Keeping the cottage in the family

(June 2007) Cottages are synonymous with family get-togethers, but without the proper planning, it’s the real estate agent who could be showing it off next summer.

To prevent a client’s cottage from falling out of the family’s hands, it’s important to figure out who’s going to pay the capital gains tax once the cottage-owner passes the place on to the kids.

“The earlier you start the discussion with the family and the advisor, the easier the solution,” says Christine Van Cauwenberghe, director of tax and estate planning at Investors Group.

Upon the death of the parents, the capital gains tax that results from the deemed disposition can quickly throw children into debt or, in many cases, a lifetime of arguments.

On a cottage, the adjusted cost base can be enormous, especially with the price of vacation properties soaring across the country. Depending on the area, a cabin purchased decades ago for $30,000 can easily command upward of half a million today. With capital gains tax being levied on 50% of the difference, children could be left paying tens — or even hundreds — of thousands of dollars.

“If the estate has other liquid assets, that may not be a problem,” says Van Cauwenberghe, “but a lot of people don’t have that cash.”

Fortunately, there are ways to mitigate the capital gains tax burden. Van Cauwenberghe says the use of life insurance to offset future tax liability is one strategy that has gained traction.

“The value of cottages in Canada has been rising quite dramatically, and children can’t afford to pay the gains,” she says. “That’s why insurance has become a much more popular option.”

The trick can be predicting the future value of the property.

“We can come pretty close to figuring out what we think the amount of tax would be owing on the cottage at the time of death,” says Greg Holohan, an investment advisor at Scotia McLeod. “Buy a paid-up life insurance policy, and you’ll know that the kids will have enough money to at least pay the gains tax on the cottage.”

Holohan sees more clients choosing the life insurance route, but there are still many cottagers who don’t understand how it works. “It’s up to the advisor to re-educate clients on life insurance,” he says. “A lot of people think about it the same way they thought about insurance when they were in their 30s — that it’s so a spouse will be looked after. In this instance, it’s not about income protection.”

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One way to reduce the amount heirs will owe the government is to include renovations when determining the initial purchase price. If a client bought a cottage for $50,000, then added a deck and upgraded the kitchen and bathroom for another $50,000 at any point over the years, the ACB could be calculated as $100,000.

“This doesn’t include a new coat of paint or fixing light bulbs,” says Van Cauwenberghe. “It has to be a capital expenditure.” It also doesn’t include what she calls “sweat equity” or an owner’s labour costs. If someone was hired to work on a new deck, then that cost can be included, but if your client and family spent years building a front porch, they can’t calculate hourly wages for themselves. However, spending $2,000 on lumber every summer in order to build a new deck should be tallied. “Those expenses can add up over a number of years,” says Van Cauwenberghe.

Another way to alleviate some of the capital gains burden is to claim the cottage as the primary residence and designate the client’s house as the secondary home. The logic is that more often than not, the gain over the ACB for a home is less than that of a cottage.

“If a house was located in an area that hasn’t appreciated significantly, and you have a cottage in Muskoka, at the time you sell the property, or if [your client passes away], the executors can decide which has appreciated more and which should be subject to the personal residence exemption,” says Holohan, who adds that a lot of older people who sell their homes to buy condominiums might want to consider this option.

This works best if your clients have owned their house for at least as many years as the cottage. If not, and if they have bought and sold a few places before changing their primary residence to their cottage, they’ll have to pay capital gains taxes on their previous homes.

Whatever option your client chooses — and there are several more complicated ways to cut down capital gains taxes — both Van Cauwenberghe and Holohan say it’s imperative to discuss the family’s needs first.

“How is someone going to give their cottage to their children?” asks Van Cauwenberghe. “It’s not so much a tax issue as an emotional and family issue.”

She says many families avoid talking about their cottage’s future, but it’s better to do it sooner than later. Holohan adds that part of the advisor’s job is to talk to clients about these challenging, emotional issues.

“An advisor should be included in a conversation like this,” he says. “You get to understand the family dynamic really well. You get to understand the motivation of the children, how they perceive the parents’ financial situation. The big picture gets revealed.”

Planning early can help diffuse some of the tension that might occur after the parents have passed away, but more importantly your client can start deciding the best way to minimize the tax hit. If an insurance policy is the answer, it’s best to put those wheels in motion today, before a client is forced to pay high monthly premiums due to old age and failing health.

If your client’s not sure what the best option is, there’s always one other way to go. “You can just do nothing,” says Holohan. “If an investment portfolio is sufficient enough to pay the gains tax, going through the trouble to set up a trust or buy life insurance might not be worth it.”

Filed by Bryan Borzykowski, Advisor.ca, bryan.borzykowski@advisor.rogers.com

(06/08/07)