable at the creditor’s request, rather than on a specific date, is also beneficial for the degree of control it offers the parents. The loan allows parents to spread out their capital gains, and can then be forgiven in their will on death, but it also gives parents the opportunity to call the loan and retake possession of the property if there is friction in the family at some point in the future.

For relatively new cottages, trusts are another interesting way to defer taxes. As trustees, parents have the legal right to occupy and maintain a high degree of control over the cottage, while putting title in the children’s names. Trusts are typically subject to a rule whereby accrued gains need to be reported every 21 years. Lawyers can structure the terms so the trust would dissolve before its 21st anniversary and any assets in the trust would roll out to the trust beneficiaries. The beneficiaries, likely the children, are then liable for taxes due for any capital gains made from the date that the property was first placed in trust if the parents die or sell the cottage.

Finally, for those interested in conservation efforts, environmental charitable giving, or for those with no apparent heirs, changes announced in the federal budget this spring eliminated the capital gains tax on donations of ecologically sensitive land made through the Environment Canada Ecological Gifts Program. The changes allow clients to donate their property or an easement on the land title and receive a charitable tax receipt if the property meets specific national and provincial criteria.

Making such a gift to an environmental charity or government body, a process with its own set of special considerations, also requires that clients plan ahead and clearly communicate their interests. Such property transfers can either be made through a will, through a life interest arrangement, a conservation agreement or as an outright donation.

“We emphasize to potential donors, at a very early stage, to get independent legal and tax advice, because even though the rules are the same for everybody, the net result for individuals is very different depending on their personal situation,” says Howard Hamilton, legal counsel and land securement officer with The Nature Conservancy of Canada.

Typically, land donations come from people with large parcels of recreational property that have high natural values, because stewardship costs to maintain small acreages are usually too great for the amount of protection they offer. As well, early discussions with an environment conservation group will help determine if the property is even eligible for protection. In addition to national criteria, provinces and organizations each have their own set of standards. Click here for the Environment Canada list of national and provincial ecosensitivity criteria. (Site will open in a new window.)

If the property qualifies and the charity is willing to accept the donation, clients can sever off the area around their cottage and donate the balance of the property, thereby retaining ownership of the cottage, or they can set up a conservation agreement or conservation easement agreement placing restrictions on the title to the land.

Under a conservation easement, clients typically give up certain use and development rights to the property, such as the right to cut trees, build roads or introduce non-native species. To determine what an easement is worth, appraisers assess the property, first to determine its worth without restrictions, then its worth after the restrictions are placed on the title.

Life interest arrangements allow clients to transfer the property to the charity immediately under an agreement whereby they can continue residing there, using the property for limited purposes. Some arrangements are also made, within limits, where clients can reserve the right for future generations to use the property as well.

“There’s a lot of flexibility in the way that people can approach things,” says Hamilton. “The very basic criteria is that the land is worth protecting.”

Filed by Kate McCaffery Advisor.ca, kate.mccaffery@advisor.rogers.com

(08/22/06)